Opportunity Knocks: New Tax Incentives for Community Investment Funds

Opportunity Knocks: New Tax Incentives for Community Investment Funds

Since 2015, a bipartisan coalition of lawmakers has advocated for tax incentives for those who invest in low-income communities, recognizing that the benefits from the economic recovery have largely bypassed those communities. Their efforts were rewarded when their proposed opportunity zone program was included as Subchapter Z of the 2017 tax law overhaul that was passed in December. While Subchapter Z wasn’t specifically tailored to community capital, it offers tax incentives that will apply to some kinds of community investment funds.

First, here’s how the new law works: A taxpayer with capital gains can defer capital gains tax if they sell their appreciated assets and, within six months, roll over the profits into a “qualified opportunity fund.”

But it gets better. Investors in the qualified opportunity fund who hold their investment for at least 5 years will have their basis bumped up by 10% of the deferred gain (thus reducing their capital gains tax), and by another 5% if they hold it for 7 years. In 2026, there will be a realization event (in which investors are taxed on the other 85% of the original profit invested in the fund, assuming the investment has been held for 7 years). But if they continue to hold their investment for at least 10 years, their basis is bumped up to the market value of their investment, which means any further capital gains tax is eliminated completely.

A qualified opportunity fund is a partnership or corporation with at least 90% of its assets consisting of qualified opportunity zone property (and acquired after 12/31/2017), which can include:

  • Equity interests in a corporation or partnership that is an opportunity zone business (and issued directly by the corporation or partnership, not acquired in secondary sales); or
  • Tangible property (real or personal) located in the opportunity zone that is either first used by the fund or is substantially improved by the fund (the latter meaning that additions to its basis exceed its original basis).

A business is an opportunity zone business if:

  • Substantially all of its tangible property is located in the opportunity zone;
  • At least 50% of its gross income is derived from operations in the opportunity zone;
  • A substantial portion of its intangible property is used in its operations in the opportunity zone; and
  • Securities comprise less than 5% of its total assets by tax basis.

While this new law provides tax incentives to invest in funds that serve low-income communities, it does not provide any new strategies under the securities laws. It is probably inevitable that the vast majority of qualified opportunity funds will be open to accredited investors only, like nearly all private funds.

However, there are at least three strategies that allow a qualified opportunity fund to be open to its entire community, including non-accredited investors:

  1. Real estate fund: A fund whose primary business is investing in real estate and 90% of whose assets consist of real estate in an opportunity zone will be a qualified opportunity fund and will be exempt from the burdensome regulations of the Investment Company Act of 1940 (the “1940 Act”), which paves the way for the fund to raise capital via a direct public offering – making it a true community investment fund.
  2. Small business holding company: This type of fund is exempt from the 1940 Act if most of its assets comprise controlled or majority-owned subsidiaries – the idea being that the fund is in whatever business its subsidiaries are in, rather than in the securities investment business. Again, if 90% of its holdings are businesses in opportunity zones, it will also be a qualified opportunity fund.
  3. Intrastate fund: A closed-end fund of up to $10 million, all of whose investors reside in the same state, is eligible to seek an exemptive order from the SEC that allows it to raise community capital via a direct public offering and while avoiding all or most of the 1940 Act’s regulations. Such a fund could invest in either business or real estate in opportunity zones and thereby also become a qualified opportunity fund.

With any of these strategies, a community-scale fund can open up the opportunity for community ownership of community assets, with everyone able to participate on a level playing field, and everyone able to reap the profits from local ventures.

It should be noted that governors of each state had until late March to designate low-income census tracts as opportunity zones, but some have asked for a 30-day extension. However, only 25% of the low-income communities in each state may actually be designated as opportunity zones. It remains to be seen which communities will actually win that designation.

But community investment funds can be offered to the public in any community anywhere in the U.S. At Cutting Edge Capital we believe community investment funds are an effective way to significantly move the needle toward a more inclusive, democratic and decentralized economy.

If you would like to see this happen in your community, here are some steps you can take:

  1. Look at this map, which shows the census tracts that may be eligible for designation as an opportunity zone.
  2. If your community includes eligible census tracts, write to your governor, asking him or her to designate those tracts in your community as an opportunity zone.
  3. If you would like to see community investment funds serve your community, fill out our intake form to make an appointment with us to explore the kinds of funds that can be offered in your community.
Webinar Replay: Economic Activism Starts at Home: The Impact of Community Investment Funds

Webinar Replay: Economic Activism Starts at Home: The Impact of Community Investment Funds

What if your community can come together to fund local ventures? Watch our webinar with Kim Arnone and Brian Beckon to find out how to utilize community investment funds (CIFs). Get an in-depth look at the array of opportunities CIFs offer.

This is an immensely useful webinar for nonprofit organizations, coworking spaces, accelerators/incubators, community organizers, and economic development specialists.

WEBINAR: Economic Activism Starts at Home: The Impact of Community Investment Funds July 27, 2017 11 a.m. PT

WEBINAR: Economic Activism Starts at Home: The Impact of Community Investment Funds July 27, 2017 11 a.m. PT

Work for or operate a nonprofit organization, innovation hub, accelerator, or incubator? Are you a community leader or economic development specialist? Do you want to learn about community investment funds and community capital raising? Join Cutting Edge Capital’s webinar on July 27th at 11 a.m. PT with Kim Arnone and Brian Beckon to learn in depth about community investment funds and how they can propel your mission and community vision. Click here to save your spot now!

