As anyone in Silicon Valley will tell you, wealth begets wealth. Whenever you have areas with disproportionately large concentrations of resources - from human capital to venture capital - you'll see disproportionate investment and exponential growth over time. This is one of the main reasons why almost 40 percent of Americans live on the coasts, despite the fact that these areas comprise a tiny fraction of the country geographically.
Concentrations of wealth and human capital are good for some entrepreneurs and bad for others. They make it easy for investors to ignore huge swaths of the country and ensure that entrepreneurial ecosystems are much healthier in places like San Francisco than places like Detroit. Like over-investment, under-investment is self-perpetuating, and it can lead to economic stagnation, population decline, and other pernicious consequences for cities and regions that have been neglected.
The 2017 Tax Cuts and Jobs Act attempts to address this problem with the creation of "Opportunity Zones" (OZs) - economically troubled parts of the country that are in dire need of investment and entrepreneurial activity. To get more capital flowing to these areas, the government is offering various tax breaks to investors who put their money in OZs. This won't just contribute to the revitalization of areas that are experiencing sluggish (or nonexistent) growth and the accompanying social and civic problems - it will likely give investors some huge returns. Here's a closer look at why OZs matter and what they mean for investors.
Geographic investment disparities have been surging
There are significant geographic disparities in economic activity in the United States. For example, almost 45 percent of venture capital investment in the country is funneled into the Bay Area, while another giant chunk goes to firms located in Boston, New York, and Washington, D.C. According to a recent CityLab analysis of data from Pitchbook, the "five leading metros account for more than 80 percent of total venture capital investment and 85 percent of its growth over the past decade."
That second point is a reminder why OZs are so important. It's not just that certain parts of the country receive more VC investment than others - it's the fact that those areas are continuing to grow so much more quickly than others. As CityLab notes, San Francisco and New York have seen 400-plus and 500-plus percent VC growth rates (respectively) over the past decade - orders of magnitude larger than the rest of the country.
There are plenty of problems with this status quo, even for the cities that ostensibly benefit from it. Monique Villa is an investor at Mucker Capital, and she points out that we're "witnessing the fallout of an over-concentration of resources in coastal cities like San Francisco where fundamental needs aren't being met, like access to affordable housing." Meanwhile, she argues that it's "important to infuse capital into these [underserved] regions, but it is important to participate in the community as a local stakeholder while providing access to resources all across the country." That's where OZs come in.
What OZs can do for distressed communities
According to the Economic Innovation Group (the think tank behind OZs), more than $6 trillion in capital investment is available for deployment in distressed communities through the program.
While the level of actual investment remains to be seen (echoing Treasury Secretary Steven Mnuchin, Republican Sen. Tim Scott thinks a "realistic estimation, in the first few years, would be about $100 billion"), it isn't difficult to see how thousands of OZs could see an economic boon if they convince investors that they're worth looking into. Outside investment can create jobs, attract educated workers, retain the existing workforce, and strengthen the entrepreneurial ecosystem (the network of businesses, foundations, and educational institutions that fosters innovation and collaboration in a community).
As Villa puts it: "While the Opportunity Zone's true benefits to economically distressed communities remain unclear, unlocking investable capital while encouraging a more distributed network of startups has real potential in the coming decade."
Most new jobs over the past decade have come from new business formation, but as the EIG reports, new firms are heavily concentrated in a small number of counties. OZs can balance out these disparities, but communities can't just sit around and wait for the money to pour in. They have to remember that they'll be competing with other opportunity zones, which is why they should enlist the help of local foundations, businesses, and other stakeholders in attracting new investments.
Why OZs are good for investors
Brian Phillips is managing partner at The Pearl Fund, the first Opportunity Zone fund in the country that is also a venture capital fund, and has been building and selling high-growth companies for three decades in heavily capitalized innovation hubs. He believes there are "huge incentives to release capital into OZs," which is why he says "we are moving high growth businesses into these zones." Villa echoes this point: "We have seen a significant shift in thinking from the venture capital community thanks to the Opportunity Zone discussion. Despite regulatory uncertainty, VCs from coast to coast are finally recognizing the opportunity to invest in high-potential geographies in need of capital."
By putting their resources in OZs, investors can drastically reduce the amount of capital gains tax they have to pay. For example, if an investor sells a property, invests the proceeds in an OZ within 180 days of that sale, and keeps the investment through 2026 (as long as it was made before the end of 2019), she will receive a 15 percent reduction in capital gains tax. If she invests in an OZ and holds onto it for ten years or longer, the capital gains tax is eliminated entirely. But all of these advantages are time-sensitive. As Phillips notes, "with new regulations closing in April, the floodgates have opened up in opportunity zones. Investors should be informed about this now."
OZs will expire in 2026, which means investors have to act quickly if they want to take advantage of certain elements of the program. For example, to get the 15 percent reduction in capital gains tax, reinvestment in an OZ has to be finalized by the end of this year. What's more, investors are competing to identify the OZs with the most potential. These are all reasons why investors should be looking into OZs sooner rather than later. Not only do they have an opportunity to benefit from some of the most generous tax incentives the U.S. government has offered in decades, but they can also contribute to the restoration of American cities that have been neglected for far too long.
As Phillips aptly notes: "My perspective is that you can build and grow solid businesses with good returns in the middle of the country. Companies with the right amount of capital can see returns of 10 to 50 times the initial investment. It doesn't always need to be a 1000 times. After all, how many unicorns can there possibly be?"