Opportunity sprouts in impoverished areas, thanks to tax reform

Outgoing Speaker of the House Paul Ryan talks about the new tax reform law quite a lot, as one would imagine. When he does, he invariably talks about three things—the corporate income tax rate cut, the tax cut for middle class families with kids, and Opportunity Zones. The latter is also a favorite topic of both White House Council of Economic Advisers chief Kevin Hassett and his colleague Larry Kudlow of the National Economic Council.

What are these “Opportunity Zones” that have these pillars of the Republican tax world so excited? A component of tax reform shepherded by Sen. Tim Scott, R-S.C., Opportunity Zones are a close cousin of the “enterprise zones” championed by Jack Kemp a generation ago.

Under this tax reform provision, the nation’s governors designate high-poverty, low-income areas (known as “census tracts”) in their states for Opportunity Zone consideration.

These Opportunity Zones are eligible to be recipients of investments from Opportunity Funds—picture a venture capital pool of money that only invests in Opportunity Zones. Investors can roll unrealized capital gains tax-free into Opportunity Funds, and thereby plow capital into Opportunity Zones.

A census tract is an area with approximately 4,000 residents, but it could have as few as 1,200 or as many as 8,000 residents. In order to be on the list, a census tract must have a poverty rate of at least 20 percent and household income lower than 80 percent of their state’s median level. There are 42,000 such communities in the United States today.

Where are these census tracts? They are both urban and rural, home to Americans of all races. Poor whites in Appalachia will be beneficiaries of the same Opportunity Zone law as poor blacks in Chicago or poor Indians in South Dakota. Under the provision, a state can designate up to 25 percent of the low-income census tracts in their state as Opportunity Zones, with a minimum number of 25 zones per state. In April, states had to make their choices. Massachusetts has named 138 Opportunity Zones. Maryland has 149. Florida, which is wealthier thanks to having no state income tax, has 28 zones. All over the country, these areas are opening up for business and capital. To date, 4,831 low income census tracts have been designated as Opportunity Zones.

Investors get three big tax benefits by rolling their gains into Opportunity Funds. First, they get tax deferral on the gains they roll in. Currently, that deferral is available through 2026, but if Opportunity Zones are successful there is every reason to believe Congress will extend this. Second, investors can “step up” their basis in their deferred capital gain by up to 15 percent provided they keep the money in an Opportunity Fund for at least seven years. Finally, an investor in an Opportunity Fund asset who holds the investment for at least 10 years pays a 0 percent capital gains tax upon sale, to the extent the gains are derived from the Opportunity Zone asset.

These Opportunity Zones and their related Opportunity Funds should be very attractive to investors sitting on large, unrealized capital gains who want to both benefit from tax deferral on their original investment and potentially get a tax-free windfall from investing in some of the poorest areas of the country.

The Economic Innovation Group, using data from the Federal Reserve, estimates that corporations and households are sitting on $6 trillion of unrealized capital gains. If even a fraction of that was redeployed to the poorest areas of the country, just imagine what that would do to lift millions of families out of the poverty trap. There’s every reason to believe the allure of tax deferral, a capital gains tax cut for the rollover gain, and a capital gains tax-free investment opportunity will do just that.

An interesting test case will be the troubled territory of Puerto Rico. Under tax legislation passed after tax reform, almost the entire island of Puerto Rico is, by default, designated as an Opportunity Zone. Today, an interactive map of all Opportunity Zones provided by the Treasury Department literally shades the entire island as eligible. That means that any investment in Puerto Rico—which is a part of the United States and enjoys the same property rights and other legal protections as anywhere else—is now a tax free activity for those who commit to keep their capital there. Just imagine the chance investors have to buy low: a decade of debt crises, fiscal mismanagement, power outage issues, and hurricanes has knocked Puerto Rico off her feet. But this is prime American real estate, just ready to be bought at a bargain. Businesses should be eager to set up shop there and provide superior services to the 3 million American citizens still living on the island.

If Republicans believe what they say they do about how tax laws change behavior, Opportunity Zones are a good test case. President Trump ought to team up with Sen. Scott and take the message of Opportunity Zones to America’s distressed inner-cities and storm-ravaged Puerto Rico as well. If they work, Opportunity Zones can be the difference between an America where too many get left behind and one where the benefits of our prosperity can truly be shared by all.