No Shock

The Wall Street Journal reported last week that opportunity zone funds are falling short of capital raise expectations.  The article notes that opportunity zone funds, on average, have raised less than 15% of their goals, which I am taking to mean their offering size.  This shortfall comes as no shock, and it's not because of the neighborhoods where properties are located.

An investment in opportunity zone separates when capital gains taxes are due from from when capital can be removed from the opportunity zone to maximize the benefit.  Capital gains taxes must be paid in 2027, and this is a hard date no matter when the opportunity zone investment is made, but an investor must hold the investment for ten years to have all profits from the opportunity zone exempt from taxes.  Investors, therefore, must have other means to pay their capital gains taxes in 2027 than from funds they invested in the opportunity zone.

An opportunity zone fund investment triggers the capital gains tax event, where other investments can continue the capital gains deferral.  An investor in an opportunity zone fund must pay capital gains taxes in 2027, but an real estate investment in a 1031 exchange, for example, can continue to defer taxes.

As time goes by, I don't expect opportunity zone fund sales to increase because the time value of the deferral continues to decline.  By the end of 2020, all step-ups (added incentives) for investing in opportunity zones end, which reduces the incentive to invest in opportunity zone funds, but capital gains taxes are still due in 2027.

It seems to me that the opportunity zone provision was structured to benefit specific properties or one-time events, not as a sustained program to provide long-term benefits through continued opportunity zone investments.  Since I began to write and edit this post last week, I have read two news articles that confirm my opinion that opportunity zones were designed for specific, already in progress projects.   This story from ProPublica talks about Dan Gilbert in Cleveland, and the New York Times details Michael Milken's influence to qualify for tax breaks for his properties, including this passage:

The former “junk bond king” has investments in at least two major real estate projects inside federally designated opportunity zones in Nevada, near Mr. Milken’s Lake Tahoe vacation home, according to public records reviewed by The New York Times.

One of those developments, inside an industrial park, is a nearly 700-acre site in which Mr. Milken is a major investor. Last year, after pressure from Mr. Milken’s business partner and other landowners, the Treasury Department ignored its own guidelines on how to select opportunity zones and made the area eligible for the tax break, according to people involved in the discussions and records reviewed by The Times.

The unusual decision was made at the personal instruction of Mr. Mnuchin, according to internal Treasury Department emails. It came shortly after he had spent time with Mr. Milken at an event his institute hosted.

To make opportunity zone properties sustainable, the timing of capital gains payments needs to be adjusted to match the timing of investment.  The period when capital gains are due needs to be tied to when the investment is made, such as a fixed seven-year time frame, not just a random hard date (2027), which erodes the value of the deferral as the date approaches.  A 10% or 15% step-up should be a permanent incentive.  These changes would help encourage ongoing investment in opportunity zones by providing continued investment and incentive.

Even with political influence and map making that would make a partisan gerrymanderer blush, without a change to make opportunity zone investments attractive over time, I suspect higher values of many properties ascribed by the tax law will languish due to lack of long-term demand inside the opportunity zones.  Future opportunity zone articles are going to focus on the people who had projects in the works before the tax law changed, used their influence to get their properties included in an opportunity zone, then sold the projects a profit because of value of the tax benefit, and how future buyers experienced lost value due to lack of development tax incentives for surrounding properties.