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.
ComCap17: It’s About Democracy

ComCap17: It’s About Democracy

“[T]his is a fundamentally pluralist vision, in which multiple forms of public, private, cooperative, and common ownership are structured at different scales and in different sectors to create the kind of future we want to see. The vision begins and ends with the challenge of community. If it does not meet the test of everyday life in the communities in which we Americans live, it does not meet the test of serious long term change.”

Gar Alperovitz writes these words in his introduction to Principles of a Pluralist Commonwealth – in which he shares his vision of a new political economy. In it, he explains how a transformation in the ownership of capital is at the very core of the changes that are needed on the path toward a system that works for all and not just for the wealthiest few.

At last week’s ComCap17 conference in Monterey, we collectively put these words into practice. We brought the ideal down to the ground level and worked through how to actually create these diverse forms of ownership. And indeed, perhaps the most important theme that emerged in the conference is that there are a variety of effective tools in our toolbox to help us get there.

To be sure, much of the discussion at ComCap17 was about one particular collection of strategies – state securities exemptions for intrastate crowdfunding, which is now available in some 37 states. But as pointed out by a number of speakers, including my team from Cutting Edge Capital, there are several other strategies available to raise community capital, including direct public offerings and community investment funds.

And clearly, there is no one-size-fits-all. Each strategy has its advantages and disadvantages, and each has a “sweet spot” where it is most effective. For example, where an enterprise wants to raise capital directly from its community:

  • State-specific exempt crowdfunding can work well for small offerings where the investors are all within one state.
  • Exempt crowdfunding under Reg CF (Title III of the JOBS Act) can be effective for offerings up to $1 million where investors are in multiple states.
  • Intrastate direct public offerings are usually best for larger raises (i.e. any amount over the applicable exempt crowdfunding limit) where investors are all in one state.
  • Rule 504 offerings are often best for offerings up to $5 million where investors are in multiple states.
  • Regulation A offerings are best for offerings from $5 million to $50 million where investors are in multiple states.

Of course, these strategy choices are more nuanced than this, and a big part of our work at Cutting Edge Capital is helping our clients figure out which strategy among these and others best aligns with their values and strategic goals. (And then, together with our sister law firm Cutting Edge Counsel, we take our clients through the regulatory process until they have raised the capital they need.)

And yet, even these direct offering strategies are just the beginning. Indeed, most of them remain underutilized. It remains that case that a typical person living in a typical American town has virtually no local investment options; or if such options exist, they are hard to find. So how do we move the needle much faster toward a world in which community capital is truly ubiquitous and everyone has opportunities to invest locally in any town in America?

Community investment funds are the key to scaling up community capital and taking it from the fringe to the mainstream – whereby everyone thinks about local investing before they think of investing in Wall St. Besides scalability, community investment funds also have the advantages of diversification and greater efficiency in raising community capital, and they can typically offer more liquidity (that is, opportunities to get your money back) than a typical business can.

With investment funds, there are strict legal limits on what can be done, but as with capital-raising strategies, there is an array of options – which my partner Kim Arnone and I described in our ComCap17 workshop on Wednesday morning. A few options that allow a community-scale fund to raise capital from the community include:

  • Charitable loan funds, which raise debt investment and deploy it for some charitable purpose.
  • Real estate funds, which could focus, for example, on urban revitalization, agricultural land preservation, or affordable housing.
  • Supplemental funds that are an outgrowth of some other primary business, such as business services, co-working space, incubator, or grocery coop.
  • Intrastate funds up to $10 million – though these require explicit SEC approval.

And that’s still not all; there are other innovative strategies not mentioned here that can be explored. The community capital movement is ripe for creative thinking about what could be, and what is possible under the law.

At ComCap17, there was much discussion about new laws or changes in the laws that would help our movement; and at Cutting Edge Capital we have our own wish list of changes we believe would help boost this movement. But let’s not let imperfections in the laws distract us from the fact that most of what is described here can be done in every state in the U.S. today. There’s no need to wait.

In the big picture, what we’re doing in this movement is taking back our economy, restoring economic power to communities, and leveling the playing field so that everyone of every economic class has an opportunity to participate fully and reap the benefits of our economy.

