The Tax Cuts and Jobs Act included a new federal incentive—Opportunity Zones—to spur investment in poor and undercapitalized communities. These incentives could become the nation’s largest economic development “program,” but their potential for positive impact depends first on decisions America’s governors make.

Last week was the first deadline for governors (and the mayor of the District of Columbia) to select which among the roughly 56 percent of eligible census tracts should be classified as Opportunity Zones. Over half of states have requested an extension; governors can have 30 more days to decide.

Of the tracts designated eligible, governors get to designate 25 percent (or at least 25 tracts in states with fewer than 100 qualified tracts) as Opportunity Zones. The incentive provides three tax benefits for equity investing in Opportunity Zones. Investors could take advantage of one or more of the benefits.

• Permanent exclusion of taxable income on new gains. For investments held for at least 10 years, investors pay no taxes on capital gains produced through their investment in Opportunity Funds (the investment vehicle that makes investments in Opportunity Zones).
• Basis step-up of capital gains invested. For capital gains placed in Opportunity Funds for at least five years, investors’ basis on the original investment is increased 10 percent. If invested for at least seven years, investors’ basis on the original investment is increased 15 percent.
• Temporary deferral of capital gains. Investors can place existing assets with accumulated capital gains into Opportunity Funds. Those capital gains are not taxed until the end of 2026 or when the asset is disposed of.

Apart from the exclusion of a few “sin” businesses, the activities and projects Opportunity Funds can finance are broad. Funds can finance commercial and industrial real estate, housing, infrastructure, and current or start-up businesses. For real estate projects to qualify for Opportunity Fund financing, the investment must result in the properties being “substantially improved.”

Where should governors select Opportunity Zones?

Given the range of investments and projects eligible to receive benefits in Opportunity Zones, governors must select communities where tax subsidies will maximize the return on public investment. Their selections are doubly important because the statute includes no provision to change which communities are classified as Zones over time as local conditions change.

Many elements will factor into governor decisionmaking. We offer two for consideration:

• Need. While a case could be made for each of the qualifying census tracts, the return on investment for public subsidy is likely to be higher among communities struggling to access capital.
• Benefit. Opportunity Zones will be more likely to bring opportunity to low- and moderate-income residents if those residents are not priced out of their communities as they upgrade.

A tool for governors to select areas with the most to gain

To guide selection, we prepared a dataset for all eligible tracts, ranking them in terms of the investment flows they are receiving and the social and economic changes they have experienced.

We scored investment flows to tracts based on commercial lending, multifamily lending, single-family lending, and small business lending. We also created an indicator for whether tracts have experienced high levels of socioeconomic change.

Decisionmakers can use our data to determine which areas are undergoing natural change or gentrification (where Opportunity Zone distinctions would likely be unnecessary), as opposed to areas in more need of a tax incentive to boost investment.

The investment and social change measures we created are national in scope. While useful, no measure can fully summarize the complexity of local conditions. Governors assessing their options will need local knowledge to validate, verify, and modify the information presented and should consider the broader criteria of need and benefit.

The communities that governors select will eventually provide evidence on this incentive’s capability to drive meaningful, positive change in neighborhoods that need it. This is an exciting moment in the development of a new, sizable federal incentive for investing in undercapitalized communities.

This was originally posted to Urban Wire on March 20, 2018.