By Joseph McKinney CEO of Nuhanse Network
Opportunity funds are the newest tools in a long line of game-changing technologies. “Putting it on the blockchain” has been replaced by “Qualified Opportunity Zone Property”.
For those less familiar, Opportunity Zones are a designation created by the Tax Cuts and Jobs Act of 2017. They allow certain investments in lower income areas to enjoy corresponding tax advantages. The purpose is to put capital to work that would otherwise stagnate due to an asset holder’s unwillingness to trigger a Capital Gains Tax. The goal of an Opportunity Zone is to funnel capital where it’s most needed. Treasury Secretary Steven Mnuchin predicted $100 billion would be invested into Opportunity Zones by 2028. The total size of self-registered Opportunity Funds exceeds $18 billion.
Like all contemporary trends, there are certain challenges associated with early adoption. Beyond the constraining yet still opaque rules, Opportunity Funds are struggling to find financially sustainable projects. Also, few funds are interested in affordable housing investments. Many invested in luxury apartment developments in search of higher returns. This betrays the law’s intended purpose: to empower distressed areas. If the trend continues, policymakers may let the law expire in 2028.
We cannot expect financiers to ignore profit motives. But we can structure incentives, preventing Opportunity Zones from being only a tax cut for the rich and a vehicle for gentrification. How do we make Opportunity Zones work for all? The answer is simple: More Zones.
Opportunity Zones program comes from a long history of geographically based Zone policies. The most successful version, known as “Special Economic Zones” (SEZs), has transformed economic growth for the past 60 years. Starting with Puerto Rico in 1946, SEZs provided exemptions from certain tax and regulatory policies. The goal was to spur investment and attract businesses for job growth and did so with wildly successful results. SEZs served as a testing ground of sorts; policies that worked in such Zones could be replicated elsewhere on larger scales.
While Puerto Rico showed success, the raw potential of SEZs went unrealized until 1980. China was still reeling from the famines of the Communist Cultural Revolution and political obstacles prevented necessary reform on a large scale. To circumvent these constraints, then-Chairman Deng Xiaoping designated four coastal Special Economic Zones.
One of China’s new SEZs, Shenzhen, grew from a fishing village of 30,000 people to a bustling metropolis of 12.5 million. Their nominal GDP now exceeds that of Ireland, South Africa, and Israel. In the wake of this success, Special Economic Zones began spreading like wildfire and now accounted for 22% of China’s GDP. Worldwide, there are about 4,000 Zones spanning 130 countries. SEZs have been hailed as one of the few reliable tools for economic development and have become a mainstay for national policy. SEZs have not only made $100 billion projects possible; they’ve made such ventures a common occurrence each year. With the market size of smart cities expected to balloon to $2.57 trillion by 2025, we can expect these “mega” SEZs to become much more common. Marc Andressen predicted the early dominance of software, but perhaps the future will be “eaten” by Zones instead.
Despite being an earlier mover, the United States suffers from a significant Zone gap. Many new Zone frameworks have failed to live up to their expectations. And let’s be honest, Zones in the U.S. are not very interesting. Despite this, the most successful are Foreign Trade Zones.
Foreign Trade Zones
Foreign Trade Zones (FTZs) were created in 1934 to ease the devastating effects of the Smoot-Hawley Tariffs. Similar to their Free-Trade Zone counterparts abroad, these Zones act as territories outside U.S. Customs. This exempts occupants from duties and excise taxes. If they process imported goods within an FTZ, they are taxed at a lower rate than the original materials. The result was 2,900 firms, 420,000 employees and $86 billion worth of exported goods within U.S. FTZs.
While the stats seem impressive, the impact is debatable. Even NAFTZA (the leading FTZ trade organization) admitted that job growth increased only 0.2% in areas surrounding FTZs and general economic growth only by 0.4%. The biggest culprit was the prevailing concentration of benefits for specific, large industries. They didn’t help smaller companies with a wider, more inclusive framework.
The World Bank found that Zone success is more predicated on regulatory reform rather than taxes. Enterprise Zones were intended to meet the demand for lower regulatory burdens and a more generalized tax framework. Federal legislation was established in the 1970s in response to businesses fleeing city centers. The Enterprise Zone framework offered a host of tax and regulatory exemptions. Sadly, when states ratified their own laws in response to the program, it did not live up to expectations. Reforms often focused on tax credits, which came with endless red tape. Bureaucracy limited the benefit for small firms who could not afford compliance. This rewarded large businesses instead. The Department of Housing and Urban Development (HUD) concluded that the Enterprise Zone program produced mixed and inconclusive results.
