All over the country, there are distressed communities that need investment. But except for the occasional local charity, there really hasn’t been a straightforward way for individuals and nonprofits to invest in these neighborhoods in need, until now. Today, there’s Opportunity Zones.
Last year’s Tax Cuts and Jobs Act contained a provision that should be on the radar screen of every investor, philanthropist, nonprofit, and community leader in the country: the creation of Opportunity Zones. The promise of the legislation behind the newly created Opportunity Zones is to positively transform designated low-income communities by attracting private capital that might not otherwise be invested in such communities.
What Is the Opportunity? Where Are the Zones?
To attract the investment, the legislation offers compelling income tax incentives. Individuals or corporations can defer paying income taxes on recognized capital gain by rolling it into a Qualified Opportunity Fund (QOF) within 180 days of selling the appreciated asset. Provided the QOF meets the investment requirements, the gain is deferred until the earlier of when the investment in the QOF is sold or the end of 2026. Partial elimination of the deferred gain is possible if the investment is held long enough—if held for five years, 10% is eliminated, increasing to 15% if held for seven years. Additionally, any appreciation from an investment that’s held in the QOF for at least 10 years is permanently exempt from taxes. The full suite of tax incentives can significantly enhance the after-tax return profile of a QOF investment compared to a comparable non-QOF investment (Display 1).
The legislation permits state governors to designate up to 25% of low-income census tracts in their states as Opportunity Zones. The Treasury Department finalized the designated zones in June for all states.
The selected zones have a total population of 31 million, where half of the people are minorities. The poverty rate is around 31%—the median family income is only 59% of the median for the surrounding area, and the average unemployment rate is over 14%, with many having a rate that is more than 1.5 times the national average. The zones are equally split between urban and rural areas, with fewer suburban regions.
An Opportunity for Philanthropists and Nonprofits, Not Just Taxable Investors
There is an estimated $6.1 trillion in unrealized capital gains held by US households and corporations. Philanthropists and nonprofits have an enormous incentive to help shape how this capital is deployed and perhaps leverage additional complementary investments and resources for these communities as well.
Investing for positive social and environmental impact in underserved communities, in addition to financial return for the investor, is by no means a new concept—particularly among community foundations, nonprofits, and other philanthropies with missions focusing on specific geographic areas. This type of investing can be an inordinately expensive and labor-intensive endeavor if the structure, expertise, and economies of scale are not already in place. In many cases, however, philanthropies simply don’t have the internal capacity required to successfully and sustainably invest in this way. The creation of Opportunity Funds eliminates this hurdle, and provides a vehicle for many tax-exempt entities to further leverage their resources.
Further, certain investments made by a private foundation may qualify as Program Related Investments (PRIs), whereby all or part of the invested funds count toward the annual 5% distribution requirement. This could be helpful in a year where a foundation that, due to a sudden inflow of capital or other reasons, is not prepared to deploy the full required 5% of the investment portfolio’s corpus.
The primary purpose of investments in distressed communities is to accomplish one or more of the foundation’s exempt purposes, so production of income or appreciation of property is not intended to be a significant driver. The cost and complexity of structuring such an investment may be prohibitive for an individual foundation, but Opportunity Funds may provide pathways for foundations to perhaps elect a lower-than-market rate of return and qualify its investment as a PRI in this way. So while nonprofits do not receive the tax advantages of private investors, they certainly achieve mission synergy and some expectation of financial return.
Finally, this period of development of Opportunity Funds presents an opportunity for a diverse mix of community stakeholders to provide input and guidance on a collective vision for success. This may include complementary programs such as targeted job training, childcare, and other services that best position residents of the designated zones to benefit from an influx of private investment.
Numerous questions remain. What are the certification requirements for a QOF? How long can eligible capital sit in a QOF before it must be invested? Can capital be recycled in one QOF through multiple investments? Will states apply the same tax breaks?
The Opportunity Zone program holds a lot of promise, but there are many aspects of the legislation that require guidance before it can really take off. The IRS and Treasury Department have indicated that providing this guidance is a high priority, and state and local governments are in the process of legislating their own rules. The clock is ticking on the program, and investors and community stakeholders are eagerly waiting and watching.
For more on timely topics for nonprofits, explore “Inspired Investing”, a new Bernstein podcast series that covers investing, spending, policy and more for Endowments & Foundations, and for additional thought leadership, check out the related blogs here.
The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.