But at a deeper level, this movement is about more than just the economy. As Teddy Roosevelt said, “There can be no real political democracy unless there is something approaching an economic democracy.”

Community capital is about true democracy. Let’s make it happen!

Community Capital Makes Strange Bedfellows

Community Capital Makes Strange Bedfellows

These past few months have shown us an America more politically polarized than ever. Any proposed solution is viewed through a conservative vs. liberal lens, and each side vows to oppose any proposal by the other. So it may be worth asking where community capital fits on that spectrum.
As our readers know, the term “community capital” refers to community-focused investment opportunities that are open to anyone in the community, including both wealthy and non-wealthy investors; in other words, everyone can participate in community capital. But is that a liberal idea or a conservative one?
Our answer: Both. And neither.
You could say that community capital is conservative because that is the way capital was raised for centuries until economic power became concentrated on Wall Street in recent decades. But you could also say it is liberal because it defies the dominant Big Money-driven paradigm.
It is conservative because it is fundamentally pro-business. It is liberal because it reflects the belief that business can be a force for good.
It is conservative because it restores economic power to local communities. It is liberal because it restores economic power to local communities. Oh wait, what was that?
Maybe the traditional liberal vs. conservative distinction just doesn’t make sense when we’re talking about democratizing the economy and empowering everyone to invest, grow local businesses, and build wealth in their communities. Don’t we all want those things regardless of our political views?
It’s true that our firm is based in left-leaning Oakland, California.

But our work transcends the political divide. Our mission is to build an economy that works for all. The economy we envision offers opportunities for everyone, regardless of economic class, to participate in the economy, profit from investments, and thereby to build wealth, while financing the growth of local businesses and other values-aligned ventures. When this happens, everyone benefits.
In fact, we see our work as a way for liberals and conservatives to work together toward a common goal. Perhaps the distinctions between those two groups aren’t as important as our common interests. We all want a fair and equitable economy, with opportunities for everyone to achieve their full potential. And we all hope this results in a safe, prosperous, and cohesive community where we live and beyond. Maybe it’s time to forge a movement to democratize the economy and seek these common goals, a movement that includes both liberals and conservatives.
Strange bedfellows? Maybe not so strange.
At Cutting Edge Capital, we’re fortunate in that there is no real opposition to what we do. Our biggest challenge is simply the need for education: Entrepreneurs don’t realize it’s possible to raise capital from their own community. Regular people don’t realize it’s possible to invest in local businesses or in alignment with their values. They only know what Wall Street offers, and they have learned to live with those disappointing options. Because that’s just the way it is. Except that it doesn’t have to be.
We would love your help in getting the word out about what’s possible. How? Invest in local businesses, nonprofits, and community investment funds. Tell your friends about direct public offerings. Help start a community investment fund in your community if there isn’t one already. Little by little, we can together change the culture, and make community capital as ubiquitous as a corner convenience store. Are you in?

What is Community Capital?

What is Community Capital?

Community capital is investment sourced from a broad spectrum of a community, including both wealthy and non-wealthy investors. While typically defined by geography (like a city or county), it can also be based on a common interest (like education or biodynamics).

Why is Community Capital Better for My Venture?

Better terms: Your community invests in you to help you succeed, not just to maximize their profit.

Deeper connection with your community: Your investors can be great ambassadors, and sometimes customers.

Why is Community Capital Better for My Community?

Keep wealth circulating in your community: Through a cycle of investment, growth, returns, and reinvestment, you can help your community build wealth sustainably.

Democratize the economy: You can level the playing field for wealthy and non-wealthy investors alike, and help narrow the wealth gap.

How Can I Raise Community Capital?

Directly, using a direct public offering. This approach offers maximum control over the terms. And engaging your community directly has non-financial benefits.

Indirectly, from a community investment fund, which raises community capital and invests in community ventures. For entrepreneurs, this approach can be easier and quicker. For investors, it offers diversification and efficiency.

What Types of Community Investment Funds Are There?

Charitable loan funds: Some (though not all) nonprofit lenders raise community capital via direct public offerings. Examples include NCCLF and RSF Social Finance.

