The Opportunity Zone (OZ) program has started to take shape in communities nationwide. And with things getting off the ground for participants in the OZ market, it’s critical that proponents stay on course with the true intent of the policy. But what does economic impact in OZs mean exactly? And how can Qualified Opportunity Funds (QOF) help achieve this desired impact?

DEFINING ECONOMIC IMPACT GOALS AND OBJECTIVES IN OZ’s

Commentators have ascribed a myriad of economic policy goals to the OZ provision of the Tax Cut and Jobs Act of 2017. Since this legislation is tax policy, it is beneficial to follow the policy goals as articulated by the Internal Revenue Service (IRS) in defining the purpose of your practice:

“Opportunity Zones are an economic development tool—that is, they are designed to spur economic development and job creation in distressed communities.” [1]

Importantly, the IRS states both job creation and economic development as distinct goals within the OZ program. Therefore, it is fundamentally important not to conflate the two goals when striving for economic impact [2] in an OZ investment. The two goals are distinct in their ease of measurement. And, as discussed below, the objectives to support the goal of job creation are different than the ones in support of economic development. [3] The priorities given to these objectives vary across OZ communities. [4] In short, the goals of job creation differ from those related to economic development, and should be treated as such.

JOB CREATION

Job creation is relatively simple to measure. Here, the goal and objective are the same throughout OZ communities. An OZ business or project knows how many employees it has, and the growth in employees is easily tracked over time. Indeed, the IRS could even gauge jobs in OZs through payroll and other required tax filings. Of course, such distinctions as temporary jobs in a real estate development project versus longer-lasting jobs in an operating business matter here; but even these distinctions can be countable. Even the indirect “multiplier effects” associated direct job creation can be quantified. [5]

ECONOMIC DEVELOPMENT

Economic development is inherently a broader, fuzzier goal compared to job creation. Inspired by Nobel prize economist Amartya Sen, economic development is defined as “the expansion of capacities that contribute to the advancement of society through the realization of individuals’, firms’ and communities’ potential.” [6] In OZ discussions, the specific objectives within the goal of economic development expansion of capabilities to realize the potential include: [7]

• quality of wages

• education levels including workforce training

• career advancement opportunities, including individual equity across racial and gender lines

• surrounding work-life conditions such as connected to transportation, medical services, child-care, grocery stores, affordable housing

• access to capital to start or grow businesses, including minority and women-owned businesses

• wealth creation including to individuals in the OZ communities

• environmental conditions affecting quality of life

Each of these economic development objectives can be measured at least qualitatively, but the measurements are more complex and variable compared to the simple task of “counting heads” as in job creation. For example, opinions may differ on quality wages, affordability, wealth, connected transportation, equity, etc.

All OZ communities share the objective of job creation, but they vary considerably on the priorities assigned to the myriad of objectives under the goal of economic development. These differences are the reason that engagement and measurement must be performed at the OZ community level. Let’s examine how QOFs can engage at the local level and how progress on local economic impact can be measured and reported by the QOF.

LITANY OF GOVERNMENT-INCENTIVE FINANCING TOOLS

The first step in establishing guidelines for the OZ program’s success and sustainability is to look at similarly situated government programs and how those initiatives have implemented economic impact.

For the last 50 years, the United States has sought to execute government incentive programs to promote development in low-income or distressed communities. These established programs serve as an example of a working partnership between government and the private sector for the purpose of a shared, common goal. These programs also help lay a foundation and framework from which the OZ program can operate. Here, the partnership has the shared goal to change the landscape of forgotten communities through the development of affordable housing, businesses, and aesthetically-appealing buildings to create livable and desirable communities.

