The power of opportunity zones has yet to be unleashed. With the potential to be a transformative economic development tool, this program should be embraced by stakeholders, but they need to be cautious to avoid potential pitfalls.
Opportunity zones may seem too good to be true. These funds aim to produce a healthy return for investors by offering valuable tax benefits, including capital gain deferrals, partial elimination of capital gains taxes on the deferred capital gain, and total elimination of taxes on the appreciation of the investment.
The obvious benefits - for investors and fund managers - are there. But to maximize the program's success, meaningful best practices must be adopted industry-wide. Security, compliance, and transparency will be huge components of a successful program.
Opportunity zones are still new, which means important guidance is still being developed by the U.S. Treasury, IRS, and state and local authorities. As a result, investors may face greater risk of unexpected tax liabilities due to unintentional lack of compliance. Because of the inevitability of change, it is vital to be transparent from the start and have a fund administrator who can keep your data organized.
One thing will stay constant: No matter what regulatory changes are made throughout the process, given the sophistication of opportunity zones, you want data with the sophistication to match.
What Did EB-5 Teach Us?
Setting up an initial opportunity fund might be simple, but preparing for how the landscape around opportunity zones will change is not. Understanding the tax and securities laws is difficult. Keeping up with developing tracking and reporting requirement can be extremely challenging, especially for new market entrants. Frankly, an Excel spreadsheet isn't going to cut it.
Examining the EB-5 program can illuminate important lessons about transparency. United States Citizenship and Immigration Services, an agency of the Department of Homeland Security, established this employment-based visa program to encourage foreign investment in 1990, though it grew in popularity after the 2007 financial crisis. Foreign investors could gain permanent residency through investments, between $500,000 and $1 million, in a new commercial enterprise that created at least 10 full-time jobs.
In the early days of EB-5, the dimensions of the program were undefined, but it has become a vital driver of the American economy. Throughout the course of any program, consumer opinion will ebb and flow. Regulations will change, and funds need to expect and be ready to manage that. No fund environment will ever remain static.
You need to have the data and paper trail to be prepared to answer questions from not only the government, but from investors. Ask yourself: “What happens if the IRS does this or that?” Make sure you have an answer.
EB-5 also taught us a lot about security. In opportunity zone funds, the capital investment is driven by the investors' taxable event, and capital is moved into the fund before the specific need and use of that capital are predicated. Large pools of capital will exist in the subscription phase before distribution into a qualifying opportunity zone project.
The EB-5 marketplace was similar, where we saw multiple instances of fraud and abuse where those resting funds were inappropriately allocated for purposes other than the EB-5 development. The need for third-party oversight and investor transparency of this capital became increased measures of security. Industry best practices were developed to prevent malfeasance and ensure investors' capital was properly protected and appropriately utilized.
Best Practices from Your Fund Administrator
Hiring a third-party fund administrator to help manage your investments is not required, and some companies feel that they don't need extra oversight. But if history tells us anything, third-party oversight should be sought, and dismissing it completely may be a misstep.
Take the Bernie Madoff scandal, where regulators missed his $50 billion Ponzi scheme that defrauded thousands of investors. With third-party administrators, investors would have been less likely to be fooled by his scheme by requiring the fund to be more transparent.
Investors should want fund managers to have reputable outside administrators to help ensure their investments are safe and that all regulations are being met. Fund managers should want third-party administrators so they look good to investors and to protect their own company.
It can be extremely challenging to work with opportunity zone fund tax and securities laws, regulations, and tracking and reporting requirements. Scaling up to meet sudden investor demand can also pose problems, especially if the accounting is performed with software too basic for such sophisticated fund accounting.
Opportunity zone funds must be equipped with tools that allow them to adjust, and best practices need to be established in security, compliance, and transparency.
In other financial industries, the use of independent, third-party controls and record keeping is standard practice, so it should be no different with opportunity zone funds. If you don't have a third-party administrator, investors will likely hesitate for fear of poor record keeping. They will also want to be certain their information is not subject to a cyberattack, so assuring them that their data is secure will be key to gaining trust - and their investment.
Opportunity zone fund structures are inherently different than traditional private equity funds, where investors make capital commitments that are realized when there is a capital call necessitated by a pending fund investment. Opportunity zone funds feature single asset funds where the operator/developer is both the fund and the project. Once the money moves from subscription to deployment, it's imperative to provide visibility and assurance that capital is being allocated consistently with the project's business plans and in compliance with opportunity zone regulations.
In the world of compliance, it is better to overprepare than to underprepare. Track compliance at the fund and investor level and, once again, prepare for rules and regulations to change. Opportunity funds must also comply with additional tax and reporting requirements, such as the “substantial improvement” and 90 percent investment in qualified opportunity zone property tests. This can add complexities and make evolving regulations more difficult to manage.
If history is any indicator, the IRS is certainly able to shift from friendly to aggressive. Funds must plan for a potentially exhaustive level of scrutiny by the IRS at the fund level and at the investor level. Oversight is a dangerous and potentially costly risk for a fund to take with investor capital.
Fund managers should be transparent from day one. The complexity and number of stakeholders make transparency a challenge - but it is best practice to make sure all material information is accessible to all relevant stakeholders. Unsurprisingly, investors want to know where their money is and how it is being used.
If you want to invest in opportunity zones, make sure you do it right. You need to know your paper trail is continually up to date.
Capitalizing on Opportunity Zones and Section 199A
Evan Liddiard, director of federal tax policy, and Erin Stackley, senior representative, commercial legislative policy, both of the National Association of REALTORS, review how the new opportunity zone program and the section 199A deduction for pass-through entities and the self-employed may impact your after-tax income.