Leering at the "Opportunity Zone"

A Man having his OZone Touched

The most recent Republican revision of tax law, written for 2018, created a new legal-financial concept called an "Opportunity Zone" also referred to as an OZone. OZones are physical areas where different, looser financial rules apply. The idea behind opportunity zones is ostensibly to encourage development or redevelopment of blighted areas. While this will no doubt happen to some degree, mostly what I see in this law is a massive tax loophole.

The IRS is overdue in publishing many of the specific and detailed regulations regarding OZones, but I'm going to pick apart what has been published, as well as what has been said by the OZones promoters and it's legislative sponsors, to take a look at how it works. Starting with the basic rules:

Investors can defer tax on any prior gains invested in a Qualified Opportunity Fund (QOF) until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026.

If the QOF investment is held for longer than 5 years, there is a 10% exclusion of the deferred gain.

If held for more than 7 years, the 10% becomes 15%.

Second, if the investor holds the investment in the Opportunity Fund for at least ten years, the investor is eligible for an increase in basis of the QOF investment equal to its fair market value on the date that the QOF investment is sold or exchanged.

That's a sizable tax "incentive", though most of the real madness is packed into the last item. There is also the very real question of "what is it incentivizing"? Let's break it down:

1) Investors can defer prior gains if they invest in a QOF until 2027.
This means if I bought some amazon stock in '99 that gained $1 million in value that instead of paying the $200,000 (20%) in capital gains tax I would normal owe, I could invest that $1 million in a QOF, and not have to pay that $200,000 until 2027. The date "2027" doesn't move, so this part of the law, as well as the next two sections, are essentially temporary. That is to say, if I were to sell my amazon stock in 2025, and invest it in a QOF it would be, at most, deferred 2 years instead of the 9 years if I did it now. If I were to sell in 2028 I could not gain any deferment.

2) If the the gains are deferred for more than 5 years, I receive a 10% discount on my taxes.
This means that if I cash out of the QOF in 2023, instead of needing to pay $200,000 in taxes I only need to pay $180,000. This also means that to effectively be eligible for that $20,000 perk, I need to invest before 2022 1. That probably means that there will be a bit of a mad scramble to invest in that year. If we also assume that money has a growth value of 7% per year that $200,000 will make an extra $80,0002 over that 5 years. That brings the tax advantage to a nice round $100,000, or about 50%.

3) If the gains are deferred for more than 7 years, I receive a 15% discount instead of a 10% discount.
This means if I cash out of the QOF in 2025, save $30,000 instead of $20,000. It also means that I would need to invest before 2020 to make it happen3. If we assume that money has a growth value of 7% per year $200,000 would have made an extra $121,000 over that 5 years. That brings the tax advantage to a nice round $150,000, or about 75%.

4) Any gains that are realized in a QOF are entirely tax free!
This means that if that $1 million performs as expected and you make 7% interest on it for 10 years which generates another million dollars, when you pull it out instead of having to pay 20% on your new earnings you will pay $0, saving you $200,000.

There is no upper limit on the amount of money that can be used in these "incentivizing" loopholes, but for all intents and purposes there is a lower limit for who can take advantage of this. These tax cuts only apply to invested income, and are useless to those who's invested income is already locked up in a tax deferred account, such as a retirement account like a 401k, or a school savings account. In short the only people who can take advantage of this are those rich enough to be investing considerably more than a retirement accounts worth.

If that still sounds great because you just don't like taxes, you're probably failing to notice that every dollar that is "saved" is another dollar that the federal government doesn't have to put towards social services, national defense and other obligations. That means that either the nation goes deeper into debt to pay for them, or that someone else picks up the tax bill.4 In this case the people who will largely be "saving" their money from taxation are those in the investor class5. In my opinion capital gains tax is already absurdly low at 20%, It's hard for me to think that any "savings" in this space are a good thing.

What does this law incentivize?

This law is supposed to incentivize investment in bad neighborhoods. The details of how these neighborhoods are designated are a little bit complicated, but honestly the process seems to have worked moderately well, and the designated zones seem to approximately match my own experiences6. The law seems to hope and imply that bringing investment dollars into these neighborhoods will improve them and that the residents will be lifted out of poverty. This seems very unlikely to me given the minimal structure of the requirements on the financial investment.

The best case scenario: Gentrification

In the simplistic and naive version, also the one that seems to have been most planned for, an "opportunity business" buys real estate in one of the OZones and improves it, selling or renting it out at a profit in the process. The law is actually written to support this quite well, with a requirement that significant infrastructure improvements be made on real estate purchased in OZones for the investment to qualify7.
This will likely result in housing being bought by outside investors, renovated to a higher quality level, and rented out at a higher price. None of this really helps the people who live there at all. The impoverished and working poor who live in the OZone generally don't own the houses they live in, so investors buying the real-estate there is unlikely to benefit them directly. Since OZones are generally only part of a city, there is no reason to think that someone would make a special effort to hire folks from the neighborhood to do the renovation. The investors will likely hire whatever construction company they usually work with, so no additional employment flows into the OZone. Finally, the newer and nicer apartments that get constructed or renovated will likely come with higher prices, and essentially not be practical for those who lived in the OZone to rent. They may benefit some from a boost to local tax revenue due to the increased activity in their neighborhood, and the increase in the number of higher wealth people moving in, but that's pretty much par for gentrification anyway.8

There are no provisions in this law to fight gentrification. The fig leaf quote that addresses this concern is:

To help fight gentrification, impact investors can offer cheap renovation loans and subsidized mortgages so locals can benefit from rising property values instead of getting priced out. --Forbs

For those who are unfamiliar with the term "Impact Investor" that's an investor who isn't aiming to make a profit... exactly the sort of organization that wouldn't be worried about taxes in the first place.

