2020 was a turbulent year. The year started with an impeachment trial, and then a once-every-hundred-year pandemic shut down the U.S. economy. The year ended with a presidential election where each candidate received a record breaking number of votes with the incumbent president challenging the election results.
In 2021, we are now facing an economic crisis as a result of this deadly pandemic. The U.S. Bureau of Labor Statistics recently reported that, as of January 2021, the unemployment rate was 6.3% or 10.1 million unemployed persons.1 This is almost twice the amount of the pre-pandemic levels (3.5% or 5.7 million). The Economic Policy Institute (EPI) has provided that the labor market is down 9.9 million jobs since February 2020.2 EPI claims that after adjusting for misclassification and undercounting and taking into account folks that have quit the labor force, 25.5 million workers are considered to be jobless or have seen pay and hours drop as a result of the pandemic.3
The Biden administration will be engaging in a number of policies which differ from the previous administration including changes in public health, fiscal policy, immigration, and energy. The Biden administration has been signaling the need for economic recovery legislation, which could be in the form of an infrastructure plan. Still, the OZ incentive could be a significant economic recovery tool and can be combined with any possible incentive included in such plan.
The purpose of the OZ incentive is to encourage the making of long-term investments of private capital in certain population census tracts, called Qualified Opportunity Zones (QOZs), and to increase the economic growth of such QOZs. To date, the OZ incentive has been used frequently for making investments in real estate projects.
Here is why the OZ incentive could be an important recovery tool, especially with respect to providing financing to start-up businesses, and infrastructure projects.
THE OZ INCENTIVE SUBSIDIZES EQUITY INVESTMENTS
The OZ incentive is unique as it provides a subsidy for investors to make equity investments in real estate projects and operating businesses located in QOZs. It provides three income tax incentives to investors and rewards the investors for holding their investments for at least ten years.
During the last major economic crisis, the American Recovery and Reinvestment Act of 2009 provided a number of incentives which included low-interest loans, loan guarantees, and grants to certain projects and businesses. The OZ incentive is functionally different as it directly subsidizes investors for making equity investments in real estate projects and businesses (including infrastructure projects). It is an inherent prerequisite with this incentive that these projects and businesses have certain fundamentals for the potential of success. This results from the exclusion of gain on the disposition of the underlying investment after an investor has held an interest in a Qualified Opportunity Fund (a QOF) for at least 10 years. Generally, investors need to make a business determination that they believe that their investment in the QOF will appreciate over this ten year period.
The ten year exclusion offers a valuable income tax benefit that should hopefully allow investors to reduce their expected minimum rate of return and invest in a project or business that has a cash on cash expected return outside their typical investment criteria. Obtaining equity capital that is difficult to find and/or obtaining less expensive equity capital is attractive for any project or operating business.
CAN BE USED WITH OTHER INCENTIVES AND DEBT FINANCING
The OZ incentive is a very flexible economic tool as it can be used with most other federal, state, and local incentives. Below are some examples of incentives that have been combined with the OZ incentive:
- Federal historic tax credits involving the rehabilitation of buildings located on the National Register of Historic Places
- State or local grants including the grant of real property for development purposes
- Real property tax abatements; and
- State tax credits designed to work in conjunction with the OZ incentive.
PLACED-BASED NATURE OF THE INCENTIVE
The OZ incentive is targeted to particular population census tracts rather than certain industries. It is a broad incentive that can be used for most businesses where the location requirement is satisfied.
The locations for QOZs are based upon economic criteria and the specific QOZs were chosen by each of the states. A population census tract was eligible to be nominated to be a QOZ if the population census tract had (1) a poverty rate of at least 20%, or (2) a median income below 80% of that in the state or metropolitan area, or 80% of that in the entire state, in the case of rural areas. A small number of eligible tracts included tracts that were contiguous to a tract meeting the requirements set forth above and where the median income of such tract was less 125% of the qualifying contiguous tract. There are 229 QOZs that meet this contiguous category. There are approximately 8,766 QOZs across all 50 states, six territories, and the District of Columbia. QOZs represent approximately 11 percent of all population census tracts.