Diversified business funds: This type of fund supplements another primary business and makes equity or other types of investments, while sharing profits with investors.

Real estate funds: While not a source of funding for ventures, a fund that deploys community capital into real estate can be a key revitalization tool.

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 communities to build wealth though a cycle of investment, growth, profit, and reinvestment. As I wrote in a separate post, Community capital can be raised directly through direct public offerings (DPOs) and Title III exempt crowdfunding, or indirectly through community investment funds (CIFs). Of these, CIFs have several significant advantages: scalability, efficiency, diversification, and opportunity for liquidity.

With this much going for them, one may wonder why CIFs are not far more common than they are.  One would think that every community should have a least one CIF. Yet most do not – at least not yet. Setting aside cultural factors that I noted in my previous post, the other key reason for their scarcity is the regulatory environment. A CIF must navigate through two layers of securities law. The first, and more commonly understood, are the laws that regulate the offering of an investment to the community. This is regulated at the federal level by the Securities Act of 1933 and by each state’s securities laws. In essence, a CIF must do its own DPO to raise investment. While this must be done carefully, it is not so burdensome as to prevent CIFs from flourishing.

But there is a second layer of securities law that is unique to investment funds and presents  another challenge. The Investment Company Act of 1940 (the 1940 Act) imposes burdensome regulations on an entity that raises money from investors and then invests that money in other companies. This is the law that regulates mutual funds, and the compliance costs are well into the six and seven figure range for funds of that type. Among other requirements, such a fund must conduct a full registration under the 1933 Act.

However, the 1940 Act also includes a number of exemptions. And that is where the opportunities lie for a small CIF that cannot afford 1940 Act compliance. With all that in mind, the following are four models for a CIF that can raise capital from its community without running afoul of the 1940 Act:

Charitable Loan Fund

The simplest (and by far the most common) type of CIF is the charitable loan fund. This is because the two key federal securities laws noted above (the 1933 Securities Act and the 1940 Investment Company Act) both have a blanket exemption for charitable organizations. To be clear, this does not work for other types of nonprofits, such as cooperatives and mutual benefit corporations. The entity must be truly charitable—basically a 501(c)(3) organization. Most states also have an exemption from securities offering registration for charitable organizations, though a few do not, including California.

With those exemptions, it can be relatively straightforward to set up a charitable loan fund – with good legal guidance, of course. It is still a securities offering, which requires comprehensive disclosure of all material facts, risk factors, state level review (in some states), and so on.

There are two key limitations of this model. First, the assets of a charitable organization may only be used for charitable purposes. And charitable is not the same as socially beneficial. While an analysis of what makes a loan charitable is beyond our scope here, let it suffice to say that a charitable organization needs to be careful, so as to avoid jeopardizing its charitable status.

A second limitation of a charitable loan fund is that it can only raise debt investment, not equity, because no one can own a charitable organization. Moreover, a charitable organization is forbidden from sharing profits with investors. And while a charitable fund could in theory raise debt investment and deploy it in equity investments in other local business, that kind of leveraged equity investment is considered too risky and therefore an unwise strategy. So, charitable funds generally only make outgoing loans with little or no opportunity for capital appreciation. Then, after subtracting a spread to cover its operating costs, the fund typically pays its investors a fairly low interest rate, again with no opportunity for capital appreciation.

And yet, the charitable loan fund is a very effective model for community investment and there are many success stories. Here are a few charitable loan funds that appear on CuttingEdgeX.com, along with their funding focus:

Real Estate Fund

The purchase by a fund of real estate is most likely not a securities transaction at all; and even if it is, the 1940 Act provides an exemption for funds that invest in real estate. Therefore, a real estate CIF need not be concerned about 1940 Act compliance. On the other hand, there is no exemption from the other federal or state securities laws for a real estate fund, so a true real estate CIF typically must raise capital via a state-registered DPO.

A real estate CIF can be a powerful tool for urban or rural revitalization. The concept is simple: The community invests in a fund that acquires, renovates and leases out properties that have become blighted. A portion of the profits may be reinvested in further revitalization, but any remaining profits are distributed to investors. As a result:

  • New businesses are attracted to newly renovated properties;
  • Property values rise as blight is eliminated;
  • Safety improves, as more workers and customers generate more foot traffic;
  • City tax revenues rise as all those people spend more money locally;
  • Local investors share in the profits of the business and reinvest in the community.

