So Far, Real Estate Dominates a Tax Break Meant for Businesses

This article was originally published by Stateline, an initiative of The Pew Charitable Trusts.

Members of Congress who pushed for the “opportunity zone” provision in the 2017 federal tax law said it would help businesses and entrepreneurs in low-income communities. The tax break rewards investors for spending capital gains on businesses or real estate in more than 8,000 economically distressed neighborhoods selected by governors.

The incentive “will unlock new private investment for communities where millions of Americans face the crisis of closing business, lack of access to capital and declining entrepreneurship,” said a bipartisan congressional group — Sens. Tim Scott, a South Carolina Republican, and Cory Booker, a New Jersey Democrat, and Reps. Pat Tiberi, an Ohio Republican, and Ron Kind, a Wisconsin Democrat — in announcing the idea.

But almost two years after the tax break became law, and almost two months after the Trump administration clarified how private equity firms, venture capitalists and other investors can qualify for the tax break, only a handful of people have started funds that focus on operating businesses. Many are still trying to figure out how to satisfy both the IRS and investors eager for high returns.

Meanwhile, real estate-focused funds have already raised billions. And real estate companies are cashing in. For example, Kushner Companies, the family business of President Donald Trump’s son-in-law, Jared Kushner, has been buying up property in the zones, according to the Associated Press.

Confusing U.S. Treasury Department rules held business-focused funds back, said John Lettieri, president and CEO of the Economic Innovation Group, a public policy group in Washington, D.C., that lobbied for opportunity zones. Now that the agency has issued more guidance, Lettieri said, “opportunity funds that are geared toward investing in local businesses are going to proliferate.”

But the tax break has always been easier to apply to real estate. “The truth is, it’s a tax break that’s place-based,” said Napoleon Wallace, a former deputy secretary of the North Carolina Department of Commerce and a founding partner of Opportunity North Carolina, a group that helps expedite deals in the state.

An Uneasy Alignment

The opportunity zone tax break is several incentives in one. Investors defer paying income taxes on capital gains that they invest in special funds that, in turn, invest in real estate or businesses in the zones. After five years, investors get a tax break on those gains. After seven years, the tax break increases. And most importantly, after 10 years, they can pocket any money they earn from their zone investment tax-free.

Brian Phillips is an entrepreneur who is confident he can find promising tech startups that are already in a zone or willing to move to one. But last year, when Phillips was considering creating an opportunity zone fund focused on businesses, he was “kind of the only one.”

Investors had to wait until the April release of Treasury guidelines to learn how businesses would qualify as being in a zone for tax purposes. The guidelines said businesses need to perform at least half their services in a zone, pay half their wages in the zone, or generate half their income from a mix of property and management functions in a zone.

Yet despite the new clarity, investing in businesses remains more complicated than investing in real estate.

Buildings, by definition, stay put. And while 10 years is a long time to own a building, a property that’s delivering good returns after five years likely will still be a good investment in 10, said Michael Kressig, an opportunity zones expert and partner at Novogradac, an accounting and consulting firm.

Businesses, on the other hand, can change a lot in 10 years. They might fail, get acquired, go public, move or radically change their business model. “It is contrary to your normal kind of private equity, or venture capital, investment-hold periods to think about holding something for 10 years,” Kressig said.

There’s not much fund managers can do to control the business cycle, and it’s difficult to delay business decisions — such as whether to relocate — until the 10-year mark.

Many fund managers have “sort of landed on the understanding that this is a best-efforts proposition,” Kressig said, “and so I can’t — and I’m not going to — promise an investor that they’re going to get 100% of these tax benefits.”

Investors could still make money if a growing company leaves a zone, said Chris Schultz, CEO of LaunchPad, a chain of coworking spaces that also makes venture investments. “If a company is moving out of a zone, presumably it’s because something very good is happening,” he said. LaunchPad is setting up a $20 million opportunity zone fund focused on startups in mid-sized cities.

Business-focused funds also may face more technical difficulties than real estate funds do. For instance, while a real estate fund can be set up to focus on a single project, Phillips’ fund has to spread investments over several companies to soften the blow to investors in case any of the companies fails.

“The real estate [opportunity] fund is not that much different from what these real estate companies have been doing for a long, long time,” said Phillips, now managing partner of an opportunity fund called the Pearl Fund L.P. For him, however, setting up a fund was uncharted territory.

Phillips worked with Kressig and a lawyer to come up with a workable structure. “It’s challenging, but I tell everyone to please note, it is doable,” he said. He hopes this year to raise $25 million and spend it on up to 25 early-stage companies either in or willing to relocate to zones within a three-hour drive of New York City. Once the money is spent, he’ll raise another fund.

Making it Work

Venture capitalists and public equity firms still have a good pitch for investors. Phillips is looking for startups growing so fast they could increase his original investment 10 times over, or more.

“The relative tax benefits are actually better for investing in operating businesses, particularly those with heavy capital assets,” said Jonathan Tower, managing partner at Arctaris, an impact investment fund manager based in Boston.

Tower is planning to raise over $500 million for an opportunity zone fund and spend it on up to 25 primarily industrial and manufacturing companies, including some that he’ll shepherd through mergers and acquisitions with other companies.

Finding good deals in distressed communities will be a challenge for real estate and business investors alike. But Schultz and Phillips are confident they’ll strike enough deals to spend their initial funds. Arctaris is particularly well-positioned, as the firm has been investing in low-income areas for a decade.

Arctaris’ approach is somewhat unique, however. “Traditional private equity is not used to selecting companies based on their place,” Tower said, “and they probably don’t have as good deal-sourcing relationships in those areas.”

The Arctaris opportunity zone fund also includes a $15 million guarantee — from the national Kresge Foundation, which focuses on cities — that will help protect investors if the fund loses money.

Funds focused on small businesses unlikely to grow rapidly may need a guarantee, or some other risk-reduction mechanism, to attract investors.

The Community Reinvestment Fund, USA, a Minneapolis-based nonprofit that issues loans to entrepreneurs underserved by traditional banks, is considering creating an opportunity fund that will invest in businesses such as small food and beverage manufacturers and expanding child care centers, said Keith Rachey, senior vice president of development and community advancement for the fund. Rachey is hoping to raise between $50 million and $100 million that would be spent on up to 100 businesses nationwide.

“We’re heavy into the feasibility piece of this right now,” he said. Part of the challenge is finding business owners who are willing to relinquish full ownership. “Can we find enough small businesses in these areas that would be willing to give up a portion of their equity, for a period of time?”

It may be possible for business owners to buy back the company once the opportunity investment period ends, he said. He’s also wondering if his fund will need to be bolstered with a guarantee.

Phillips, of the Pearl Fund, said that he believes opportunity zone investment will occur in waves. “The first wave is all the things you’ve seen with real estate investing, because it’s easy,” he said. But once the best property deals have been secured, such investments will slow, and business investments will accelerate, he said.

Eventually, he said, business and real estate investors will work together to secure office, warehouse or manufacturing space for growing companies.

Lettieri said that the real estate and business sides are working together already. “Every commercial real estate investor wants a tenant.”