Three Burning Questions about Opportunity Zones in Vermont
Last year’s federal Tax Cuts and Jobs Act (the “Act”) contained many substantial changes to the tax code to generate a $1.5 trillion tax cut. Included in the Act was a “small” $1.5 billion provision that could have an outsized effect in small, rural states like Vermont. Section 1400Z of the Internal Revenue Code creates the opportunity zones incentive, a program aimed at attracting capital into low-income and rural areas that investors often overlook and that have largely not felt the effects of the economic recovery. This new program has the potential to provide a major boost to economic development efforts in Vermont, appears to mesh well with Vermont’s statewide planning and development goals, and could create additional incentives for smart growth in the State.
The goal of the opportunity zones program is to help low-income communities that have the potential for growth and revival, but lack the initial capital to begin the process. If this goal sounds familiar, it may be because Congress has in the past created many other programs attempting to incentivize rural and low-income development (we wrote earlier on the Act’s impact on some of these existing programs, such as the new markets tax credit and low-income housing tax credit programs). What distinguishes opportunity zones from these previous efforts is the new program’s simplicity. The tax credit programs, for instance, are highly complicated, heavily regulated and involve rigorous benchmarks to ensure that projects advance the program’s goals. In contrast, the Act defines the opportunity zones program in broad terms and the program is expected to be light on regulatory requirements.
The opportunity zones program works by enabling taxpayers who reinvest capital gains in qualified opportunity funds to receive substantial tax benefits that build over time. For the taxpayer to receive the full array of incentives, these funds must invest—and remain invested over a period of time—in qualified property and businesses in opportunity zones that the State designates and the Secretary of the U.S. Treasury Department approves. Below we unpack some of the mysteries of the opportunity zones program and explore where the program can be utilized in Vermont.
1) What is the Opportunity Zones Program?
The program provides incentives for taxpayers to reinvest unrealized capital gains in opportunity zones. The value of the incentives depends on the duration of the opportunity zone investment. Some benefits accrue immediately, but the most significant benefits kick in after five, seven, and ten years respectively. Opportunity zone incentives fall into two categories: tax relief for the capital gains from an earlier investment that the taxpayer reinvests in a qualified opportunity fund, and a tax exemption on capital gains arising out of the new opportunity zone investment.
First, the program provides tax advantages with respect to capital gains from an earlier investment that the taxpayer reinvests in a qualified opportunity fund. A taxpayer who reinvests capital gains in a qualified opportunity fund within 180 days can defer paying tax on that capital gain. The tax is deferred until December 31, 2026, unless the taxpayer sells their opportunity fund investment earlier, in which case the capital gain is taxed at the time of sale. This deferral provides investors with a guaranteed upfront incentive, which may help alleviate concerns around investing in unproven low-income areas.
In addition, the opportunity zones program provides further tax advantages relating to the initial capital gains and aimed at incentivizing longer-term investing. If the taxpayer maintains the opportunity zone investment for five years, he or she receives a 10% step-up in basis on the deferred capital gain, generating 10% in tax savings. After seven years, the taxpayer gets another 5% step-up in basis on the deferred capital gain. However, under current law, a taxpayer needs to invest in a qualified opportunity fund early to receive the full 15% step-up. Because the taxpayer must pay tax on the deferred capital gains for the tax year ending December 31, 2026, he or she cannot currently benefit from any step-up in basis that would otherwise occur after that date.
Finally, the program further incentivizes long-term investments with extremely favorable tax treatment of the investment in a qualified opportunity fund held for a sufficiently long period. If an investor holds the opportunity zone investment for at least ten years, all capital gains on that investment are tax exempt. Thus, an investment in a successful qualified opportunity fund could be highly lucrative for an investor.
2) Where are the Opportunity Zones in Vermont? How do they overlap with State programs like designated downtowns?
So now that you understand the benefits associated with opportunity zone investments, where exactly are these zones located? The Act, and subsequent Treasury regulations, direct the states to designate the zones within their own borders. Each state chooses from a list of “population census tracts” that qualify as “low-income communities” (“LIC”), defined in the Internal Revenue Code. States may also designate a limited number of “contiguous tracts,” slightly wealthier census tracts that are adjacent to LICs, as long as the median income in such tracts does not exceed 125% of the neighboring LIC. The governor nominates the proposed zones, and the U.S. Treasury Department certifies the pick.
