California Opportunity Zones

Without federal support California has to begin to look at new sources of funds and how to achieve scaled investments.

Whatever the structure will be for California’s rebuild, we will need a new bill to create a tax treatment for investment incentives to bring the necessary capital to rebuild post-disaster. There should be some guardrails. We wrote a bit about the concept a couple days ago. Now I want to flesh out the concept further after conversations with various people and their input.

First things first, let’s acknowledge a few of the lefts and rights. Here is your problem set.

1. We have a state dependent on income taxes (i.e. Capital Gains).

2. We have a desire not to add any new taxes to the residents of California.

3. We need to fund rebuilds with State-related resources but not with existing budget dollars spoken for.

4. We need hundreds of millions or billions of dollars to be an “equity” slice of the rebuild.

5. We also have a need to ensure where climate-related concerns are evident, there is not a repeat of the development decisions which could create another disaster.

Another reality is disasters are rising in price and affecting California more frequently. We need to do something to incentivize local governments to make development decisions which begin to limit disasters in the future, especially where the federal government is signaling States will be required to take on more of the cost of disaster recovery. If so, the true cost of development decisions are being born on those localities and their residents.

Now we have these “districts” being formed to rebuild. They are woefully undercapitalized for the needs they are promising (more on this issue in another post to come regarding the promises made about 782 and the reality). Tax Increment Financing cannot possibly address the scale and scope of these rebuilds and will distort priorities toward gentrification and commercial investment and away from housing, in particular low-income housing which does not increase property tax for the funding, at least in the near-intermediate term. To give context, TIFs in their previous form were only generating $5 billion annually across all of California. Assuming Los Angeles is 20% of California, that would mean potentially $1 billion for all of Los Angeles. Considering Altadena and the Palisades are a fraction of a fraction, $100 million is a high number. I would say $50 million is a more realistic number, certainly for Altadena.

As this Stack has tackled, there are federal supports and State programs being created to corral the money and focus it. AB 797 for instance is a new class of security which can consolidate and allocate Community Reinvestment Act (CRA) monies. There is no new legislation needed for these efforts and the scale can replace, in the right package, much of the Disaster Relief (CDBG-DR) funds from the federals.

Tax-free bonds are another source of funds, but they are infrastructure related. Other “private activities” are limited up to $4 billion for the entire state of California, including all other efforts besides the disasters. Tax-free bonds also have to be guaranteed by tax dollars which are increasingly reduced relative to what is promised in the budget.

However, we have a source of funds we can tap which is likely a huge, underdeveloped market, that of capital gains. Capital gains are the profits you receive when your investment “pays off.” At the federal level, capital gains over a certain amount are taxed at generally 20%, regardless of your tax bracket (which is up to 37% in the highest income tax bracket). At the state level, capital gains are not treated specially. They are taxed the same as regular income, with a top bracket of about 13.3%. Therefore, when I sell stock or my company is sold, I am paying what I would as a regular income.

Opportunity Zones are a tax incentive program at the federal level to induce investors to take their capital gains and “roll them over” within 6 months of the “liquidity event.” If the investor puts their money into a qualified fund, the investor can “step up the tax basis” over a period of time depending on how long they hold the investment for, but can knock the tax down to 10% from 20% of the gain. Moreover, if you hold an investment for over 10 years, the investment itself will be essentially tax free federally.

For investors, Opportunity Zones are very atractive. Obviously the mechanics of the State will be different than the federal government, but the principle can be the same. Capital gains are a huge source of income, particularly for our State, representing between 10% and 25% of annual income tax revenue which exceeds $130 billion.

They also present a source of untapped investment for supplementing parts of our State’s needs, pulling investments forward. They can, if structured right, be a catalytic investment for our disaster recovery.

How would it work, as there are a lot of words there. Well, the tax break would need to be a “deferral” instead of actual reduction as the income from capital gains are a huge part of the State’s needs in cash flow. We would also need to make it an incentive for investors to see some benefit to make the investment and take the risk in a disaster area. Also, we need to ensure, if deployed, we are taking steps to reduce the risk of future disasters if we are having to address these concerns going forward.

There are your lefts and rights for those who do policy for a living. For those who are going to call out, “but Steve, the State needs to have that cash, so if you ‘defer’ it you are subjecting the State to a cash crunch,” I respond, “but everyone in the State is fine to TIF property taxes, so what’s the difference?” TIFs are pulling forward promised income. Why not defer and pull it forward by paying to have it or a portion thereof. In fact, I think these investments would be cleaner than TIFs. There is no projection- you know what the tax liability is every year. TIFs are what everyone is using to fund the rebuild, so let’s TIF what we can really use.

Ah, you see, there is a way to get there and I would think we can get around the detractors.

Ok, so we pass the first hurdle. How do we make it work?

1. I would make sure it was a deferral of tax up to 7 years to be invested in qualified activities including disaster relief, affordable housing, and climate related investments (i.e. microgrids, water capture).

   1. Maybe we make certain investments deferred up to 10 years if we want for certain policies or disaster-related needs.

2. Investments must be allocated into a specific fund operated by the State.

3. The State can obtain up to 1.25% of the gross invested dollars to operate such a fund in management and overhead.

4. After 7 years, the original tax is due.

5. For the investment, you can opt to pay tax on the gains to date when you pay your deferred tax, or you can opt to pay at the end of the investment.

   1. The choice allows investors to defer the gain or take a treatment similar to the federal Qualified Small Business Stock (QSBS) treatment, meaning you pay tax at the outset of an investment or when it sells. Waiting 7 or 10 years allows time to decide which way to go.

   2. If you push up the tax date to 7 years to get a better treatment on the investment, all the better for the State to get its funds.

6. Investors can only defer 75% of their total capital gain on an investment at any one year.

7. Investments must be made through a qualified Opportunity Zone fund operated by the State and I-Bank.

   1. The fund can only invest up to 30% of the total assets in real estate.

I mean the parameters are pretty easy once you realize what we are trying to do.

For the funds created, here is where we “show the money.”

It is said that from 10% up to 25% of California’s income tax comes from Capital Gains. If the number is 10%, and our State generates $130 billion in income tax, then $13 billion of revenue comes in via Capital Gains. If we can use 20% of that figure in the above scenario, it allows us the ability to catalyze $2.5+ billion to be used to supplement investments annually. Over 5 years, there could be more than $13 billion available to help rebuild after disasters.

We are just trying to think outside the box. Perhaps there are other ways to generate revenue, but if you look at the fact Redevelopment Agencies (RDAs) generated $5 billion before their dissolution per year, the Opportunity Zone model could get us close to that kind of money, and would be catalytic considering. I am only considering a small portion here and using very conservative figures. There is a desire to turn the EIFDs to RDAs, and just think about how much can be generated if we pulled the OZ money forward into a State run program.

Again folks, it is about new thinking in light of what is ahead of us. Time to consider all the options because we need them. A bill can be drawn up pretty quickly. You need the funds. You need to create something new. Here is a source you can control.