Windows of Opportunity

Existing investment challenges financial institutions should understand to capitalize on tax incentives offered by Tax Cuts and Jobs Act of 2017.

CCBJ: For financial institutions, what kinds of investments qualify as opportunity zone investments under the 2017 Tax Cuts and Jobs Act?

Tucker Thoni: The 2017 Tax Cuts and Jobs Act established the Qualified Opportunity Zone program to provide tax incentives for private, long-term investment in economically distressed communities. These “opportunity zones” are designed to spur economic development and job creation in distressed communities throughout the United States by providing tax benefits to investors who invest eligible capital gains into these communities. However, for banks and financial institutions to qualify is more problematic than one might think because only equity investments qualify for the tax benefits associated with the qualified opportunity zone tax regime. Banks and other financial institutions generally do not have a lot of capital gains and tend to make investments with debt more often than equity due to existing banking regulations restricting banks from holding a large amount of equity investments.

Another problem for banks qualifying under the new tax regime is that only capital gain is eligible for the tax benefit associated with the new tax regime, which will be an issue for banks and other financial institutions because most of the financial assets held by those institutions are ordinary assets. Similarly, real property that’s acquired by foreclosure by a bank is held as an ordinary asset. This is not to say banks can’t have capital assets. If they’re holding something as a capital asset, and that capital asset has appreciated, and the bank recognizes capital gain, the bank is eligible to invest that capital gain – and defer paying tax on it – into an opportunity fund.

But as I mentioned, banks often don’t hold a lot of equity interests, and since the amount of capital assets they have are modest at best, I do not think that there’s going to be great potential for banks making direct equity, or eligible gain investments, into an opportunity fund. By the same token, it is possible, if not likely, that an investment bank would have capital gain so there’s potential for investment banks to focus in on the opportunity zone program.

What are the top regulatory and reporting considerations for financial institutions seeking to invest in opportunity zones?

From a regulatory standpoint, in addition to the capital gain and equity investment requirements discussed above, the asset tests are likely going to be a prohibitive obstacle for financial institutions and banks with respect to opportunity zone investment.

Under the asset test applicable to a qualified opportunity fund, which is the investment vehicle used for qualified opportunity zone investments, the fund must hold 90 percent of its assets in either zone property, which is tangible property used in a trade or business that is owned or leased by the fund itself, or entity interests in a qualified opportunity zone business. A qualified opportunity zone business, or a QOZB (a.k.a. Quasi-B), is a lower-tiered regarded entity that is generally owned by a qualified opportunity fund.

However, banks and other financial institutions generally hold substantial financial assets, which are not going to meet the definition of zone property, or a QOZB entity interest. So the asset test is going to make it difficult for banks and other financial institutions to qualify as an opportunity fund.

It’s feasible for an investment bank to qualify as an opportunity fund if it were to hold 90 percent of its assets in QOZB interests. It is certainly a remote chance but we may see some investment banks in the private equity world try to create funds that are specific to the opportunity zone regime.

Banks and financial institutions also likely won’t qualify as a lower-tier QOZB entity because there are strict limitations on the amount of non-qualified financial property – debt, stock, partnership interest, options, future contracts, warrants, annuities and other similar financial property – that a QOZB can hold, which is a prohibitive condition for most banks and financial institutions.

Though this is beyond the scope of the question, I wish to point out that most taxpayers are going to utilize a two-tiered QOZB structure where the opportunity fund, the top-tier entity, will just be the funding entity and the parent. Most of the business operations, whether it’s real estate or an operating business, will carry on in these lower-tier QOZB entities.

That is why the strict limitation on non-qualified financial property is going to be problematic for banks making qualified investments under the regime.

How do opportunity zones relate to the Community Reinvestment Act (CRA)? Can banks count opportunity zone investment as CRA credit?

This is a hot and emerging topic right now. As currently constituted, there is no CRA consideration directly linked to an investment in an opportunity zone. So whether or not a lender will get CRA credit is going to be determined under the particular community development standards applicable to the CRA and will not necessarily have anything to do with relation to an opportunity zone.

It would be good policy, and it would certainly help the opportunity zone regime, if opportunity zone investments within the bank’s assessment area were deemed to be community development under the CRA. I believe such policy is being considered by the Federal Deposit Insurance Corporation (FDIC), which held a meeting of the advisory committee on community banking, on October 10, 2019. At that meeting, the FDIC senior staff discussed tools and resources related to opportunity zones, among other topics.

