A Big Tax Break for Socially Responsible Investing

Steve Baird runs a Chicago real estate firm that is in its fifth generation. It’s a big operation that serves some of the nicest areas in the city and suburbs with brokerage, mortgage and title insurance services.

But in running a family-owned business, Baird said, he inherited his father’s interest in investing in underserved communities. And a recent clarification of a tax incentive for opportunity zones — which are aimed at encouraging substantial investment in communities that need it — has caused him to step up his efforts in these areas.

“You’re going into an area that as a general rule hasn’t had any investment, and people don’t know about it,” said Baird, chief executive and president of Baird & Warner. “A normal investor doesn’t go into these areas and doesn’t understand the economic drivers. When you’re developing in downtown Chicago, you know all those things: demand, community, underwriting. These opportunity zones don’t have that or they’d have attracted investment.”

Generous incentives in the Trump tax cuts that Congress passed last year are meant to persuade people to work through those challenges. They include a reduction of the tax on capital gains that are used for the investment in the opportunity zone and then tax-free gains later from that investment.

Yet the incentives have made opportunity zones such a shiny tax break that investors need to be cautious. Anyone with considerable capital gains from other holdings, regardless of their source, is likely to be pitched on opportunity zones.

Substantial money is at stake. Investors can put any amount of capital gains into these opportunity zones, but many of the funds have minimums of $1 million.

A slew of banks, asset managers, advisers and funds are already setting their sights on opportunity zones. Soon, they will be tripping over one another to solicit wealthy investors. The investments could do a lot of good for the people living in the zones and earn investors a lot of money, or they could do little and enrich only the people running those funds.

Opportunity zones, pushed last year with bipartisan support, were created for a mix of urban, suburban and rural areas. They hark back to plans from the 1980s meant to steer capital into blighted neighborhoods.

These new investment vehicles differ from enterprise zones, which provide incentives like lower property taxes, corporate tax credits and other sweeteners for businesses moving to a designated area.

The structure of the investment is novel. The zones aim to entice people who, after years of increases in the value of their investments, have a lot of “embedded gains,” or taxes that would be owed if those holdings were sold.

Investors can put those profits into opportunity zone funds, which will invest in businesses and real estate in these designated areas. In return, the investors will get various tax breaks on both the investment they sold and the one they made in the opportunity zone.

If they maintain their investment for five years, they’ll get a 10 percent break on the capital gains tax they would owe today; if the investment lasts seven years, the reduction is 15 percent. When the investment in the opportunity zone hits 10 years, the gains on that investment are tax free.

Investing in these zones would seem like a win-win. But not all opportunity zones are the same, and the tax incentive could also keep investors from being sufficiently rigorous with their due diligence.

For starters, some of the zones are a stretch to qualify as neighborhoods in need of help. In Connecticut, South Norwalk, a bustling restaurants and arts area, is on the list. So are East Austin, Texas, where property taxes are rising quickly as property values soar, and Oakland, California, which is becoming San Francisco’s younger, hipper sibling.

There are investors who plan to focus on the edges of opportunity zones. Among them are Avy Stein, a co-founder of Cresset Capital Management, and Larry Levy, a real estate investor and a founder of Levy Family Partners, who have teamed up to raise a $500 million fund. Stein said one of the criteria is that the investments would need to have been worthy without the tax break.

“It makes sense to identify those areas where, with a substantial amount of capital, those communities can change,” Stein said. “It doesn’t make sense to put money into areas where the capital won’t come out.”

Still, an investment like that may not deliver the social return or have the wholesale community revitalization intended by opportunity zones. Investors moved by the social component of the zones will need to closely assess how and where funds are investing. “How do you verify independently that the location where you’re investing is really low income?” asked John Wilson, head of research and corporate governance at Cornerstone Capital Group, a firm that specializes in socially responsible investments. “You want to put an added layer of diligence on this.”

Other nuances, both positive and negative, also need to be considered. For instance, the tax incentives work at full force only if the money put in is the capital gains from another investment. Those gains can be from just about anything — real estate, private equity, a business, public securities, even a house.

“The government wants to unlock money tied up in other investments,” said Craig Bernstein, a co-founder of OPZ Capital, a $500 million fund in Washington focused on opportunity zones. “It can be short- or long-term capital gains. But the only dollars you get the benefit from are capital gain dollars. It’s very confusing.”

Another consideration is the lockup period. For all intents and purposes, it’s 10 years. Real estate investments will probably pay distributions from the rents collected, but the bulk of the investment will be inaccessible for a decade.

Because opportunity zones are a new area of investment, no one has any experience to track.

“We can’t do any due diligence on these funds, per se,” said Chris Pegg, senior director of wealth planning for Wells Fargo Private Bank in San Diego. “Even when someone has a track record of putting together a fund, they’ve never been required to put together a fund so constrained by tax legislation.”

This may cause people to seek established firms or successful real estate investors. But as every prospectus says, past performance is not an indication of future returns. Because most of these investments are going to be through funds, John D. Dadakis, a partner at the law firm Holland & Knight in New York, said he worried about the managers: “Are they going to do a good job or take all the money?”

There are other ways to get a tax break on real estate, by swapping one property for another through 1031 exchanges, which are named after that section of the tax code.

But what makes the opportunity zones attractive is that investors can take back the money they initially put into any investment, not just real estate, or even some portion of the gains and pay tax on it. With the traditional 1031 exchanges, the investor needs to swap real estate for real estate.

The biggest unknown may be how the final regulations will look. Guidance came out last month, and a public hearing is set for January, but there are still areas that are unclear, said Lesley P. Adamo, a lawyer at Lowenstein Sandler in New York.

For one, the ventures that funds invest in are supposed to do a certain amount of business in the opportunity zone, which is what makes real estate attractive. But there could be other options.

“A restaurant that is in an opportunity zone but delivers most of its food outside of it — that creates uncertainty,” Adamo said.

So does the requirement that an investment substantially improve the zone. Does that mean building something new, or rehabilitating an existing business?

“As a tax lawyer, you want to be really careful on how you advise your client,” Adamo said. A decade from now, though, there will certainly be success stories. As Pegg pointed out, investing in the nicest building in, say, San Diego will produce predictable returns and keep your investment dollars safe. But that investment is not where the biggest returns are made.

“The real money has been made in areas that are economically distressed by the person who got into storage facilities or trailer park facilities early,” he said. “Those areas can have astronomical gains, but they require a lot of work.”