By Salman Siddiqui 

Changes in the Opportunity Zone regulations could incentivize environmental, social, and governance (ESG) focused investments and encourage more OZ investors in this area. 

ESG investments are often a bonus rather than the essential part of a project, tax professionals said. What can be done to spur more ESG-friendly Opportunity Zone investments? 

CONGRESSIONAL DIRECTION IS KEY FOR ESG INVESTING IN OPPORTUNITY ZONES 

Matthew E. Rappaport, who is the vice managing partner of Falcon Rappaport & Berkman PLLC, pointed out that Congress could offer changes to put ESG in focus in Opportunity Zones. 

“If you view OZ as an ESG initiative, Congress would need to pass laws stipulating this. Right now, there are no ESG-related measures in the OZ program as presently constructed,” he said. 

The OZ legislation, which emerged in 2017 as part of the Tax Cuts and Jobs Act, was intended to push private investment in low-income areas with the intention of creating communitywide growth. 

“What was supposed to lead to ESG participation was the designation of the zones themselves, but that process has seen some scrutiny from major media outlets, and the use of 2010 census data turned out to qualify certain zones that didn’t really need the investment as badly,” Rappaport said. 

Even though there are proposals to make impact studies and other ESG measures part of the OZ program itself, none of them is in the currently proposed tax legislation. 

“Without such an obligation, investors don’t have any special motivation to report more than the minimum required,” said tax attorney Forrest David Milder, who is a partner at the law firm Nixon Peabody. 

MAKING ESG IMPACT IN OPPORTUNITY ZONES 

Milder agreed that a change in the rules could spur competition in Opportunity Zones. 

“There is a somewhat comparable provision in the Code, the New Markets Tax Credit (NMTC), in which there is an award of ‘credit authority’ from time-to-time made to entities which present the best case for why they should get that authority,” he said.

 “Like the OZ provisions, projects funded with NMTCs benefit low-income communities. Unlike the OZ rules, the potential allocatees work very hard at demonstrating the good work that they have done with the tax break so as to get later rounds of NMTC allocation.” 

However, according to Milder, the problem is that OZ investing was designed to give a tax break to everyone with a capital gain, “and it did not contemplate any kind of ‘award’ or competition for the tax break, like there is for NMTCs. So, you’d really need a fundamental change in the rules to accomplish this.” 

Milder explains why socially responsible investments are harder under the present OZ rules. 

“Inherent in OZ investing is the possibility of not paying tax when you sell the investment after 10 years. That encourages investments that appreciate in value, regardless of whether they are ‘socially responsible.’ 

“These things make it hard to broadly turn OZ investing into socially responsible investing. Yes, there will be plenty of people who do socially responsible investing with their OZ funds, but mostly, that will be because that is the kind of person that they are, and not because of a motivation provided by the OZ rules.” 

Milder also said a lower tax bill in 2026 could be one of the ways to push ESG investments. 

“If you wanted to encourage ESG, I’d think that your best bet would be to provide a lower tax bill in 2026 (when the deferred capital gain is included in income), or refundable tax credits (to reward certain behaviors), or cheap government companion financing, or some other economic incentive that would encourage that kind of behavior. And you’d have to have some kind of agency (like the CDFI for NMTCs) to monitor and encourage desirable projects,” he added. 

ALTERNATIVES TO CHANGING THE OPPORTUNITY ZONE REGULATIONS 

Not all OZ professionals believe that the OZ regulations need to change. Brett Siglin, a corporate and securities attorney who is a member of Jennings Strouss, cautioned against changing it. 

“Amending the law could potentially further complicate the statute and might confuse or frustrate investors, who may already be on the fence about investing in opportunity zones,” Siglin said. 

“An alternative strategy would be to convince more individuals that investing in qualified opportunity funds could be a potentially lucrative long-term strategy to consider leading ultimately to exclusion of capital gains from taxation,” he added. 

Others point out that attitudes within the private sector of the OZ industry also could change. 

“If this were to happen solely in the private sector, you’d need a change in national attitudes. Right now, ESG seems to involve a lot of window dressing from some of the players in the financial space, while other players view it as a serious mission,” Rappaport said. 

Meanwhile, Siglin said, “it is critical to continue to get the message out to high-net-worth individuals that investing recent capital gains into funds utilizing the opportunity zone incentive is a great option to consider, especially in light of the potential increase in capital gains tax rates and other pending tax changes being considered at the federal level.” 

WHAT ESG STRATEGY WORKS BEST UNDER PRESENT OZ RULES 

The ESG criteria refers to investments based on environmental impact; social impact such as employee and community benefits; and corporate governance impact that assesses issues like transparency and ethics. 

According to Rappaport, currently, most investors seem to be more interested in the societal rather than the environmental projects. 

“I have heard a lot about making sure that disadvantaged populations benefit somehow from this program, from both clients and government stakeholders. I’ve heard much less about environmental, though I’ve discussed renewable energy OZ projects with several people over the years,” he said. 

He suggested that there were still several ways under the present OZ rules to make a successful and powerful ESG strategy. “Combining the OZ program with other federal tax credit programs or local incentives is very powerful – stuff like PILOTs and historic rehab and low-income housing,” he said. 

“Put the OZ benefit on top of some of the state and local measures across the country and you can get very serious results from the housing side. Environmentally, the fit with renewable energy is pretty good, but it’s not ideal for several technical tax reasons. There are some strategies combining both together – for instance, having a green multi-family project in an OZ with lots of solar panels all over the property.”

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