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Extension, Roll-Overs and Impact Investing Should be Part of OZ 2.0 Legislation

Published by Michael J. Novogradac on Monday, April 3, 2023

Journal Cover April 2023   Download PDF

Advocates of the opportunity zones (OZ) incentive are looking ahead to the next iteration of the community development resource. Next up: OZ 2.0.

Billions of dollars have been invested in low-income communities over the past five years through the OZ incentive. Through the end of 2022, $34.09 billion in equity was invested in qualified opportunity funds (QOFs) tracked by Novogradac–and that does not include proprietary or private funds that are owned and operated by their principal investors. Adding those investments likely at least triples the investment, which means there has likely been $100 billion or more in investment in low-income communities through QOFs in the past five years.

But a deadline is looming. Investors gain a deferral on capital gains invested in QOFs until the earlier of when they dispose of their asset or Dec. 31, 2026. For investments held at least 10 years, investors pay no taxes on capital gains produced through their investment in QOFs.

Under the current iteration of OZs, there were additional benefits for holding investments for five years and seven years before the end of 2026. Those benefits expired, but investment has continued–likely due to the gain deferral and the exclusion of gain on a 10-year hold.

As stakeholders look at the next steps–including the possibility of interim legislation extending the expiration date by two years and requiring reporting on QOF investments–they turn their eyes toward legislation to extend or expand the incentive: What should a subsequent version of OZ legislation include?

OZ 2.0 is an opportunity to not only retain the incentive, but to enhance its most valuable aspects. There are plenty of desired changes; a survey of Novogradac Opportunity Zones Working Group members turned up 25 potential provisions for the legislation, including 12 considered a “high priority” by at least half of those voting. Of those, three key provisions should be a part of any OZ 2.0: extension, rolling over of interim gains and additional impact investing incentives.

Extension (or Permanence)

Extension is obviously the central part of any OZ legislation, with the current incentive expiring at the end of 2026. The ideal scenario is making the incentive an indefinite part of the Internal Revenue Code.

That would provide long-term stability and under that option, there would be a rolling deferral with inclusion coming eight years from the date of each investment. The current bonus for holding investments five and seven years would also see the clock begin ticking at the date of investment, without a looming deadline by which to make investments for those benefits, while OZs would be redesignated every 10 years by governors–with enough runway to allow investors to adjust.

Alternatively, Congress could consider another fixed OZ period, such as a 10-year window starting when the current legislation expires at the end of 2026 (or 2028 if the incentive is extended as advocated by legislation in the previous session of Congress).

With a second (or an indefinite) period for OZ investment, other changes that would be beneficial, starting with the ability to reinvest gains and additional benefits for deeper impact investing.

Ability to Roll Over Interim Gains into Another OZ Investment

The primary benefit of OZ investment is that a taxpayer excludes from taxable income new gains if their OZ investment is held for 10 years. The problem? Many investments–particularly those in non-real estate businesses–have an investment period shorter than 10 years. Under the current rules, that makes them ineligible for the 10-year benefit.

However, if OZ 2.0 allowed taxpayers who hold their investment for less than 10 years to roll over their investment (or gain) into another qualified investment without restarting the 10-year clock, it would both meet the desires of the taxpayer and increase the volume of the investment in OZs. Both investors and OZs would win.

Making that change would bring in new investors and generate greater investment in OZs.

Additional Benefits for Deeper Impact Investing

Deeper impact investing–making investments in properties or businesses with greater social benefits–could be rewarded under OZ 2.0 by tying a bonus tax benefit to certain types of investments. Consider a scenario where an investor could see a basis step-up of 50% of their deferred gain (rather than the current maximum of 15% for a seven-year hold) for specific types of investments. This would encourage more developments with greater targeted benefits–such as affordable housing. Education, health care and renewable energy are among other types of specific OZ investments that could be further incentivized under OZ 2.0.

Other Enhancements

The Novogradac Opportunity Zones Working Group’s wish list for OZ 2.0 provisions included several other provisions, including:

  • QOFs reasonable expectation for qualified OZ businesses,
  • an extension of the QOF reinvestment rule to qualified OZ business reinvestments,
  • allowing related-party acquisitions to qualify if property is overwhelmingly improved (by at least 100% of the acquisition basis),
  • modifying the 30-month substantial improvement period, and
  • allowing improvements to nonqualified property to qualify as OZ investments.

The OZ Working Group intends to provide a complete list of its recommendations to members of Congress during 2023.

Likely New Designations

Governors made the first OZ designations in 2018. Due to changes in census tract income levels, poverty rates and demographics–some driven by OZ investment–periodic redesignations of census tracts as OZs is warranted. Changing OZ designations to a rolling 10-year period (in the case of permanence) or a upon renewal (in the case of a set-period extension) is a likely provision in any OZ 2.0 legislation.

Two-Year Extension, Reporting Requirements

The Opportunity Zones Transparency, Extension and Improvement Act was introduced in 2022. That bill, which would have extended the incentive by two years, added reporting requirements and provided an early sunset date for non-impoverished OZs, is likely to be reintroduced in some form in this Congress.

The bill would also have allowed QOFs to be organized as “funds of funds” to invest in other QOFs, a provision that would allow smaller businesses or projects to receive funding. It had six co-sponsors in the Senate and seven in the House of Representatives and was a candidate for inclusion in year-end tax legislation. However, no widespread year-end tax bills passed (or were introduced), so the bill will need to be introduced again this year. OZ 2.0 would presumably come after that legislation is enacted and would likely retain the reporting provisions.

Timing, What to Do Now

We are a few years away from a strong push for OZ 2.0 because major modifications take time to prioritize changes, draft legislation, get sponsors and wait for the ideal legislative vehicle. One opportune time is when most Trump-era tax cuts expire in 2025, a period when both Republicans and Democrats will be incentivized to pass major legislation.

Until then, advocates will do well to prepare legislation and rally supporters. For those in the field, making federal representatives aware of OZ-financed properties in their districts makes a huge difference. Like with other community development tax incentives, it’s not always obvious to elected officials when an incentive helps finance a beneficial project in their state or district. Including members of Congress on communications and invitations to groundbreakings and grand openings is a great way to share how this major tax incentive is making a difference where their voters live.

Be sure to share your thoughts with the OZ Working Group as they continue to evaluate the incentive and advocate for the next generation.

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