Opportunity zones are the tax shield tech wanted — but is it living up to expectations?

A rendering of Canton Lofts, an opportunity zone housing development in Seattle’s Pioneer Square neighborhood. (Nitze-Stagen Image)

It’s been more than three years since Republicans unveiled a plan to encourage high-net worth Americans to invest in economically distressed areas as part of the 2017 tax overhaul. Opportunity zones were billed as a tool to lift up communities left behind by the modern economy — and if the wealthy got a generous tax break in the process, all the better.

The program was the brainchild of several high-profile investors from the tech industry, where soaring stocks lead to big gains. By immediately investing those gains into a fund in a designated opportunity zone, investors can defer their capital gains tax and avoid paying taxes on the profits of the new investment altogether.

But despite the early enthusiasm, tech leaders haven’t rushed to invest in opportunity zones with the fervor many expected. And early studies suggest the program itself has done little to help the communities that need it most.

Now, as the economy jolts back to life and the Biden administration considers a capital gains tax hike, opportunity zones face an uncertain future. The program could become an even greater “windfall for the rich” than some predicted, or it could languish under too much political uncertainty.

A new political climate

President Joe Biden’s plan to raise the capital gains tax rate to 39.6% for households earning more than $1 million annually could sweeten opportunity zone investments. If investors will be on the hook for higher capital gains taxes down the line, it could encourage them to cash out now and funnel the money into an opportunity zone fund, which allows them to defer capital gains tax after sitting on the investment for a decade.

But investors aren’t certain the tax benefits will become more attractive in the future because of comments Biden made on the campaign trail. He signaled his intention to reform opportunity zones so that they do more to benefit low-income areas. It remains to be seen whether those promises will be realized given the administration’s other priorities, but the federal government has taken some steps to clarify the opportunity zone program. In late 2019, the Treasury finalized new regulations that make it easier for people with capital gains from the sale of a business to invest in opportunity funds.

The think tank behind the opportunity zone idea is hopeful that additional regulations will address some of the equity issues that the program has raised and attract more investments from the tech sector.

Formed by high-profile tech entrepreneurs, including Napster founder Sean Parker, The Economic Innovation Group first pitched the opportunity zone program to the Trump administration. In March, EIG — along with the U.S. Chamber of Commerce and other business groups — proposed reforms to the program that could make opportunity funds function more like venture capital investments.

EIG is pushing the administration to allow fund-to-fund investments between opportunity funds so that small investments can be pooled and diversified. The recommendations are also designed to improve transparency and reporting, and sunset the opportunity zone designation in neighborhoods that are already booming.

“From the tech industry it is not as popular as expected or hoped,” said EIG Research Director Kenan Fikri, noting that tech investors typically prefer a shorter time horizon for returns.

Fikri added: “We know that Congress may be considering some reforms to OZs soon and we’re hopeful that some of those may include steps to make it a little more attractive for an opportunity fund to operate a little more like a venture capital firm, where you can recycle gains from one investment to another and preserve the underlying tax benefits.”

EIG is also hopeful that the share of opportunity zone investments in startups will grow, particularly in rural and economically distressed areas. Real estate investments still dominate the program, but capital gains can be invested in any qualifying business within an opportunity zone.

“It’s hard for rural areas or mid-tier markets to compete with major metropolitan areas on investment returns in real estate,” Fikri said. “However, when you’re talking about investing in a business and seeing a business potentially take off and grow, the playing field is much more level.”

He acknowledged real estate will probably “always be a majority of the market,” but said he is hopeful that other types of investments will become more attractive as the program matures.

It is getting more expensive to invest in real estate in opportunity zones. Home prices in opportunity zones are up 75% year-over-year, according to a report last month from the property database ATTOM Data Solutions.

Opportunity zones or hot real estate markets?

There are more than 8,000 opportunity zones across the country, designated by the governors of each state. Though most of them are low-income communities, a slice of opportunity zones don’t have to fit that designation. That has led to the chief criticism of the program, as investments in some trendy neighborhoods qualify for the tax breaks. Parts of Brooklyn and Seattle’s Capitol Hill neighborhood are opportunity zones, for example.

A study by economists at the University of California Berkeley found that most opportunity zone investments are real estate projects concentrated in higher-income neighborhoods that were already becoming more affluent and popular.

“Investors favored neighborhoods with higher income, educational attainment, home values, and pre-existing population and income growth,” the report’s authors wrote. “These neighborhoods have also experienced significant changes in their demographic composition over the past decade, with increasing shares of college educated adults and declining shares of non-white residents.”

An earlier study found opportunity zones in West Coast tech hubs to have the greatest risk of gentrification. The researchers ranked opportunity zones on a variety of factors, weighing the potential for an investment to deliver a positive financial, environmental, and social return against “social vulnerability,” a measure of how likely residents are to be displaced.

That trend is raising concerns that the program is fueling gentrification under the guise of helping economically distressed neighborhoods. But Fikri said it’s too early to judge the impacts of opportunity zones, a nascent program that emerged during a period of extreme economic uncertainty.

“We’re seeing that some zones are better at attracting money than others,” he said. “Zones with pretty strong fundamentals, where they may be low-income communities but investors don’t face real significant risks that may continue to deter them from wading in, are ones that seem to be benefiting most in the first round here.”

Where tech sees opportunity

Although tech investment in opportunity zones across the country is lower than some expected, that’s not the case in every market. Opportunity zones in tech hubs like Seattle and San Francisco are attracting tech investors who realize gains from stock sales and other assets.

Pinnacle Partners is a Seattle-based opportunity fund founded by former tech executive Jeff Feinstein and Leo Backer, a corporate real estate advisor. With funding almost exclusively from tech execs, Pinnacle is building workforce housing in Seattle’s Pioneer Square neighborhood. The so-called Canton Lofts project is nearly complete.

Projects like Canton Lofts may become more attractive to the tech elite in the next few months. Wealth advisors who work with the tech industry report some clients are accelerating deals to sell startups and stocks to avoid a higher capital gains tax bill down the road.

The tax benefits opportunity zones afford could make Biden’s tax reform plan an inadvertent boon to the controversial Trump-era opportunity zone program. But investors will have to stomach months of uncertainty in the meantime for opportunity zones to truly take off.

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Civic Biden Finance Investment Opportunity zones Politics Real estate Taxes Trump