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California Opportunity Zone Funds: A Developing Compliance Landscape

By Michael Halloran, Chairman and CEO of NES Financial

Originally published in The Registry.

As innovative as California is, there’s one key area the state could better improve in and can’t afford to be in last place for: Opportunity Zones.

The basics of the Opportunity Zone program are intentionally simple. Individuals who reinvest capital gains into designated Opportunity Zone Funds may temporarily defer, and eventually reduce, their tax burden on those capital gains. These funds in turn go toward distressed communities that might not otherwise get investors’ attention. In addition to the tax deferral and reduction on the original capital gain invested, after 10 years in the fund, no capital gains tax is recognized on post-acquisition gains from the investment in the Opportunity Zone Fund.

The program is a win-win for everyone involved, especially the local distressed communities and investors wanting to make a significant social impact for good.

So why is California late to the Opportunity Zone party?

NES Financial, headquartered in Silicon Valley since 2005, is the predominant and preferred fund administrator when it comes to Opportunity Zones. This exposure has allowed us to identify some clear Opportunity Zone trends – even if the program is relatively young. Authoritative statistics will emerge soon, but right now we can see where things are headed.

California will likely catch up once it’s clear how the program works with the Golden State’s slower and more complex land-use process.

In fact, the San Francisco Bay Area has already been featured in headlines around Opportunity Zone funds, including Urban Catalyst, an Opportunity Zone fund based in the state, and EJF Capital, an Opportunity Zone fund investing in Oakland from their base in Virginia. Currently, less than 8 percent of Opportunity Zone fund managers we work with are located in California, compared with more than 18 percent who are in New York, and 12 percent who are in Florida.  As new fund managers enter the Opportunity Zone space we anticipate that New York will soon account for more than a quarter of the active fund managers, Florida will host more than 16 percent, and California will lag behind with roughly 10 percent of the active fund managers.

To be clear, California stands to be a key region for Opportunity Zone development. Of the total 8,760 Qualified Opportunity Zones in the U.S. today, California is leading the other U.S. states with over 870 of those Qualified Opportunity Zones available for new projects. However, while 14 percent of the current projects we have reviewed are in Florida, and more than 19 percent are in the New York/New Jersey region, only a little more than 7 percent can be found in California.  Worse yet, our data indicates that we will see Florida moving in the direction of having closer to 23 percent of the projects while California is trending toward a meager 9 percent.

Despite the fact that California is late to the party, no one should debate that the state needs Opportunity Zone projects and their associated funds. Even if the state can be more challenging than most for land use and development, it can be done right if the correct processes are in place.

Increased Compliance and Reporting Requirements

Generally, the Opportunity Zone Program is set up to encourage investment in underserved areas.  The statute, as written, requires little on the part of the investors in order to qualify for the tax benefits participation in the program will allow. However, with important guidance still being developed at the federal, state and local levels, the risk of unexpected tax liabilities for investors can be considerable. Given the overarching goal of economic development in disadvantaged communities, it is likely that the federal government will impose specific reporting requirements and collect economic impact data on the Opportunity Zone investments. Sens. Cory Booker (D-N.J) and Tim Scott (R-S.C.) are planning to file a bill to reinstate requirements for the Treasury Department to collect data on and disclose the tax breaks’ progress the week of May 6.

Some states and municipalities have begun offering incentives to encourage Opportunity Zone development in their areas such as matching funds, favorable zoning, expedited permitting and additional tax breaks.  But if investor capital is misdirected or misappropriated, if highly publicized failures begin to pile up – or simply, if the evolving network of federal, state and local regulations becomes too onerous to track and comply with – the Opportunity Zone program will fail to achieve the good it is intended to do.

The ultimate success of Opportunity Zones largely hinges on participants engaging in best practices when it comes to compliance, transparency and security – in California and elsewhere. 

The Importance of Transparency

From the start, new fund managers should implement audit best practices. Not only will this save time during regulatory inquiries, solid auditing can strengthen marketability with potential investors. The Opportunity Zone program has many stakeholders and is tax-centric, which means there are more moving parts than with traditional funds and this could lead to more complex tracking and reporting requirements. All material information must be made accessible to all relevant stakeholders – with verifiable audit trails – as and when needed.

Investors naturally want to know where their money is, what it’s doing, and when it is being invested into a qualified Opportunity Zone property or business. They also want to be confident that the fund is complying with relevant milestones. The best way to protect their funds, their tax benefits, and their loyalty is through verifiable oversight – preferably through a user-friendly portal.

A fund manager should establish an Opportunity Zone reporting framework that includes the following elements: how the project was conceived with a focus on local communities, evidence of genuine community engagement, and measurement and tracking of socioeconomic impact – job creation, wage growth, increasing affordable housing units – through one or more common methodologies. This type of reporting should be done consistently, at least annually, throughout the entire project life cycle.

Security at the Forefront

Third-party, comprehensive, institutional-grade quality Opportunity Zone fund administration services should be a cornerstone of any offering. Opportunity Zone fund managers should use the same level of third-party oversight to ensure funds are operating as intended. Fund administrators should generally undergo ongoing third-party compliance examinations. That includes reviews of controls over technology, financial processes, information security and data protection. Fund administrators in the Opportunity Zone space should also be able to offer customized reporting capabilities that address the unique needs of these offerings.

It’s important to set up proper controls on the movement and tracking of the monies to ensure funds’ safety as well as verifiable oversight.  Not only is it imperative to have records reflecting the fund’s usage of the investments at specific times throughout the development of an Opportunity Zone project, but each investor requires detailed accounting and reporting of the timing and use of their particular investment in the fund in order to take advantage of the tax benefits afforded by the Opportunity Zone program .

Understanding the tax and securities laws and keeping up with the panoply of still-developing tax regulations and tracking and reporting requirements can be challenging. Scaling up to meet sudden investor demand can pose thorny problems. New managers may struggle to meet investor demands for instant transparency into their positions and holdings. That’s especially the case when holdings are in illiquid assets. Being confronted with an unexpected regulatory inquiry can put pressure on a fund if there is no clear audit trail embedded in their fund administration processes.

At the end of the day, best practices including thorough record keeping, and specialized reporting will support the Opportunity Zone program.  It may also be exactly what the State of California needs in order to get comfortable and agree to conform with the federal program.

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If you’d like more information on Opportunity Zones, please take a look through our web-based OZ resource center — or feel free to contact us at 1-800-339-1031.