The IRS may be making a huge mistake that only supports the wealthy. (But you can help fix it.)
At Cutting Edge Counsel we stand for fairness and equity. A big part of what drives us is the need to level the playing field between the wealthy and the non-wealthy. We envision an America where everyone can invest, with the same benefits available to all investors regardless of economic status.
So we were very disappointed in a recent IRS release that will lead to the opposite result. We’re talking about some of the tax benefits of investing in a Qualified Opportunity Fund — a new type of fund that is intended to incentivize investment in low-income communities designated as Opportunity Zones, which we wrote about here.
The new tax rules are contained in Subchapter Z of the Tax Cuts and Jobs Act of 2017. Section 1400Z-2 of that new law provides for three tax benefits of investing in a Qualified Opportunity Fund (a QOF): Clause (a) provides for a deferral of tax on rolled-over capital gains until the end of 2026. Clause (b) provides for a 10% or 15% step up in basis for rolled-over capital gains held in a QOF for at least five or seven years by the end of 2026. Clause (c) provides that “any investment” held in a QOF for at least ten years will get a step up in basis to market value upon a sale of the investment. This last benefit is the most valuable of them all.
While the plain language of Section 1400Z-2 says that literally any investment in a QOF, which would include an investment of after-tax capital, can get this last benefit (tax-free capital gains after ten years), the IRS stated in an October 2018 release that this benefit is available only to rolled-over capital gains. The IRS offered no analysis or reasoning behind its statement, which suggests the IRS may have simply mis-read the statute.
This is more than just a technical detail. This is a fundamental reinterpretation of the law in a way that excludes the roughly 95 percent (i.e. non-accredited investors) who may not have capital gains to roll over. As passed by Congress, the law allows for the creation of a true community investment fund that invests in real estate projects in Opportunity Zones. Taking in investment from residents of the very low-income communities that the fund is designed to serve would help to ensure not only that the profits from those projects circulate within the community, but it would also give those residents a voice in the kind of development that happens in their communities. The benefit of tax-free capital gains after ten years in the fund can be a critical factor in attracting these investors.
But this reinterpretation by the IRS changes everything. Bear in mind that, typically, it’s only the wealthiest Americans who have capital gains that can be rolled over into a QOF. From the point of view of a QOF manager, if only the wealthiest investors can enjoy any of the tax benefits of an investment in the QOF, there is no incentive at all to open up the QOF to the less-wealthy residents of those Opportunity Zones.
Hence, under the IRS’ reinterpretation of the law, QOFs will likely be only open to wealthy (accredited) investors; and those wealthy investors will then effectively determine the kinds of development that happens in low-income communities, with no opportunity for the residents of those communities to have a voice or to participate in any way. The outcomes will be very predictable. Overwhelmingly, these wealth-driven funds will invest in so-called “market rate” housing – a euphemism for unaffordable luxury housing that is not intended to serve the residents of those communities but is intended to displace them.
It does not have to be this way; it should not be this way; and the law does not say this! Our firm has written this letter
IRS-Letter-Re-Opportunity-Fund-Tax-Benefit.pdf to the IRS pointing out the apparent error, and we have asked the IRS to clarify that the benefit of tax-free capital gains after ten years in a QOF is available for any investment in the QOF, including investments of any kind of after-tax capital, whether or not an investor is sheltering or eliminating their capital gains taxes.
But meanwhile, we are making an ask of our community — individuals and organizations. It would be easy for the IRS to ignore one letter from a small law firm based in Oakland that only serves mission-aligned businesses. It would be much more difficult for them to ignore howls of protest from around the country. If you care about leveling the playing field (and if you’ve read this far, you likely do), we strongly encourage you to write to the IRS (addressed to CC:PA:LPD:PR (REG-115420-18), Room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044), or to your Congressperson, to bring this to their attention. While the official comment period for the proposed regulations has closed, we think this is too important to ignore.
And there is urgency to this, because the IRS may be finalizing their QOF regulations at this very moment. Once they have issued final regulations, it will be much harder to get them to back away from their blunder. So the time to act is now. Together, we can make a difference.
We spoke to Lauren Grattan and David Lynn at Mission Driven Finance to talk about their mission, and how their community-first perspective guides them to find investment opportunities.
What does Mission Driven Finance do and what are its guiding principles?
Mission Driven Finance is an impact investment firm dedicated to building a financial system that ensures good businesses have sufficient, affordable access to capital. Built from the ground up with a single purpose—to make it easy to invest in your community—all our funds and structured products are designed to close financial gaps that will close opportunity gaps. We work with local and national investors to help them create the impact they want, and work with businesses and community partners to help them get the capital they need.