As I’m sure readers are well aware, the National Bank Act makes CRA credit difficult for national banks. But there’s a public welfare exception provided under the guidance and authority of the Office of the Comptroller of Currency (OCC), the agency that enforces the CRA.

What the public welfare exception allows is for national banks to make investments in community development entities and projects aimed at promoting public welfare, including direct and indirect investments that provide housing, services or jobs in low- or moderate-income areas.

Since opportunity zones are based on low-income census tracks, it would appear there is a nexus of common purpose between the two programs. It would be nice to see, and it would certainly open up a lot of national bank lending into opportunity zone projects, if we could link these two programs. The OCC, too, is currently mulling a suggestion to give banks CRA credit for investments made in opportunity zones. That was reported in August. To that point, the FDIC chair, Jelena McWilliams, said, “The OCC, the Federal Reserve Board, and the FDIC are working to issue a joint proposal on CRA reform in the next few months.”

But the comptroller of currency, Joseph Otting, tempered expectations by responding, “There’s no guarantee that the opportunity zone CRA credit linkage will be included in the reforms.” I think there’s been a lot of hope and speculation that linking the two programs will pan out.

I do know that there’s a concerted effort by the Trump administration to incorporate opportunity zones into various executive agencies. For instance, the Small Business Administration is currently trying to determine ways to fold in the program under its various programs. This would be great and would help bring banks more fully into the opportunity zone program.

As discussed in the previous question, banks will likely be excluded from direct investment but hopefully they can get a piece of the pie by getting some CRA consideration, and maybe the credit.

What unique challenges might financial institutions face when investing in opportunity zones?

We’ve discussed the challenges banks and financial institutions will face in qualifying for the tax benefits under the new opportunity zone regime. But they can still be great lending partners for developments and businesses operating within the zones.

A recent Federal Deposit Insurance Corporation (FDIC) report on opportunity zones indicated that there are just under 1,100 FDIC-insured banks headquartered in opportunity zones. Of these, 899 are community banks, 38 are community development financial institutions, and 32 are minority depository institutions. There are also more than 12,500 FDIC-insured bank branches located in opportunity zones, including just under 4,300 community banks, just over 200 community development financial institutions, and just over 450 minority depository institutions.

Because banking is a relationship business, bankers know their communities and the movers and shakers within those communities. The successful bankers generally have developed strong working relationships with the developers, business owners, property owners, local officials and community leaders.

Assuming that bankers are well positioned in these communities – even if these may be identified as blighted based on a low-income census track – and these areas can be designated as opportunity zones, the bankers know all the players in the deal. They have a working understanding of how their clients and borrowers are underwriting deals. Consequently, the bankers, by virtue of their presence in the community, become better lending partners.

Anecdotally, I think banks need to be flexible and adaptive with their lending practices to accommodate the particularities of opportunity zone investments. For instance: We’re currently working on a large industrial deal in Greenville, South Carolina. One of the peculiarities of opportunity zone investments is that it makes sense – and is often advantageous – for the client to close on a newly constructed building before obtaining a certificate of occupancy.

This doesn’t happen normally. Closing on a newly constructed building prior to obtaining certificate of occupancy is anathema and certainly caused some consternation in the bank’s underwriting and legal departments. Luckily we had good banking relationships, and credit goes to our lending partner that was willing and able to understand why we were closing prior to the developer obtaining the certificate of occupancy. To the extent banks can be great lending partners, and can be flexible to the peculiarities of opportunity zone investments, they could really do well in the space.

The opportunity zone regulations may be finalized and published by the end of 2019. What are the key questions and issues facing financial institutions that may be addressed with the updated regulations?

I think this is optimistic. I’m not confident that the current proposed regulations, of which we’ve had two tranches, will be finalized this year, or that a subsequent tranche of proposed regulations, which is expected, will open the door for direct investment by banks.

The opportunity zone tax regime has received some bad press in the national media and on the Democratic Primary debate stages. I’m more concerned of what changes we might see in terms of taking back parts of the regulations that have already been put forward. But I don’t think we’re going to get finalized regulations by the end of the year.

There’s some concern over what might happen legislatively. But from my understanding, I don’t think there’s going to be anything that opens the door for financial institutions to make eligible investments that qualify under the regime.

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