For example, the Internal Revenue Service (IRS) created the non-competitive 4% and competitive 9% Low Income Housing Tax Credit (LIHTC) program in 1986, which have assisted in creating the largest stock of new affordable housing in the U.S. [8] The IRS allocates these LIHTC awards to investors through certain local government agencies in exchange for providing upfront capital to developers of affordable housing. Currently, there are about 2 million tax credit units and this number continues to grow by an estimated 100,000 annually. [9]

Also, the New Markets Tax Credit (NMTC) program, enacted by Congress as part of the Community Renewal Tax Relief Act of 2000, is also administered by the IRS through the U.S. Treasury’s Community Development Financials Institution (CDFI) Fund. [10] NMTC permits individual and corporate taxpayers to receive a credit against federal income taxes for making Qualified Equity Investments (QEIs) in qualified community development entities (CDEs), which aims to attract private investment necessary to reinvigorate struggling local economies.

Around 1979, the federal government revamped the use of the National Historic Preservation Act of 1966 (the “Act”), which created the National Register of Historic Places, through introducing the Historic Tax Credit (HTC). [11] The Act was created in order to help coordinate and support public and private efforts by identifying, evaluating and protecting historic and archeological resources. In essence, old and dilapidated buildings, usually in distressed areas, could now be improved to support changing the face of these communities.

In addition, the Housing Urban Development agency (HUD) administers incentive programs to further encourage development in distressed communities. For example, Community Development Block Grants (CDBG) program funds, in part, finances housing development to revitalize neighborhoods, promote economic development and improve community facilities through local government agencies. [12] HUD’s Home Investment Partnerships (HOME) program provides direct financing for developers to build, buy, and/or rehabilitate affordable housing through local government agencies as well. [13]

The tax incentives associated with these programs benefit the private sector, providing economic tools to revamp communities nationwide. As such, the OZ program is evolving this notion further through community engagement, creating even more vital economic tools.

COMMUNITY ENGAGEMENT

Job creation in OZs is unanimously stated as a top-tier objective by communities and economic development agencies. The economic development objectives, however, vary substantially across OZ communities. The widely publicized criticisms of some OZ projects so far are due to the lack of participation by individuals in the OZ community in establishing local economic development objectives and in participating in the OZ investment. To offset this, they should engage local agents into asset selection and due diligence processes, and have main-street investors participating in the QOF.

LOCAL AGENTS

Community engagement can be defined as the collaboration and relationship between organizations, government, and public for the purpose of achieving a long-term, sustainable, and customized vision for their community’s future. Programs and projects that strategically engage the community often see foundational benefits such as:

• Community-wide acceptance and participation

• Trust between community members and governance

• More effective, diverse, and targeted solutions

• The development of a community network

• Elevated problem-solving skills and subject knowledge

• Inclusion of community members from varying backgrounds

• And a united front for a common good

Establishing and utilizing local partnerships in searching for high-growth, impactful OZ businesses is critical. Without these resources, government-sponsored programs, like the OZ initiative, are vulnerable to threats at both the implementation and long-term stages.

For the OZ market, true community engagement – and ultimate success – will only be reached if participants tap into the well of local, grassroots resources. These include local economic development teams and leaders, local philanthropic foundations, and local universities.

The practical approach to utilizing local partners is exactly that, practical. It comes in the form of diligent, targeted outreach and it is often as easy as sending an email or making a phone call. By opening the lines of communication with local advocates such as state and municipal economic development offices, local incubators and universities, designated OZ leaders and so forth, investors, fund managers, and developers become directly linked to the communities they’re impacting. And through this connection and collaboration, OZ will see smarter, more customized and unified, sustainable change.

MAIN STREET INVESTORS

A powerful method of community engagement is to enable individuals in the community to directly participate in the OZ investments.

Under a mosaic of IRS OZ and Securities and Exchange Commission (SEC) rules, the ability of QOFs to bring in main street investors has been viewed as very limited. By SEC securities registration exemption rules, QOFs must effectively raise capital through exemption Rules 506 of Regulation D under the Securities Act. [14] However, Rule 506 offerings are largely limited to “accredited investors” that have high income and/or high net worth. [15] This is the standard offering rule used by the SEC to maintain investor protections in private offerings. What’s more, QOFs under Rule 3(c) of the Investment Company Act allow for general marketing but further limits the QOF to a maximum of 100 investors.