We believe this model has enormous potential, and we hope it will be replicated in every city in need of urban revitalization. But there are other potential uses for a community real estate fund, such as:

  • Affordable or workforce housing
  • Agricultural land (perhaps in conjunction with a community land trust that acquires a conservation easement)

Equity Investment Funds

There is no general exemption from the 1940 Act for funds that make equity investments in other companies. To be sure, many modestly-sized funds do invest in other businesses: hedge funds, private equity funds, and the like. What those all have in common is that none of them is open to non-wealthy investors. In other words, they are not community investment funds.

But there are ways to build a true community investment fund that can invest in equity positions in other companies (along with other types of investments) and share profits with its investors. The idea behind this model is that the entity is exempt from the 1940 Act because it is not primarily in the business of investing in securities. We will discuss two variants of this model.

The first of these variants begins with Section 3(a)(1) of the 1940 Act, which excludes from the 1940 Act’s coverage any fund that is not primarily in the business of investing in securities, and where investment securities comprise less than 40% of the fund’s total assets. As we’ll discuss further below, this type of fund will necessarily be fairly diversified; hence we have called it the “diversified business fund.”

The first requirement for the diversified business fund is that the fund is primarily in some other business besides investing. In other words, the fund’s investing activities must be supplemental to another primary purpose. There is a lot of flexibility in the kind of primary business that would support this type of fund, but three business types that would work particularly well are a start-up incubator, a business accelerator, and a co-working facility – or some combination of those. The fund could also be in the primary business of providing education or other services.

The second requirement of the diversified business fund is that no more than 40% of the entity’s total assets consists of investment securities. Fortunately, there are several types of investments a diversified business fund can make that are not counted as investment securities for purposes of the 1940 Act. These include:

  • Majority-owned subsidiaries: If the fund acquires a majority of the voting securities of a target company, that won’t count toward the 40%. Note that while such an investment would ordinarily be treated as a “security,” it is specifically excluded from the definition of “investment security” for purposes of the 1940 Act. One challenge here is that the entrepreneur behind a potential target company may (understandably) not want to give up a majority position in their company. That concern might be addressed by coupling the investment with a redemption right giving the entrepreneur the right to re-acquire a majority position at some time in the future. This strategy can also be used to acquire the business of aging baby boomers who are ready to retire. 
  • Real estate: As long as it is directly held by the fund, real estate is not a security at all, as noted earlier. A syndication interest, or an interest in a real estate partnership would likely be an investment security. But real estate that the fund owns for its own use or to lease to others would not be.
  • Secured loans: For purposes of the federal securities laws, not every loan is a security. Where a loan is privately negotiated between lender and borrower, is not offered broadly to potential lenders, and is secured by assets, it will probably not be deemed a security at all, so it will not count toward the 40% threshold.
  • Non-securities assets: The fund may also invest in equipment and other assets that are not securities.

So, as long as at least 60% of the entity’s total assets comprise these types of assets that are not counted as “investment securities,” the diversified business CIF will meet the second requirement. The remaining 40% or less can be any other type of investment, including minority positions in portfolio companies, as well as publicly-traded stocks, bonds and other investment securities. From an investor’s point of view, one key advantage of the diversification inherent in this model is that it may very well reduce the fund’s risk and make it a more attractive investment.

A second variant on the equity investment fund model is similar to the diversified business fund but doesn’t require the 60-40 split in its portfolio. Under Section 3(b)(1) of the 1940 Act, a company is exempt as long as it is clearly in a primary business other than investing in securities. For that reason we call this the “supplemental investment fund.” For this purpose, the following factors are considered important in determining whether it really is in another primary business:

  • Company history: A company with a history as an operating company in some primary business other than investing is less likely to be deemed an investment company.
  • How it represents itself to the public: If investors are likely to invest because of the investment portfolio, investing is more likely to be deemed its primary business.
  • Activities of its officers and directors: Whatever the officers and directors spend most of their time doing is likely to be deemed the primary business.
  • Nature of its assets: The more of a company’s assets that are associated with a line of business, the more that will be considered their primary business. However, courts have recognized that some businesses are asset-light, and that fact should not by itself transform an operating company into an investment company.
  • Sources of its income: Both net and gross income should be considered. An activity that produces a majority of both will likely be considered the primary business.

