06 Mar The Times They are A-Changin; Qualified Opportunity Zones*

The Times They are A-Changin

“Most of us assume that the future will more or less resemble the present, but this is not necessarily so. In a long and eventful life, I have witnessed many periods of what I call radical disequilibrium. We are living in such a period today,” Europe, Please Wake Up, a February 11^th commentary by George Soros. His focus: “Europe is sleepwalking into oblivion, and the people of Europe need to wake up before it is too late. If they don’t, the European Union will go the way of the Soviet Union in 1991.” The ripples from such an outcome would create waves that would reach across both the Atlantic and Pacific Oceans.

The Euro was launched in 1999. It was the culmination of post-WWII efforts to link the countries of Western Europe and thereby prevent another war. In May 2010, former German Chancellor Helmut Kohl endorsed this strategy when he said, “Today, I am more convinced than ever that European unification is a question of war and peace for Europe and for us, the Euro is part of our guarantee of peace.”

Initially, 11 European countries swapped their local currencies for Euros ÔÇö Austria, Belgium, Finland, France, Germany Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. With a new common currency, trade among them was expected to leap. This was to be the economic beginning of integration. Companies in one part of Europe would be incentivized to invest in facilities in other parts of Europe. These pan-European companies would service an expanding common currency area breaking down national and cultural barriers. Europe would be on its way to becoming a single union. That didn’t happen. People and their long-standing prejudices got in the way. After running up from 1.18 U.S. dollars per Euro to 1.60 in April 2008, the Euro is now at 1.14, below its debut price. There are a number of reasons. A principal one is that the U.S. dollar has strengthened. However, it also reflects the fact that a common currency without a unified fiscal policy cannot work … and has not worked. How could it have with the different cultures and political histories of Europe? Today, slowing global economic growth is painful for European exporters, especially in Germany. So is Brexit and the U.S. trade wars with China and the EU. The weakening Eurozone has created more resistance to immigrants and has spawned populism and extremism, fracturing the leadership that originally rested with Germany and France. It also has reduced Western abilities to appropriately address Russia, China and Iran. Rather than uniting Europe, the Euro became a fracturing force. As Soros now cautions, unless “the sleeping pro-European majority [awaken] and mobilize … to defend the values on which the EU was founded…, the dream of a united Europe could become the nightmare of the twenty-first century.”

In 2002, a widely-read essay in The Atlantic stated that the “rising challenger” to American global supremacy was “not China or the Islamic world but the European Union, an emerging polity that is in the process of marshaling the impressive resources and historical ambitions of Europe’s separate nation-states.” How wrong that was.

Qualified Opportunity Zones

As part of the Tax Cuts and Jobs Act of 2017, Congress created Qualified Opportunity Zones (QOZs or OZones). An OZone is a population census tract that meets the definition of a low-income community. The designations were chosen by States’ legislatures for political humanitarian economic a variety of reasons and were rubber–stamped certified by the U.S. Treasury in the Spring of 2018. There are over 8,700 OZones in the 50 states, Washington, D.C., Puerto Rico, and the Virgin Islands. Surprisingly, OZones comprise approximately 10 to 12 percent of the United States!

An OZone investment offers three significant tax benefits to those investors who have realized a capital gain within the prior 180 days: (1) that capital gain is deferred until the sooner of disposal of the OZone investment or December 31, 2026; (2) 15{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} of the deferred gain is permanently eliminated if the OZone investment is held for at least 7 years (10{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} if it’s held for at least 5 years); and (3) 100{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} of the gain on the OZone investment is permanently eliminated if the OZone investment is held for more than 10 years. These are potent incentives for taxpayers with substantial late-2018 or 2019 capital gains (such as hedge and private equity fund investors whose gains for 2018 by definition accrue each December 31^st).

The OZone designation is intended to incentivize the movement of capital into blighted areas to create and expand businesses in an effort to reduce poverty and increase employment. Few can question that the legislation, although quickly adopted with little study or review (as was true of much of the Tax Cuts and Jobs Act), has the best of intentions. However, the road to Perdition … well, you know the rest. What we do know at this early stage is that whether or not the targeted benefits are achieved, OZones have created a feeding frenzy for the 1{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} — those taxpayers intended to benefit from the legislation. Promoters are exerting every effort to create OZone funds that target their wealthy clients. That feeding frenzy is focused almost exclusively on structuring investments in gentrifying real estate, with most of that real estate located in the urban areas of Blue States. How much good and worthy urbanizing Blue State real estate is there? We will find that out over the next 10 or so years. With the stated goal of addressing poverty in what used to be called the Rust Belt and now might be labeled Rural Red State America, is the money that will be invested going to the right places?

Blue State real estate OZones can be found in blighted urban areas, like Detroit, that are in need of more than merely OZone investment. Will tax incentives targeting wealthy, conservative real estate investors who understand that we no longer are in the first half of the real estate cycle … or even the first three-quarters … alone attract the necessary aid to devastated areas? The population growth and GDP expansion that fueled real estate appreciation over the past 75 years is behind us. In the words of George Soros, “Most of us assume that the future will more or less resemble the present, but this is not necessarily so.” Wealthy investors surely understand this. How risk-sensitive will OZone investors be in targeting truly needy areas?

Cycles wax and wane, in real estate as in other sectors. There are neglected industries and businesses in Rural Red State America that would benefit from OZone investment, to the benefit of the nation as a whole. Will investors seek out those opportunities? Based on my recent experience, I’m skeptical. And unfortunately, Congress is not about to fine-tune the OZone legislation. Like much of our law-making, it’s an experiment.

Comments received:

With respect to tax redistribution proposals:

“Did you ever hear the Jerry Jones (owner of the Dallas Cowboys) theory on wealth distribution? Jerry’s belief is this: if you could evenly distribute the nation’s wealth among the population, within 5 years the same people who control the country’s wealth today would control it again.”

With respect to the burdens that our complex tax system places on business:

“Imagine walking into a bank and asking for a standard small business account.

You tell them the name of your new business.

You are given an online portal, checks, perhaps cards, and an EIN.

BTW an entity was formed based on just a few questions that limits your liability.

You may now do business – sell things – deposit receipts, pay expenses, run a
payroll – and there isn’t a single form to file. No lawyer or accountant to consult with. You are compliant by definition – your obligations are satisfied via the machinery of the account.”

Finally (from a good friend)

1998: “Don’t get into a car with strangers.”

2008: “Don’t meet people from the internet alone.”

2019: UBER – “Order yourself a stranger from the internet to get into a car with alone.”

*┬® Copyright 2019 by William Natbony. All rights reserved.