Simply put, the OZ tax incentives only operate through accumulated, taxable capital gains that are concentrated in high net worth individuals, which was the design of the tax legislation. This means that residents in OZ communities who do not have large accumulated capital gains and do not qualify as accredited investors are not being marketed to as potential investors by QOFs.

But there is a way to make sure this community resource doesn’t go untapped. QOFs can bring in main-street investors into OZ investments by “mixing” funds. Specially, it is the union of all accredited investors inside the QOF, or non-accredited investors outside the QOF, that can be used to finance an OZ business or property. Of course the investors outside the QOF will not receive the capital gains tax benefits, but they may still investor in a OZ business or property.

First, the investors in the QOF itself can use a mixture of qualifying investors (i.e. funds from qualified capital gains realizations) and non-qualifying investors (i.e. funds that are not from capital gains realizations.) These are termed “mixed-use” funds in Section 1400Z-2 and are permissible if the two sources of funds are tracked and reported separately. While this source of QOF funding is still limited to accredited investors only, QOFs are not bound only to investors with large, accumulated capital gains. Taxable accounts and, importantly, accounts that are already taxed advantaged (e.g. IRA accounts) are also valuable funding sources for QOFs investors. [16]Neither the qualified capital gains investor, nor the already tax-advantaged IRA investor, pays any capital gains tax on their QOF investment. [17] Accredited investors in IRAs are far more numerous and more main street than the accredited investors with very large unrealized capital gains. Of course, IRA investors and taxable account investors must evaluate the risks and other characteristics of the QOF, but they can certainly participate in a mixed-use QOF if they are comfortable with the investment and look to contribute to the economic impact in OZ communities.

Secondly, the SEC has noted that a different offering exemption enables a mixture of funds to finance an OZ business or property: “a pooled investment vehicle (a “fund”) could rely on Rule 506(c) to offer and sell securities of the fund to accredited investors and use the proceeds to finance a portion of a [OZ] project, while a Regulation Crowdfunding offering to non-accredited investors is made at the same time to fund the remainder of the [OZ] project.”[18] Under crowd-funding, non-accredited investors outside the QOF can participate alongside the accredited investors inside the QOF.

Crowdfunding is a practical, widely accepted, and innovative way for individuals and businesses to access capital through small investments made by multiple individuals. The crowdfunding strategy utilizes technology, social media, and targeted sites to collect data, elevate experience and involvement, and facilitate funding. There are a multitude of benefits outside of additional capital that stem from crowdfunding, of which include expanded audience, community engagement, and a shared interest for success.

There are several channels that a QOF can assist the crowdfunding portion of an OZ investment that is outside the QOF. The engagement of local agents on deal sourcing and economic impact objectives is a common need for both the QOF and the crowdfund. Similarly, the ongoing tracking and shareholder voting on the OZ investment is shared across both sets of investors. The QOFs will typically be professionally managed; they could share the results of their analysis and ongoing investment reporting with the crowdfunding investors who may not have access to professional management. The QOF could also help subsidize the cost of the crowdfunding raise in order to foster community engagement through investment by local residents.

MEASUREMENT AND REPORTING OF ECONOMIC IMPACT

It’s vital that QOFs use, collect, and share data on the economic impact of their investments. This will gauge the success of the fund against the intent of the tax policy and the engagement of the community. The good news on measurement and reporting is that the wheel has already been invented.

INVESTMENT LEVEL MEASUREMENT

The Urban Institute has drafted a Community Impact Scorecard to assess the impact of each OZ investment project by answering a series of detailed questions in 7 topic areas: community impact, jobs, businesses, housing, environment, services, and transportation. These categories are weighted against one another based on the community-identified priorities. The questions in the scorecard cover the job creations and economic development goals outlined above. The Community Impact Scorecard is still in draft status and may be likely be refined and improved over time. This scorecard is a vital part of our due diligence process and applied to each specific investment because one, it provides a standardized measure that can be compared across the large number of OZ projects that we consider and two, it has the flexibility to incorporate each the OZ community’s relative priorities into their objectives.

