Balancing the goal of benefiting low-income communities under the Opportunity Zone regime with the statutory framework that was enacted in the Tax Cuts and Jobs Act is a challenging task. Treasury may be limited in what it can do to conform the provision to its stated objectives, while nonprofit organizations try to shape the law’s outcomes.
The tax benefit of section 1400Z-2 accrues exclusively to taxpayers with capital gains who reinvest them in qualified opportunity funds. But in 2016, when the predecessor to section 1400Z-2 — the Investing in Opportunity Act of 2017 (H.R. 828) — was introduced, Sen. Tim Scott, R-S.C., Sen. Cory A. Booker, D-N.J., and then-Rep. Patrick J. Tiberi explained that the objective was to match up “American investors [that] have trillions of dollars of inactive capital” and the “more than 50 million Americans [who] live in economically distressed communities.” They said that if the investors’ capital was reinvested, it “could be used as an important new source for catalyzing growth and opportunity in areas that need it most.”
Because of the exclusion from tax of post-acquisition gain from a QOF investment held for at least 10 years, “investors may be incentivized to seek out the deals with the highest long-term yields, which may not be the projects that bring about the most impact for the community or its residents,” said Maurice A. Jones of the Local Initiatives Support Corp. (LISC) at a May 17, 2018, hearing before the Joint Economic Committee. Jones said lower-income residents could be displaced from their communities because of the regime.
Many commentators on the proposed regulations pointed to the serious potential ramifications for communities that are already in economic distress. The Congressional Black Caucus reiterated in a comment letter that Congress’s intent was to ensure that the needs of underserved and economically challenged communities are prioritized. The letter asked Treasury to “write final rules that require more robust interaction with communities, promote partnerships with existing local stakeholder organizations and articulate job creation targets or commitments that must be met in order to preserve the generous tax benefits on offer.”
Section 1400Z-2(e)(4) directs Treasury to write “such regulations as may be necessary or appropriate to carry out the purposes of this section.” Treasury also has more specific mandates to write certification rules for QOFs and antiabuse rules. The theme of targeting investments to improve the economic opportunities of people living in Opportunity Zones that was often repeated by legislators is only hinted at in section 1400Z-1 and not mentioned at all in section 1400Z-2. Congress left important clues about what it wanted to see in regulations in the legislative history. But those directives aren't statutory, and consequently, there’s no guarantee that the capital that proponents of the regime hope will be “unlocked” and reinvested in QOFs will result in a benefit to the residents of the zones. Treasury might be able to change that by steering the program so that it would benefit the communities living in Opportunity Zones, said Mark E. Wilensky of Meltzer, Lippe, Goldstein & Breitstone LLP.
Conforming Rules to Congress’s Purposes
Section 1400Z-1 offers perhaps the best statutory indicator of what legislators claimed they were doing. A qualified Opportunity Zone is defined as a population census tract that is a low-income community designated as a zone. The statute cross-references the new markets tax credit in section 45D for the definition of low-income community. But none of that is a clear statement that one of Congress’s purposes was to benefit those communities. To compound the problem, the 2016 version of section 1400Z-2 required Treasury to report to Congress on the Opportunity Zone regime and specifically asked for “an assessment of the impacts and outcomes of the investments in the zones on economic indicators including job creation, poverty reduction, and new business starts.” That requirement, which offered more color on what the drafters considered the purpose of the statute, wasn’t included in the final bill.
Certification
Subsection 1400Z-2(e)(4)(A) and (C) gives Treasury carte blanche to write rules for the certification of QOFs and to prevent abuse. The certification process hasn’t been addressed in proposed regulations, but the IRS released a final Form 8996, “Qualified Opportunity Fund,” and instructions in January.
The final form and instructions suggest that the certification process won’t be where Treasury and the IRS will attempt to focus the regime on directing greater benefits to the residents of the zones, because the form allows QOFs to self-certify. That’s inconsistent with the conference report, which said, “The provision intends that the certification process for a qualified opportunity fund will be done in a manner similar to the process for allocating the new markets tax credit.” Section 45D(c)(1) required Treasury to create a certification process for organizations that want to be community development entities.
The community development entity certification process requires a demonstration that the applicant has a primary mission of serving low-income communities and is accountable to residents of those communities. Those substantive requirements are statutory, not regulatory. However, the certification and annual reporting process for community development entities includes a review of applications by Treasury’s Community Development Financial Institutions Fund that is quite different from the requirement to file Form 8996. The Investing in Opportunity Act text didn’t mention the certification process.
A robust certification process for QOFs could help enhance the community benefit purpose of the statute and would probably be the best way to ensure that residents of zones benefit from the investments, said Brett Theodos of the Urban Institute. But Treasury has signaled that it will allow QOFs to self-certify and probably won’t impose additional requirements beyond what the statute listed. Theodos noted that the comment letters from community and nonprofit groups explained that the certification process would have a large impact on the outcomes for the communities in Opportunity Zones.
Guidance Changes
Even if Treasury doesn’t put more stringent requirements on the certification process, there are options for tightening the Opportunity Zone regime in smaller ways to better focus it on delivering economic benefits to zone residents.
