The underlying intent ostensibly was to provide incentives for companies, high net worth investors and financial institutions to direct much-needed resources to developments in distressed communities that otherwise would not receive the attention or funding they need. That’s a laudable objective, to be sure. 

Unfortunately, the way in which OZs were designated, the kinds of transactions that qualify as tax-optimized investments and the specific communities that ended up being targeted by developers and investors leaves much to be desired. 

Yes, and at first blush, there doesn’t appear to be anything wrong with that approach in theory – governors are arguably in the best position to know where the highest needs are in their states or territories based on the local income of residents and poverty rate criteria specified by the legislation. They submitted their selections to the Treasury Department, which pretty much served as a rubber stamp for those choices.

That leaves investors free to select those areas and whatever potential projects they identify as the most promising from a return-on-investment standpoint. My colleagues in this study and I find this insufficient – there’s too much flexibility for investors to merely satisfy the specified criteria literally vs. having to gauge the relative impact of those choices in terms of the spirit of the legislation.

It is in this last step where the intent of the OZ legislation veers off the rails. Let’s remember that the responsibility of investors is to maximize the return on the investments they make. They are, by and large, private entities answerable to their shareholders. Given the choice, why wouldn’t they invest in those opportunities that leverage their primary objective of maximizing the financial returns to their stakeholders?

As it turns out, investors have been very selective in their choices. After all, among the wide variety of distressed communities and potential projects that qualify for the tax-advantaged benefits, some OZs and some potential projects offer greater financial returns and lower risk than others. There’s no requirement to invest in those OZs or projects that create the highest number of permanent local jobs or deliver the highest economic benefit to the distressed communities this legislation is intended to help. Just meet the specified terms, and you’re good to go.

Quite a bit, actually. For example, there are no provisions in the law that require any measurable level of local job creation. So, a residential real estate development in an OZ – one of the most popular types of investments – may generate short-term jobs in construction. But once the development is built, precious few local jobs are created.

Pit the value of that kind of investment against the creation of local grocery stores that can alleviate food deserts, a community center to serve after school programs or badly needed low-income housing. Under the loose rules of current OZ legislation, all qualifying investments are technically equal in terms of value – no consideration for local community impact comes into play.

There are at least three changes I would advocate.

First, as our research notes, there is little in the way of transparency into how each state or territory selects OZs. Once the basic requirements are followed, there is no way to know why one area was designated as an OZ while another, seemingly equally needy area, was not. As the NPR article points out, there are issues with using the average income of residents as a primary OZ selection criterion. It isn’t that cut and dried. For example, a good many OZs encompass college towns where the average income of residents, i.e., the students living there, is very low. Developments in these OZs compete for investment dollars against other areas with similar below-the-poverty-line income levels, but which are, in reality, more representative of truly distressed communities.

Second, some determination needs to be made regarding the eligibility of investment projects already planned pre-OZ designation vs. those now being considered as a result of the legislation – new greenfield investments need to take priority over existing projects that may already have adequate funding. Specific provisions should be made that offer more promising financial advantages for new projects vs. those already planned.

Third – and perhaps most importantly – the relative value created by potential qualifying investments from an ongoing job creation and local community impact need to be considered and rewarded appropriately. Job creation is cited as a critical objective, yet the terms of current OZ legislation don’t specifically require this.

One way to remedy this deficiency would be to use a sliding scale of tax benefits to investors based on the type of entity created through OZ legislation – a minimum tax benefit for simply investing in the OZ, a higher tax benefit awarded for investments in projects that create long-term local employment and even greater benefits for those that both create long-term local employment as well as provide access to services most needed in these distressed communities.

Bottom line, while OZs represent an admirable attempt to spur developments in distressed communities, the relatively loose requirements, and generous investment terms and lack of transparency of key aspects of the law itself too often favor the returns of wealthy investors over the returns to the residents of those communities themselves.