On their own, these Zone Frameworks would never deliver the success of Shenzhen or countless SEZs. Without support, Opportunity Zones will struggle to find good investments. There needs to be a transformation in how the U.S. treats Zones in order for such programs to compete on the global stage.
Stacked Zone is combining all the existing frameworks (I.e. Opportunity Zones, Foreign Trade Zones, and Enterprise Zones) in single area to multiply their benefits. Innovation doesn’t always require reinventing the wheel. More often than not, success hinges on combining pre-existing elements uniquely. All the components for a modern smartphone existed ten years prior to the iPhone’s release. But it took Apple CEO Steve Jobs to put them together to spur the mobile revolution.
Much in the same vein, the United States need not enact new and costly Zone legislation. Firms and governments can combine all existing special Zone frameworks to concentrate their benefits in one area. With tariff exemptions, general tax relief, streamlined regulations and deferred capital gains, business and capital would flock in droves. Such an approach could create the most competitive jurisdiction within the United States. But how can you “stack” Zones?
How do you make a Stacked Zone?
The first step in creating a Stacked Zone is identifying property within a designated Opportunity Zone. Unlike other Zone frameworks, policymakers cannot create new Zones. The federal government designated 8,000 existing Opportunity Zones on April 9th, 2018. Unless legislation is amended, those Zone are it.
Once a property has been identified, the next step is to establish a Foreign Trade Zone within the tract. While creating a “general” Foreign Trade Zone is a long and complicated process, setting up a “SubZone” is relatively easy. The process has all the advantages of a General Foreign Trade Zone, but can be set up within 1–7 months. Foreign Trade Zones can be as small as a single building or as large as 2,000 acres. SubZones can be set up in any state in the U.S. as long as it is within 60 miles of a Port of Entry.
Opportunity Funds can purchase the property itself and use it to generate lease revenues. Companies operating the SubZone are investable too since they meet the IRS requirement of having 50% of their revenues come from clients within the Opportunity Zone. Because of the FTZs tax benefits, the Opportunity Fund will generate higher returns from attracting more profitable businesses.
State legislation permitting, add an Enterprise Zone would further speed up business interest. Each state has different incentives and varying application processes. In best-case scenarios, legislation will provide solid tax benefits and even some regulatory reform. Such incentives would attract a wider variety of businesses than from an FTZ alone.
With minor amendments and a willing state government, reforms can deepen. However, in the shorter term, the consequence of stacking Zones is a useful tool to attract revenue-generating businesses to Opportunity Zones. The initiative would no longer be a “flash in the pan” stimulus to luxury apartment construction jobs. The program would be a sustainable, broad-based economic development strategy.
Stacked Zones In Action
That sounds great, but who is putting all those steps together? My firm, Nuhanse Network, is using this process to create Stacked Zones. We came up with the idea when responding to a Request for Proposal to write a business plan for an FTZ in Utah. Our team realized that an FTZ would not be effective by itself. Few companies would be attracted to the project. But after some searching we realized that the project was within an Opportunity Zone, and eligible for an Enterprise Zone too.
While that project didn’t transpire, Nuhanse Network and its team, Manchester LLC, won an RFP in Manchester Connecticut under the same premise. It granted development rights of a $100,000,000 property within an opportunity zone. Our team is implementing FTZ benefits, creating the first Stacked Zone in the United States. We are also pursuing Stacked Zone projects across the United States, including in partnership with Native American tribes.
Stacked Zones cannot be the only step. Amendments can be made to Foreign Trade Zone legislation to broaden tax relief. Stacked Zones should also show policy makers that other U.S. SEZs are possible. Pending significant growth of Stacked Zones, Congress may push for greater SEZ frameworks. Until that time, let’s dream and create a more innovative legal landscape. Perhaps the U.S. will be not be seen as only 50 states, but hundreds of special jurisdictions. Like our not-too-distant past, they would serve as laboratories of governance. These “micro-experiments” can attract capital, businesses and citizens from around the world. Old cities will expand and new cities will bloom. America will again become a land of opportunity, not just ‘“Opportunity Zones”.