The most likely case: Tax loophole

More realistically, there will be a massive amount of money that finds some way to route itself through an OZone, and in the process pay no taxes. The critical thing to realize is that a tremendous number of modern businesses are totally location independent. In much the same way that despite never living in Delaware all of the companies I have incorporated have been incorporated in Delaware, and benefited from its very low corporate taxes, I would expect a great number of companies that have nothing to do with OZones, such as a work from home accounting firm, placing their "office" in a OZone.

This seems to be at least part of the intended outcome of the law:

VCs can plow returns into opportunity funds, deferring taxes and setting the stage for a future tax-free windfall. "If Facebook could have chosen to locate itself in an Opportunity Zone, like the Tenderloin in San Francisco, the investors would've paid no capital gains on their equity," says Parker

The idea of Mark Zuckerberg having literally zero tax liability is honestly terrifying to me.9 To think about this another way: In 2013 Mark paid about $2.3 billion: about 4% of all the taxes collected in California . The year before that was probably about 2%.

If Mark and the other Facebook founders had set up in an opportunity zone, the federal deficit could be that much higher. Software engineers can, and frequently do, work remotely from their homes. Also, we can also see from the offices of major internet companies that were placed in low income neighborhoods, like Twitter in SoMa, that the poor of the neighborhood reap little benefit. I imagine that we will see the next wave of startup incorporations carefully designed to legally be located in OZones. In reality these companies live on the internet.

The Worst Case: Huge Tax loophole

We are still waiting for specific and detailed rules from the IRS, but if they are written badly or loosely, then we can expect to see unmanageably large tax loopholes. Keep in mind that most things we think of as "Corporations" are really large and complicated collections of sub-corporations. They frequently shift costs and profits between their parts in order to minimize tax expense. In the same way, one can imagine a company re-incorporating in an OZone as an OZone business. It then re-incorporates all of its components that are outside of the OZone as subsidiaries. Most of them are arranged to be financially "break even", while most of the profits are funneled to the single office in the OZone. It's the same company for all intents and purposes... but now people who own stock in it don't have to pay capital gains tax.
To the law's credit, it does indicate that it should specifically exclude banking, financial, and holding companies, but how tightly that is defined and enforced remains to be seen.

Increased appetite for risk

If you lose money on your tax deferred investment in an Ozone, you don't still owe the taxes you deferred:

The amount of gain included in
gross income under subsection (a)(1)(A) shall be the
excess of--
``(i) the lesser of the amount of gain
excluded under paragraph (1) or the fair market
value of the investment as determined as of the
date described in paragraph (1), over
``(ii) the taxpayer's basis in the investment.
``(B) Determination of basis.
--The Bill Itself

This means that you would want to drastically increase your risk appetite. Imagine for a moment that there is a casino, where it costs $100 to play. You only have $80 so I lend you $20. I also tell you "If you win, you have to pay me back, but if you lose don't even worry about it". In the casino you can either play "coin flip" that pays off $200 50% of the time, or "roll a die" which pays off $600 16.66% of the time.
Your about 6% better off playing "roll a die", because when you lose you don't have to pay back your losses. My reading is that you can just as easily borrow $200 from me, play 10 times, and segregate the losses so that you come back to me and say "well I lost 8 out of 10 times, so I only need to pay you back $40 of that $200 you loaned me".

Silicon Valley venture capitalists tend to invest by placing many, often hundreds of small bets in startups that have a tiny chance of tremendous success, this is pretty much perfect for them. Imagine the game above, but instead of playing "roll a die" 10 times, I played "One in a hundred" about 300 times. Also remember that an individual company or startup can choose tactics that modify it's riskiness.

Open Question: What happens when an OZone stops being an OZone?

Though there is a lot of detail in the law about how a district is nominated to become an OZone, there is almost nothing about how an OZone stops being an OZone, or what happens to the "Qualifying OZone Businesses" located there when it does. Imagine "New Company" buys a huge complex in Beacon Hill, Seattle and property values go through the roof. All the poor people leave, and after 5 years it clearly is no longer an distressed neighborhood, or even adjacent to any. Does it keep on being an OZone forever? There are no rules that I see to stop that from happening, and I'm sure you can imagine that there would be a lot of political pressure not to remove that status. (Particularly from the now wealthy-er investors in New Company)

Even if it did stop being an OZone, what would that mean for investments? Would the investors with deferred taxes be required to pay them back immediately? Would gains beyond this point still accumulate tax free? Will investors complain of OZone depletion?10 All of these questions remain open.

  • 1. 2022 is an election year. Not sure how relevant that is)
  • 2. But wouldn't you have to pay taxes on that extra $80k? Nope! part 4 of this tax law means you don't have to pay taxes on that at all
  • 3. The presidential election year. maybe I'm seeing things, but it seems like there is some intent to help people remember this tax cut on election years
  • 4. If you think your can "Starve the Beast", you should catch up on your reading... it's been shown not to work http://elsa.berkeley.edu/~dromer/papers/draft509.pdf
  • 5. Like myself. In my life I have payed more in capital gains tax than in income tax. A fair world gives me higher taxes not lower ones
  • 6. I have lived in 3 of the designated opportunity zones, one in Oakland, one in LA and one in Philadelphia
  • 7. It happens I already am a partner in a business that buys, renovates, and rents houses and apartments in an opportunity zone
  • 8. For what it's worth, unlike many San Franciscans I don't think that gentrification is a horrible blight on cities either. I just hold no delusions that it helps alleviate poverty
  • 9. Since he's said he's going to give 99% of his wealth to charity, I guess this actually is already going to happen
  • 10. I'm so sorry, I just couldn't resist