Opportunity Zone Fund Appeal Shows Staying Power
Tax policy uncertainty and sky-high markets are driving investor interest, but changes could be on the way.
As property and equity markets picked up steam in 2021, Opportunity Zone tax incentives attracted investors at a stepped-up pace. Through the first three quarters of the year, 1,243 funds raised some $20.3 billion, a 15.8 percent year-over-year increase, according to Novogradac, the research and advisory firm.
As 2021 ended, the question was whether potential investors will continue to be as enthusiastic about Opportunity Zones until fundraising comes to a halt in 2027. If investors wanted to receive one of the added benefits of the program—a 10 percent capital gains tax reduction for investments held for five years—they needed to write a check to a fund by the end of 2021.
That issue, in turn, raises a potentially pivotal question for Opportunity Zones, the incentive which allows Qualified Opportunity Fund investors to defer taxes on capital gains from equities, real estate and other investments in return for deploying the proceeds into property developments and businesses in economically challenged areas.
To a large degree, observers say, the program’s long-term appeal to investors hinges on tax policy. While the budget bill under debate on Capitol Hill at the end of the year would leave capital gains and ordinary tax rates unchanged, it called for some tax hikes, including a 5 percent and 3 percent surtax on adjusted incomes of more than $10 million and $25 million, respectively. Additionally, the tax cuts in the 2017 Tax Cuts and Jobs Act are set to expire in 2025.
“We’re having a huge rush at the end of 2021, but I think we could see even more demand in 2022 as we get more clarity on taxes,” said Michael Episcope, co-CEO of Origin Investments, a Chicago-based crowdfunding specialist. “If taxes go higher in the future, especially the capital gains rate, people will want to be in the most tax-advantaged investments available, and there is nothing better than an Opportunity Zone.”
Origin Investments closed a $265 million QOF this past summer and recently launched another with a $300 million target. The first fund financed 12 projects, Episcope said, including the development of Forth at Navigation, a 300-unit project in Houston’s East End neighborhood. Its second fund is investing in multifamily construction, primarily in Sun Belt markets.
Blake Christian, a tax partner with the HCVT accounting firm in Park City, Utah, acknowledged that the 10-percent tax reduction was meaningful, but he expects long-term investors to continue to plow money into the funds for some time. That’s particularly true given the robust gains that the stock and crypto currency markets generated in 2021, he explained.
“2021 may be the high-water mark as far as dollar infusions, but I think there will still be plenty of money interested in these funds,” he said. “Investors have big capital gains, and I think people are taking their chips off the table and reallocating capital, especially if they think taxes will be higher in the future.”
In late 2021, Christian launched an OZ fund with the goal of raising as much as $10 million to build a business that converts shipping containers into sustainable modular units for housing and other uses.
One of the biggest benefits of the OZ program is its long-term tax forgiveness for investments held for 10 years, said Ian Formigle, chief investment officer of CrowdStreet, an Austin-based crowdfunding marketplace. Between its two QOFs and investments in OZ deals on its platform, CrowdStreet has funded $120 million in OZ projects. They include Edge, a $62 million community in Bayonne, N.J., and Solace at Ballpark Village, a $45 million property in suburban Phoenix.
“As the OZ program has matured and investors understand it better, we are seeing them have a greater appreciation for that benefit,” Formigle reported. “A tax-free gain on an investment with a potential 2.5x-to-3x multiple over the next 10 years is really what’s driving a lot of investment interest on our platform right now.”
While investors who failed to write a check to a QOF by the end of 2021 missed the opportunity to lower their eventual tax bill by 10 percent, that could change. Federal legislation introduced last year would have extended the eligibility period for tax breaks.
Those measures failed to make headway amid other policy priorities, but experts anticipate changes, and any legislation would almost certainly build in oversight. Critics have charged that the incentive disproportionately benefits the wealthy and that the census tract designations approved for investment include affluent areas. What’s more, President Joe Biden campaigned on beefing up OZ compliance to ensure the program was fulfilling its mission.
Last November, a House Ways and Means Committee heard testimony regarding improving the program. Among the participants was David Wessel, a senior fellow at the Brookings Institution and the author of “Only the Rich Can Play,” which digs into OZ incentive impacts. Wessel, also a former Wall Street Journal reporter, told the committee that Congress should reconsider how Opportunity Zones are designated and limit the program to affordable housing and other assets or activities that clearly benefit communities. The bulk of OZ investment, argued Wessel, is producing real estate projects that likely would have happened without the incentive.
The hearing followed a U.S. Government Accountability Office report on the incentive, which largely concluded that the program was working but needed enhancement. Notable findings include:
- the OZ incentive supported at least $29 billion in new equity investment through 2019
- the OZ designation process in 2018 succeeded in targeting high-need communities
- the IRS should increase efforts to evaluate and address potential compliance challenges
OZ participants have anticipated tweaks to the program, and nobody is resisting the idea of some level of reporting and oversight, Christian said. At the hearing, Ways and Means Committee members stated they didn’t want to eliminate the incentive, and whether changes would hinder future investment remains to be seen. But as of now, experts anticipate QOFs will keep raising cash.
“The OZ program has a fair amount of runway ahead, and you’re going to continue to see investment in the funds,” said Jessica Millett, chair of the tax practice group at the Duval & Stachenfeld law firm in New York City. “It’s not right for every project, but if you’ve got the right kind of deal in the right location and the right investors lined up, then it’s still a very powerful incentive.”