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President Trump introduced one of the biggest tax reforms that the United States has ever seen in Dec 2017. As soon as the plan declared that the taxes on the rich will be reduced by $1.5 trillion, a huge debate started about the morality and the perceived economic benefits of such a move.
However, it is only about a year later that the attention of the mainstream media has gone to the subject of opportunity zones. Buried deep in the paperwork of the Tax Cuts and Jobs Act, 2017 lies a provision which could change the fortune of many inner cities in America.
In this article, we will try and understand what opportunity zones are and what are the pros and cons of investing in them.
The idea of opportunity zones seems to be inspired by the Chinese idea of special economic zones. The logic behind these zones is that they are specially designated geographic areas wherein the government provides tax incentives to industries. This works out to be a win-win situation for both parties since capitalists are looking to save on tax whereas the future of many communities would be completely changed if the received some capitalist investment.
When it comes to economic activity in the United States, the 80/20 principle is actually true. There are 20% areas which contribute to most of the economic activity in the country. On the other hand, there are 80% areas where barely any economic activity takes place. The American government wants to bridge this divide. This is the reason why they have proposed the creation of opportunity zones.
As per the provisions of this act, each state is expected to designate certain areas as opportunity zones. As per the latest estimates, a total of 31 million people are likely to be positively affected by this act. Also, it seems like the correct geographical areas have been chosen. This can be guessed from the fact that the average poverty rate in these areas is close to 31% which is more than double the national rate. Also, on average, the median income in these areas is about 60% of the national median income.
Trump wanted to take economic development to the American hinterland. It is likely that this policy of creating opportunity zones will help him do so.
The biggest advantage of opportunity zones to the capitalists is that they can be used to defer taxes. Investors can avoid paying capital gains taxes on any type of capital gains viz. stocks, bonds, real estate, etc. if they are willing to invest in these opportunity zones for a certain period of time.
In order to be able to avoid tax, companies, and individuals will have to invest the money within 90 days of realizing the capital gain. These gains cannot be directly invested in opportunity zones. Instead, the money needs to be put in a qualified opportunity fund. The longer an investor holds their money in this fund, the more taxes they avoid. After a period of about 10 years, the entire amount will be tax-free.
Many economists believe that Trump is trying to cool down the heated American property market in major cities while trying to simultaneously benefit the inner cities and the lesser developed areas. The underlying belief is that there is more than enough capital in the American markets, it just needs to be redirected in an orderly fashion in order to achieve financial growth.
From a higher level, the opportunity zone scheme seems to be the perfect antidote to the wealth gap divide in America. However, like all government policies, here too, the devil is in the details.
Firstly, it needs to be understood that this scheme only benefits a very narrow group of investors, who have an appetite for high risk as well as illiquid investments. It needs to be understood that investors have to pool in their money via qualified investment funds, the track records of which are unknown since they never existed prior to this! Also, there are no active secondary markets where investors can sell their securities and move on. Hence, the funds are both risky as well as illiquid.
The returns from the funds do not seem to be enough to compel investors to lock their money in such a scheme. This is because a typical fund will charge an annual fee of about 2%. Also, there are several other types of fees and carried interests which almost negate the tax advantage that these funds provide.
Also, it needs to be understood that only the capital gains from such funds are tax-free. If the funds invest in real estate in these opportunity zones and if such real estate generates rental income, then such rental income will be liable to be taxed.
Also, since the lock-in period is of about 10 years, there are concerns that the tidal wave of capital which will now enter the market will also exit at about the same time. Hence, the growth created may be temporary and may actually leave the economy of rural America worse off 10 years from now.
To sum it up, opportunity zones need to be approached with realistic expectations. At the end of the day, they are still an investment and hence subject to market risks.
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