We note that while business accelerators and other similar organizations in the US have often provided funding to their clients, to our knowledge none of them has yet done so using community capital. Therefore, the model as described here has not yet been utilized as of this writing, though CEC is working with several organizations who are pursuing this model.

Registered 1940 Act Fund / Business Development Company

We now come to the fourth model: A CIF could embrace, rather than avoid, the 1940 Act. While this strategy will clearly be out of reach for a small fund for cost reasons, it may be that a true community investment fund targeting a larger metropolitan area could achieve the scale necessary for full compliance with the 1940 Act to become cost-effective.

We won’t dwell on this model, except to point out that Calvert Foundation, through an affiliate, has offered a menu of Calvert mutual funds for several years. While they don’t have a specific geographic focus, they do have a strong social mission, and their success suggests strong potential for this model to serve large communities.

An interesting variation on the fully registered 1940 Act fund is the business development company (BDC), a type of investment fund that provides managerial assistance to its portfolio companies. While this model is technically an exemption from the 1940 Act, the BDC is exempt from only some of its more burdensome requirements. It must still register its offering with the SEC under the 1933 Act. And yet, a BDC with a state or regional focus could make financial sense. We will be observing a few BDCs (such as Hill Capital in Minnesota) with an eye toward the potential use of this model as a true community investment fund.

Other Possible Strategies

There are a number of other exemptions from the burdensome requirements of the 1940 Investment Company Act, each with its own limitations. At Cutting Edge Capital we will continue to explore alternative strategies that may work for community investing. Here are some possibilities:

  • An intrastate fund: The 1940 Act includes an exemption for a fund of up to $10 million where all investors reside in the same state where the fund is based. While this sounds promising, it has two key limitations: First, it must be a “closed-end fund”—meaning that the fund has a specified life (say, 7 years); investors come in at one time and are cashed out at the end of the fund, with little opportunity to come in and out of the fund during its life. Second, this is not a self-executing exemption; rather, the fund would need to request an exemptive order from the SEC, and the SEC would have the power to impose any requirements they believe are needed to protect investors. This exemption has rarely, if ever, been used.
  • Microloan fund: An exemption is available for a fund that makes “small loans”—a term that appears to be interpreted by the SEC to mean personal and consumer loans, not business loans. One possible example: A solar fund could use this strategy to make loans to homeowners to finance rooftop solar installations.
  • Manufacturer/seller loan fund: Another exemption covers a fund in the business of lending to manufacturers and sellers of merchandise or services.

Finally, we should mention one more strategy that may not be a true CIF, exactly, but might be used to achieve a similar result: the investment club. This is where a group of investors pool their resources into a single entity (typically a limited liability company) to make investments. As long as every member of the club is actively engaged in the management of the club (i.e. votes on investment decisions, etc.), the club will not be deemed to issue securities to its investor/members, and therefore it will not be subject to the 1940 Act. Because of the requirement that every member of the club be actively engaged in management, it usually works best for smaller groups of investors; but it can be open to anyone, wealthy or not.

All of the Above

Of the models described above, there is no “best” model. At Cutting Edge Capital we envision a more localized economy in which every community is served by a constellation of community investment funds of various types, each of which responds to a need in the community. For example, a real estate fund could build workforce housing, if housing is in short supply; a charitable loan fund could lend to agricultural and food-related businesses; and a diversified business fund could invest in homegrown tech start-ups.

Together with DPOs by local ventures, these CIFs would contribute to a vibrant community capital market in which everyone can participate on a level playing field, and help build a more equitable and prosperous community.

Note that this discussion is for informational purposes only and should not be taken as legal or investment advice. For more information about Cutting Edge Capital and the services we offer or to schedule a consultation, please visit www.cuttingedgecapital.com or email us at info@cuttingedgecapital.com.