Spencer Erikson, UMB Fund Services

Opportunity Zone Funds present compelling investment case


When President Trump signed into law the Tax Cuts and Jobs Act (the Act) last December, one of the key points that the media focused on was the reduction in corporate tax from 35 per cent to 21 per cent; the biggest cut in more than three decades. This was big news for corporate America. 

But as some rightly questioned, what would US corporations do with this tax windfall? Are they going to use it to invest more? If they do, it would likely lead to an immediate boost to growth, which could be inflationary in the short-term. Or are they going to use it to pay back debt, engage in share buybacks, or increase dividends to shareholders?

This remains to be seen. 

Aside from corporate tax cuts, arguably the most important feature of the Act was the creation of Opportunity Zones across the country, yet it has only been in recent months that the tax benefits the Opportunity Zones  could offer to investors have begun to be fully realised. 

Under the Act, states, DC, and US territories nominate low-income communities or certain areas within such communities to be designated as Qualified Opportunity Zones. In total, there are 8,700 qualified census tracts across all states, territories, and the District of Columbia, within which there are estimated to be 24 million jobs and 1.6 million businesses

For private equity and real estate investment managers, and their investors, this is a massive opportunity to put realised capital gains to work in economically distressed parts of the US to benefit and effectively develop local communities that are still reeling from the effects of the global financial crisis a decade ago.

“These Opportunity Zones are basically a tax incentive that was put into place to encourage new capital investment into some of our underserved and lower-income communities,” says Spencer Erickson, Managing Director, Tax and Fund Accounting at UMB Fund Services. “The tax incentive is real, it’s powerful, and we are seeing a large number of our clients looking to see if they can capitalise.” 

Each US state was able to select and nominate some of its lower-income census tracts for Opportunity Zone status. The Internal Revenue Service (IRS) took those nominations and approved them as Qualified Opportunity Zones.

One example to reference is Amazon, which has selected a tract of land in Long Island City for its HQ2 project identified by Governor Andrew Cuomo as an Opportunity Zone. Amazon will benefit tremendously from federal tax benefits afforded it by investing in an Opportunity Zone.

Now that these Opportunity Zones exist, the next few years will likely see a raft of Opportunity Zone Funds being established; something that Erickson is already seeing. 

Provided investors follow the rules applicable to Opportunity Zones, they will be able to defer the recognition of any realised gains and reinvest them into an approved Opportunity Zone Fund, designed solely to deploy capital into Opportunity Zone properties or businesses. 

“We have seen some of these funds already launch,” confirms Erickson. “Others are still in the planning and implementation phase and there are still others that are trying to understand the rules to determine where the opportunities could be for them. Funds are taking a variety of forms; many of them are similar to a traditional private equity fund but we are also seeing a number of investment managers build a special purpose vehicle, to deploy capital to standalone Opportunity Zone projects.” 

The initial tax incentive is for investors to defer their recognition of capital gains to 31st December, 2026. In addition, if taxpayers meet the holding period requirements in the fund, they will be eligible for what is known as a step-up in tax basis. In addition to deferring capital gains to 2026, investors receive a tax basis increase equivalent to 10 percent after five years, provided the deferred gains were invested by 31 December, 2021.

An additional tax basis increase of 5 percent is received by the investor if the investment is held for seven years, provided the deferred gain was invested by 31st December 2019. This would mean after seven years an investor would pay tax on only 85 per cent tax of their original realised gains. 

Moreover, if the investors hold the investment for 10 years or more, their tax basis is increased to equal the fair market value and any appreciation is not taxed at disposition.

“It’s a great initiative for US taxpayers to hold these investments for 10 years or more,” says Erickson. “Say, for example, you have USD100k in realised gains – by reinvesting those gains into an Opportunity Zone Fund, you can defer your tax obligation. The two step-up periods refer to how much tax is paid on those deferred gains. After five years, you would get a 10 percent reduction, meaning you would be taxed on USD90K in gains, and after seven years, you would get a further 5 percent reduction, meaning you would be taxed on USD85K. Further, if you hold the investment for 10 years, you pay no tax on any investment appreciation.”

“So there are three clear tax benefits: a deferral period, two basis step-ups, and tax free appreciation.”

To be considered a qualified Opportunity Zone fund, the fund manager is obligated to invest 90 percent or more of their capital in to Opportunity Zone properties or businesses. 

At a time when some investors are increasingly focusing their efforts on impact investing, and looking to ensure that how and where they invest is benefiting the planet in some way, Opportunity Zone Funds are a conduit through which to deploy capital and make a real difference to under-served communities across the country. 

Right now, Erickson confirms that there is a concerted effort at UMB Fund Services to educate clients, along with their attorneys, on understanding the rules and nuances of Opportunity Zones and how the opportunities they are looking at in the marketplace might fit into one of these funds. 

“Many of them are being organised in a similar way to the funds that we have been supporting for many years in terms of fund accounting, investor servicing and tax support. We can apply our full suite of services to these funds, in addition to services that apply specifically to Opportunity Zone Funds. For example, with the 90 percent rule and other rules that managers must comply with in order to qualify, we can track a fund’s assets in Opportunity Zones and provide reporting to show clients where they are in terms of status qualification. 

“Also, we have a full-service tax department to handle all of the tax reporting and track all of the tax basis step-ups and provide accurate tax returns,” confirms Erickson.

He believes this a significant development that has arisen out of the Act, both for US investment managers and for UMB Fund Services itself.

“There are Opportunity Zones in every state and fund managers will invariably find great investment opportunities to deploy capital into underserved areas of the country. The industry is just figuring out the implications and we are ready and waiting to service these funds, as managers take them to market,” concludes Erickson.

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