The Presenters

Kim Arnone
Vice President, Cutting Edge Capital
Kim specializes in developing community capital raising strategies for social enterprises, cooperatives and nonprofits. She works primarily on investment offerings that can be publicly offered and that are open broadly to community members. Kim has assisted a wide range of enterprises in successfully raising capital; from a worker-owned green waste recycling company to an organic farm, from a rural community development fund to an urban food coop. Kim has been with Cutting Edge for 5 years and has been practicing law for 20 years. She has her Juris Doctorate from Hastings College of Law, where she was editor-in-chief of the Women’s Law Journal. Kim lives, works, and plays in Oakland.

Brian Beckon
Vice President, Cutting Edge Capital
Brian is an attorney with over twenty-five years of experience working for nonprofits, start-ups, and publicly-traded companies. As a principal of both Cutting Edge Capital and Cutting Edge Counsel, Brian’s work is now focused on direct public offerings, corporate structuring, and strategies for community capital to help build a more equitable economy. Brian has served as General Counsel for RSF Social Finance, Clean Power Finance, and LendZoan; and before that as Corporate Counsel for Sybase and Catellus Development Corporation. He earned his J.D. from the University of the Pacific McGeorge School of Law and started his legal career with the North Bay law firm of Gaw Van Male. Brian is a member of the California Bar and serves on the boards of the Mount Diablo Music Education Foundation and the Neto Community Network.

Community Investment Funds

Download NC3’s how-to guide on Community Investment Funds. Cutting Edge principal, Brian Beckon is a co-author and NC3 board member.

Community Investment Funds Final

A venture (nonprofit or for-profit) can raise capital from their community either directly or indirectly. The direct approach is sometimes referred to as investment crowdfunding, a term that includes both direct public offerings (DPOs) and Title III Regulation Crowdfunding. Indirectly, a venture can be funded by a Community Investment Fund (CIF). CIFs help to empower communities by allowing community members, anyone of virtually any economic class, to invest in a community fund which in turns invests in ventures, revitalization projects or other mission driven enterprises. CIFs allow communities to build wealth through a cycle of investment, growth, profit (returned to community investors), and reinvestment. Read more about the power of community capital here.

Why we like Community Investment Funds. A CIF can be a particularly important component of a healthy local economy for four key reasons: Scale, efficiency, diversification, and liquidity.

  • A CIF can be more scalable because it can potentially raise an unlimited amount of money and finance an unlimited number of local ventures. Note that we don’t use “scale” in the Wall Street sense of bigger transactions. In a CIF, the transactions should always be at a human scale, but we need a lot more of them to truly change the economy and to create a culture of community investment.
  • A CIF can be more efficient because each investor only needs to do due diligence once on the fund, and then the fund handles due diligence on outgoing investments.
  • A CIF is more diversified when compared to having each investor invest in one or a small number of local ventures.
  • A CIF may be in a better position than individual ventures to offer its investors liquidity (i.e., a way to sell the investment). A CIF can be set up to redeem investors who need to exit the investment.

Aren’t funds heavily regulated? Usually, yes. However, Cutting Edge has identified several ways to structure a community investment fund that will be exempt from the regulatory burdens of the Investment Company Act and thus easier and more cost effective to implement on a community scale. A CIF still has to comply with securities laws to raise capital for the fund and can do so using community capital strategies such as direct public offerings or a Reg A+ offerings.

Types of CIFs. Types of CIFs that are are not covered by the Investment Company Act include the following:

  • Charitable Loan Fund
    • This is the most widely used CIF model because charities are exempt from the key federal securities laws. The fund is hosted by a Section 501(c)(3) nonprofit and can only offer investment notes to investors, and investors receive interest. The fund invests in ventures that align with the nonprofit’s mission.
  • Real Estate Revitalization Fund
    • This type of CIF takes advantage of an exemption from the Investment Company Act for real estate investments. Typically organized by experienced real estate professionals, this fund often has a goal of community revitalization (housing, neighborhood, main street, etc.). The fund can offer investors equity, debt or revenue share securities. The fund uses the capital raises to purchase and revitalize real estate (commercial, residential, mixed use or industrial), and then lease or sell it. Profits can be distributed to investors.
  • Diversified Business Fund
    • In this model a fund can avoid coverage by the Investment Company Act if it has some primary business other than the business of investing in securities; in other words, there has to be an existing line of business that is distinct from managing the investment fund. In addition, the fund can invest no more than 40% of its assets in “investment securities” — a term that excludes majority positions in other companies. It also excludes real estate, some secured loans, and other business assets. If those requirements are met, then the fund can offer investors an equity position in the business that runs the fund and the fund can in turn take equity positions in other business; and any profits generated can be distributed to investors in the fund. An example: An advanced manufacturing co-working facility that rents space, offers consulting services, rents the use of equipment and runs an incubator. This business can raise capital from its community to start a diversified business fund and invest in its incubated companies, as long as the company’s assets are sufficiently diversified to meet the 40% test.

Community investment funds can be powerful tools for communities. Contact us for a free one hour consultation to learn more.

Community Investment Funds: Four Models

Community Investment Funds: Four Models

Community capital is about empowerment of communities. It is a set of strategies that allows ventures to raise capital from their ideal investors within their own community, allows anyone of virtually any economic class to invest in their community, and allows...