Eliminating the rule in the proposed regulations that requires 50 percent of a qualified Opportunity Zone business’s gross income to be derived from activities within the Opportunity Zone could help support operating businesses, which could in turn improve the employment impact of the regime. LISC explained in its comment letter that this requirement “will make it very hard for QOFs to invest in operating businesses; particularly those which may be located in Opportunity Zones and are employing residents of Opportunity Zones, but which draw their revenues from activities outside of the zone (e.g., a manufacturing plant whose goods are sold outside of the Opportunity Zone).” The LISC letter suggested that if Treasury deemed an income test necessary, there should be a lower threshold for operating businesses and a higher one for real estate businesses on the grounds that operating businesses might expand over time to include assets outside a zone, but that the primary assets of real estate businesses are fixed and should be within the zone.
Wilensky said Treasury could improve the outcomes for zone residents by writing regulations with sufficient flexibility to allow investors and residents to partner up or improve leased property. He said it would be a win for both the equity partners and current zone business owners if there was less pressure in the rules to divest current owners of their property.
Theodos said the 31-month safe harbor in the proposed regulations is favorable for real estate businesses because complicated construction projects take time, but that the safe harbor is unnecessary for operating businesses that must buy equipment, for example. “Unless the real estate is tied to an affordable use case, there is less justification for investing public money in it,” Theodos said. However, it’s unlikely that the 31-month period will be reduced. (Prior coverage: Tax Notes, Mar. 25, 2019, p. 1531.)
Information Reporting
Information reporting is another area Treasury will cover in upcoming guidance. Although the decisions there won’t change the outcome of the regime, they will influence the eventual analyses of it. Congress indicated in the conference report that it expected Treasury to give an annual report on the Opportunity Zone regime starting in 2022. The annual report is supposed to contain information about the number of QOFs, the amount of assets they hold, the composition of investments by asset class, and the percentage of Opportunity Zone tracts that have received QOF investments, “to the extent the information is available,” according to the conference report. Also required as part of the annual report is an economic assessment of the outcomes of the investments. Congress wanted to know about job creation, poverty reduction, and new businesses in particular, but left any other metrics up to Treasury.
The Treasury report was required in the Investing in Opportunity Act, but that part of the statute was removed from the final version of section 1400Z-2. The sponsors of the predecessor bill asked Treasury to include in final regulations “reasonable reporting requirements, including of Fund- and transaction-level information, in order to prevent against waste, fraud, and abuse, and to ensure that the incentive is delivering impact for communities.”
Theodos and Brady Meixell of the Urban Institute encouraged Treasury in a comment letter to add reporting requirements for QOFs and QOF investors, so that fund- and transaction-level data is included and available to Treasury in preparing its report to Congress.
Shaping the Impact
Because of the lack of a statutory requirement that qualified Opportunity Zone businesses employ, house, or primarily serve the current residents of their Opportunity Zone, some QOFs organized by impact investors are agreeing to extrastatutory restrictions in exchange for catalytic funding from nonprofit organizations in a development that could help shape the Opportunity Zone regime or its successors.
The Kresge Foundation on March 18 announced $22 million in guarantee commitments for Opportunity Zone funds established by Arctaris Impact Fund and Community Capital Management. The purpose is to improve the risk-return profile of the QOFs and encourage more investors to invest in them, while also establishing a model for the market that adds features to the funds that aren’t currently required by law. In the announcement of the investment, Kresge’s president and CEO, Rip Rapson, said section 1400Z-2 lacked necessary guardrails such as transparency and reporting guidelines.
In exchange for the guarantees, Arctaris and Community Capital Management agreed to prioritize affordable housing units, invest in job creation, and “prohibit non-productive investments such as those into self-storage facilities.” The fund managers agreed to form community advisory boards, along the lines of what is required under the new markets tax credit.
Aaron Seybert of Kresge said the objective of the foundation’s guarantee agreements and creation of a QOF incubator was to “get under the hood” of the new incentive and see if it could be used as a tool for community development in a way that aligned with Kresge’s priority of helping low-income communities. The funds that have the Kresge guarantees are also likely to be held up as a model.
Seybert added, “If our funds can raise $800 million and generate a market rate return, I think policymakers would see that as a strong indicator for imposing those types of restrictions.” He said he believed that Kresge’s selected funds would do well and that that would provide a strong incentive for other fund managers to adopt similar approaches, because a record of demonstrated community benefits is more likely to lead to the continuation of incentives.
At a February IRS hearing, Michael Novey, Treasury associate tax legislative counsel, acknowledged the suggestions of speakers representing the interests of zone residents but emphasized the limits on Treasury. He noted that those speakers had identified elements that would be “very desirable for a program like this that you don’t currently see in the statute that it is our responsibility to interpret.” He asked for advice on what items might be within Treasury’s authority to act on, but added that, “Our responsibility is focused on the text of the statute, taking into account what we can infer from the statutory structure and other context . . . what Congress wanted us to do.”