We have three guiding principles:
- Community Connected Capital – We use a network mindset to source, underwrite, and support investments. This helps us build solutions for and with the community.
- Employers as Change Agents – Impact isn’t just for nonprofits. We believe small businesses are critical components of thriving communities, and help them to intentionally use their operating expenses to create positive change.
- Strength in Diversity – We’re stronger together, as a team and as a society. Diversity is not an afterthought for us but rather core to our ability to source deal flow and underwrite effectively. With a variety of lived and worked experiences, the team is collectively able to recognize untapped market opportunities and partner sensitively with traditionally underserved communities, supporting our vision of an inclusive economy that is strong and resilient.
What inspired your work and mission?
Communities need good businesses, and good businesses need capital. But the financial systems, structures, and policies in America have both intentionally and unintentionally restricted access to capital and opportunity. The result is significant wealth inequality that hinders social mobility, dampens economic growth, and fosters conditions for political instability–Mission Driven Finance can change that.
We saw bold visions, innovative enterprises, and great community programs seeking capital on the one hand, and a growing pool of impact-intrigued investors on the other, but little to connect them. So we built a team with deep impact and finance skills, and intentional diversity of thought and experience to bridge the divide between community projects and investors.
While there are increasing responsible options in public markets, these have limited intentionality and typically mean moving money out of your regional economy. Investors are hungry to support initiatives in their own backyard or issues they’re passionate about, but have few opportunities to do so. Mission Driven Finance exists for this reason: to make investing in your community a great investment.
How does MDF decide on its investment strategies?
We start always from a community-first perspective, with the goal of mobilizing capital into overlooked and underestimated areas, whether geographic or thematic. We identified five key hurdles to unlock transformative capital for communities: size, credit, complexity, timing, and alignment.
Our structure allows us to pursue smaller and more nuanced community-based transactions that would otherwise be cost-prohibitive and suffer from inertia. We can service many types of transactions while leveraging a core set of elements and operations, allowing us to close gaps in a cost-effective manner.
Our investment strategy centers around mobilizing capital in ways that meet all of the following criteria:
- Is there a capital gap that is preventing scale?
- If we close this gap, will it increase impact?
- Are we particularly well-positioned to close this gap?
- Does closing this gap create a more inclusive economy?
- Is this gap indicative of a common problem that we can close?
Our first fund, Advance, is an evergreen commercial debt fund to close a gap for community-driven small businesses and nonprofits in the greater San Diego area that are too big for microfinance, yet can’t qualify for (sufficient) bank financing or venture capital. This gap of $100k to $500k plagues retail, childcare centers, and small real estate developers alike, stymying impactful organizations.
Following our community-connected capital approach, we work with a variety of partners to source and support potential investments, including other lenders and investors, business improvement groups, nonprofits and foundations, and accelerator and incubator programs. We regularly seek borrowers that meet our 3 T’s:
- Tenacious – Driven leadership with a history of execution and commitment to their community
- Tweens – Don’t fit SBA/microloan/bank/VC criteria and stuck without affordable access to capital
- Tipping Point – Where our investment will unlock potential and attract additional resources
How does MDF evaluate potential investments?
Mission Driven Finance employs a private equity approach for evaluating financing opportunities using a deep community engagement model to find, evaluate, and de-risk investments. Our approach allows us to focus on the potential to achieve a plan as opposed to a specific credit quality or company history. In this way, we can mobilize capital to people and projects that might otherwise be unable to access financing.
The core of the Mission Driven Finance investment process is identical regardless which investment vehicle–an Asset Pool in the Fund or other vehicles outside the Fund–holds the investment or deploys the capital. In all cases we evaluate the investment on its own merits, ensure alignment with investors, and then leverage the most efficient investment structure.
Our scoring rubric includes three concurrent and interconnected underwriting modules – management, impact, and finance – and is intended to determine comfort with the:
People – The management is high quality, coachable, and well validated by their community.
Plan – There is a clear strategy and vision to grow both revenue and impact.
Purpose – They have an underlying mission that is core to their ethos and pervasive.
Potential – There is a history of achievement, commitment, and a viable path to success.
All of our processes are designed to be inclusive, intentional, and looking for ways to say “yes.” We follow a 5-stage process to underwrite potential investments:
Initial screening based on alignment with management, impact, and financial criteria.