The opportunity zone designation rules are very beneficial to small states like Vermont. Most states may nominate up to 25% of their LICs as opportunity zones. But the Act provides that all states may designate a minimum of 25 zones. Accordingly, a small state like Vermont, which has only 48 eligible LICs, can designate more than 50% of its LICs as opportunity zones. If the program is successful, Vermont and similarly situated states may receive disproportionate benefits from the opportunity zones program relative to larger states.
Vermont’s Agency of Commerce and Community Development (“ACCD”) seized on the opportunity to implement the program, inviting the public to engage in the opportunity zone selection process earlier this year. The Brookings Institute lauded Vermont, along with three other states, for “inclusivity and transparency” in the process. ACCD solicited public feedback, published two rounds of recommendations for the nominated zones, provided the opportunity for comment, and then submitted its final recommendations to Governor Scott. In the process, ACCD evaluated traditional metrics—poverty and unemployment rates, population and jobs—but also looked for overlap with existing infrastructure and State programs. ACCD further asked the public to weigh in on the potential for growth and financing. You can find a summary of ACCD’s process here.
Given this criteria, it is little surprise that Vermont’s 25 designated zones, including two “contiguous tracts,” correlate with the state’s historic population centers. Vermont’s zones are located in Barre, Bennington, Brattleboro, Burlington, Johnson, Lyndon, Newport City, Randolph, Rockingham, Royalton, Rutland, St. Albans, St. Johnsbury, South Burlington, Springfield, Vergennes, and Winooski. These zones provide existing infrastructure, the greatest potential for growth and financing, and ensure that projects benefit the greatest number of low-income people. Further, this concentrated and focused growth lines up with Vermont’s statewide planning goals of compact centers surrounded by working rural land. Developers deploying opportunity zone funding will be pleased to see that the designated zones overlap with the state designation programs that streamline permitting and provide additional incentives. Every opportunity zone in the State has a designated downtown, village center, or new town center within its borders.
Note that while every opportunity zone contains a designated downtown or center, the zones are typically much larger than the designated area and may not encompass an entire designated area. The census tracts that define the boundaries of the zones often track town borders, so an opportunity zone could apply to the whole town while the designated downtown or village center only covers a small central area. Additionally, larger cities contain several census tracts and sometimes several designations. Sometimes the statistically-drawn census tracts and the community- and planner-drawn state designations overlap poorly. In Lyndonville and Bennington, for instance, the census tracts divide the towns neatly into halves or quarters, leaving portions of those towns outside the opportunity zones. The use of statistically drawn census tracts can lead to some surprising outcomes. For example, in Lyndonville, one side of Main Street falls within the opportunity zone while the other side is outside the zone. Similar quirks exist in other cities and towns. Accordingly, it is critical to identify the exact location of a potential opportunity zone project early in the process to confirm that the project is in an eligible area.
3) How do I get involved?
To receive the benefits associated with the opportunity zones program, a taxpayer must within 180 days reinvest capital gains in a qualified opportunity zone fund. The U.S. Treasury Department has yet to release regulations concerning qualified opportunity funds, so at this point we do not know much about the process for creating such funds or the rules governing them. However, it is expected that these regulations will not be particularly onerous. In a recent FAQ, the Treasury Department indicated that the funds will likely self-certify using a simple form attached to a tax return. This form will be issued later this year along with the forthcoming regulations. In addition, the Act does set some parameters around the structure of qualified opportunity funds. They must be organized as corporations or partnerships “created for the purpose of investing in opportunity zone property.” They must also invest 90% or more of its capital in opportunity zone property during any six-month period, and may not invest in another opportunity fund. We expect to know more about the regulations concerning qualified opportunity funds in the coming weeks, so stay tuned!
Disclaimer: This blog post is provided for general informational purposes only and is not intended to constitute legal advice or to substitute for the advice of an appropriately licensed attorney. If the reader requires legal advice, s/he should contact a competent attorney licensed to practice in the reader’s jurisdiction. This blog post is general in nature and may not apply to particular factual or legal circumstances. The information presented is not an invitation to, and does not form, explicitly or implicitly, an attorney-client relationship.