The placed-based nature of this incentive allows the subsidy to target projects and operating businesses located in areas that are distressed and in need of jobs and private capital. Economic Innovation Group (EIG) found that the 8,766 QOZs had an average poverty rate that was more than double that of the entire United States.4 EIG also found that close to one-third of prime age adults in the average QOZ were not working as compared to 22% across the entire United States.5 It should be noted that there have been a few articles that have been critical of the OZ incentive by discussing certain QOZs which appear not to need any incentive for private capital investment. Senate Bill 2787, introduced by Senator Wyden, on Nov. 6, 2019, was released in response to such articles, proposes to sunset the status of most of these tracts and allow the states to replace these QOZs with tracts meeting the economic data set forth above. Senate Bill 2787 or something similar has a greater chance of passing now that the composition of the U.S. Senate has changed.
The OZ incentive has the ability to solve certain place-based problems. For example, EIG determined that QOZs (which represent 11% of all tracts) account for more than 28% of the nation’s food deserts (i.e., low-income population census tracts without a full-service grocery store within a one-mile radius in urban areas and within a 10-mile radius in rural areas).6 The New Markets Tax Credit (NMTCs), another placed-based incentive, has been used for the financing of full-service grocery stores in these food deserts. The OZ Incentive can also be paired with the NMTC (thereby also resulting in a direct subsidy for the operating business) or it can be used as stand alone incentive for this same purpose.
BUSINESS FRIENDLY REGULATIONS AND PATIENT CAPITAL
Fortune recently reported that approximately 100,000 businesses have been permanently shut down as a result of the COVID-19 pandemic.7 The good news is that the final regulations that were released in December 2019 were favorable for operating businesses, and in particular, start-up businesses. There are a number of requirements for an operating business to satisfy to be considered a “qualified opportunity zone business” (a QOZB). The final regulations provided business friendly rules for entities to qualify as QOZBs with respect to certain situs requirements involving both location of employees and location of assets in a QOZ.
As stated above, investors in a QOF are required to hold their qualifying investment for at least ten years in order to obtain the exclusion of the gain on disposition. This long-term holding requirement has often been referred to as “patient capital.” Patient capital is important for business owners since it relieves the pressure to produce immediate results for the investors and allows the owners to concentrate on achieving long term growth. Obtaining patient capital can also be helpful for operating businesses struggling with fixed payment costs such as rent and debt service.
FAST DEPLOYMENT OF CAPITAL IS CRITICAL
New incentives may be developed as a response to this economic crisis. However, timing is everything with respect to any crisis, and new incentives may not be immediately impactful. The OZ incentive already has a track record for both raising and deploying capital.
Novogradac & Company LLP has been keeping track of 927 qualified opportunity funds. As of Dec. 31, 2020, 659 of these funds have reported to have raised $15.16 billion in capital.8 This represented a $3.11 billion increase from their last update, which was data through August 31, 2020. Note that this data does not include information proprietary or private funds that are owned or managed by their principal investors. The Council of Economic Advisors recently made an initial assessment that $75 billion of private capital had been raised as of the fall of 2020.9 Whether or not this estimate is correct, the fund raising performance of the OZ Incentive speaks for itself.
Another critical factor to consider in favor of the OZ incentive is that an entire industry has been developed in this space. State and local governments have spent considerable time understanding this incentive. Many states have developed complementary placed-based incentives. Professionals such lawyers, accountants, and business consultants have developed expertise in this area, and have been engaged in the deployment of the capital raised by QOFs. Real estate developers have been using this incentive on a regular and frequent basis to raise and deploy capital for their projects.
THE FUTURE OF OPPORTUNITY ZONES
The use of the OZ incentive for operating businesses is an area that remains untapped. Ironically, the incentive was created to provide venture equity to operating businesses. In fact, John Lettieri, President and CEO of EIG, testified to the House Committee on Small Business in October 2019, that the central purpose of the OZ incentive was to support new businesses and existing small and medium sized firms in need of growth capital. It was further stated by EIG that roughly 75% of venture capital goes to just three states.
As legislation is crafted in response to this economic crisis, consideration should be given to possible changes to the OZ incentive that can make this incentive even more impactful. Some of these possible changes are already part of proposed legislation. For example, Representative John Curtis (R-UT-3) proposed relaxing the 70% asset test for small businesses located in an OZ.10 . Proposals to extend the OZ incentive have been made as well as other useful changes. Efforts should be made to consider some of these proposals in any upcoming economic recovery legislation.
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