The beginning of a formal engagement, including technical assistance around financial and impact frameworks, management evaluation, and transaction structuring.
The formal approval and closing process, including legal agreements.
In addition to servicing, we provide ongoing support and monitoring of the investment to maintain status as a trusted partner, be aware of any developing issues, and find opportunities to help them grow their business, along with collecting regular impact data, financial updates, and stories.
Even after a borrower successfully exits the portfolio, we continue to look for opportunities to help them grow or integrate with other parts of our portfolio, and also collect long-term impact stories.
Who can invest in MDF’s investment funds?
Accredited private, institutional, or charitable investors can participate, all via promissory notes. Private and institutional investors can invest directly or through accounts such as IRAs. Charitable investors can invest from foundations either as a Mission Related Investment in their corpus or as a Program Related Investment from their grant allocation. Another avenue for charitable investors is to invest through their Donor Advised Fund with a community foundation. We have good local partnerships with both the San Diego Foundation and the Jewish Community Foundation of San Diego.
How have you seen societal concepts about investing change in the last few years?
We certainly see an increased focused on responsible and impact oriented investments as evidenced by the rapid growth shown in data like US SIF publishes. However, this has also given rise to a large amount of impact-washing. Additionally, as much as people talk about shifting their investments to align with their mission or emotions, they still often end up taking a financial-first approach and mission falls to the wayside – even within mission-based organizations. The biggest shift we see is while there is still a huge need for education, most investment committees and advisors have at least heard of “impact investing” and “responsible investing”, even if they aren’t doing anything about it (yet).
We see more and more non-accredited investors wanting to invest with their values but still being unable to do so. We’re hoping to be able to reach non-accredited investors in the next year or two.
What advice would you give to companies who want to raise capital from impact investors?
Make sure your mission is completely core to your ethos and what you do, and can’t be removed from your business. For instance, we don’t get excited about buy-one-give-one or companies that pledge to donate some portion of their profits to some cause. We are looking for businesses where there is no possibility that the business can scale without the impact also scaling. It follows from all of that, you should also be thinking about how to measure your impact if you haven’t already! In addition, we look for management that clearly is a part of their community, and who would consider any loss of impact a failure even if the business is succeeding.
What advice would you give to investors who are considering impact investing?
Beware of impact washing. Do your homework–not all funds, managers, and businesses are created equal. Be clear about your goals and where you are on both the financial and impact spectrums. Don’t seek impact investments to both outperform the impact of your philanthropy and at the same time outperform your financial benchmarks.
And most importantly, you can’t close racial wealth gaps and earn 30%.
How do you hope to see Mission Driven Finance grow in the next few years?
Over the last three years, we built a core operational team, launched a creative community debt fund, and leveraged that infrastructure for multiple structured products in a previously unmet market range.
Now, we are ready to take this to scale in communities across the US. Our goal is to expand our toolkit to meet the full range of community capital needs and investor appetites. We already wield debt creatively in service of community and intend to complement that with capital options, expertise, and legal reference structures in Opportunity Zone business investing; venture and mezzanine investments; revenue-based financing; and real estate acquisition, pre-development, and construction financing.
Our near-term plan is to build on the foundation of our central team and add specialized capacity to efficiently bring creative capital solutions to more communities. We will be instituting a dedicated portfolio management function focused on the deployment of capital, and creating an advisory services team focused on building impact funds and transaction structures. Additionally, we want to capture and share stories and best practices, both to serve our investors and to build the impact investment field.
Our immediate expansion areas include:
- Launch a Community Finance Fellowship to simultaneously develop leadership in and deploy capital to more overlooked and underestimated communities
- Replicate our San Diego debt fund to other regions, particularly in Baton Rouge, LA and Columbus, OH
- Begin providing fund management services to more community partners around the country that need support to grow their own investment structures
- Add specific thematic funds to the platform without narrow geographic constraints to complement the place-based broader impact funds, such as cleantech and natural climate solutions
How can people get involved and support your mission?
It’s all about dollars and deals – and all through community partners. If you are connected to sources of capital, help them understand the power of impact investing into their own community, and how an intermediary like us can facilitate that effort. If you are connected to community-based organizations or individual companies that need capital to grow, help them understand how impact-based financing might be a good fit. And if we can add value to either of those, then call us.
The most powerful allies for us are those impact-oriented investors that will take a catalytic approach to mobilizing capital into the community or area they care most about, working with us to leverage their investment 5-20X, and at the same time leveraging their network to drive more deal flow.