FUND LEVEL REPORTING

With the attention paid to community engagement and measuring impact during investment due diligence, fund-level reporting becomes a relatively simple aggregation process. Here, you can use the OZ Reporting Framework developed by the U.S. Impact Investing Alliance and the Beeck Center. [19] The scorecard exercise on the individual investment provide much of the information needed in the Fund Report. The intended impact section of the Fund Report can come directly from the investment scorecard. For multi-asset QOFs, summary measures by scorecard topic can also be prepared. Similarly, information is readily available to be summarized in the community engagement section of the Fund Report. The measures on economic impact and the information on community engagement can then be combined with the overall mission statement and investment thesis of the fund to complete the Fund Report.

Individual Community Impact Scorecards and aggregate Fund Report should be monitored and updated on a regular frequency, e.g. annually. The QOF should monitor ongoing progress in relation to the objectives and adjust its strategy and protocol to help achieve those objectives. The Fund Report can then be made available to QOF investors and other parties.

Economic impact in OZs is a direct reflection of job creation and the community-specific objectives related to economic development. Through community engagement and streamlined project assessment – and the assistance of QOFs – investments in OZs will result in successful, sustainable, and positive economic impact for years to come.

Notes:

[1] https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions, accessed 10/18/2019

[2] This section is heavily influenced by the distinctions between economic growth and economic development in the paper, Feldman, M., Hadjimichael, T., Lanahan, L., & Kemeny, T. (2016). The logic of economic development: a definition and model for investment. Environment and Planning C: Government and Policy, 34(1), 5-21.

[3] Some management specialists state that the difference between goals and objectives is that a goal is a description of a destination, and an objective is a measure of the progress that is needed to get to the destination.

[4] We do not discuss the policy debate of whether all OZ communities have the same level of economic stress in this paper.

[5] https://www.epi.org/publication/updated-employment-multipliers-for-the-u-s-economy/ for example.

[6] Ibid, Feldman et.al.

[7] This list is influenced by the Urban Institute

[8] https://www.nhlp.org/resource-center/low-income-housing-tax-credits

[9] https://www.nhlp.org/resource-center/low-income-housing-tax-credits

[10] https://www.cdfifund.gov/programs-training/Programs/new-markets-tax-credit/Pages/default.aspx

[11] https://www.novoco.com/resource-centers/historic-tax-credits/htc-basics/about-historic-tax-credit

[12] https://www.hud.gov/program_offices/comm_planning/communitydevelopment/programs

[13] https://www.hud.gov/program_offices/comm_planning/affordablehousing/programs/home/

[14] https://www.sec.gov/news/public-statement/clayton-statement-opportunity-zones and https://www.sec.gov/divisions/corpfin/guidance/reg-crowdfunding-interps.htm#204.05

[15] Rule 506(b) allows an unlimited number of accredited investors and up to 35 “sophisticated investors”, but general marketing is not allowed under 506(b). Rule 506(c) is typically used by QOFs.

[16] See A. Johnson (2019). Optimizing Tax-Advantaged Participation in Qualified Opportunity Funds. New Directions Trust Company.

[17] A traditional IRA investor will pay income taxes at the time of their withdrawal but not at the time of the QOF capital gains. For a Roth IRA investor, the capital gains tax is effectively eliminated just like a qualified capital gains investor.

[18] https://www.sec.gov/divisions/corpfin/guidance/reg-crowdfunding-interps.htm#204.05 [19] US Impact Investing Alliance and Beeck Center for Social Impact and Innovation (2019). Prioritizing and Achieving Impact in Opportunity Zones.