How a new tax workaround could give West and South sides a boost

The city's poorest neighborhoods may have their best selling point yet to lure investors that have long been scared off by crime, poverty and population loss.

Chicago's Englewood community isn't inviting for even the most socially conscious real estate developers. In some parts of the crime-ridden South Side neighborhood, two-thirds of residents live below the poverty line, household incomes average less than $20,000 a year and violence clouds the prospect of any substantial economic development taking root.

But if a new tax incentive works as intended, Englewood and other parts of town like it might get another look.

The new tool designed to spur development in low-income communities is the federal Opportunity Zones program, which allows investors to defer paying taxes on capital gains if they redirect those profits into one of thousands of designated blighted areas nationwide. Chicago is home to 135 of those zones, in poorer parts of the city that have mostly missed the spoils of the city's post-recession comeback.

Matched up with even a fraction of what one national policy group estimates to be $6 trillion in unrealized capital gains that U.S. investors and corporations have on paper after the longest-running bull market in American history, those neighborhoods may have their best selling point yet to lure investors that have long been scared off by crime, poverty and population loss. And it could help shrink the vast economic divide that has earned Chicago a reputation as a tale of two cities.

"This is going to help people raise money to get projects done," says tax attorney Darryl Jacobs, a partner at Chicago-based law firm Ginsberg Jacobs who is advising real estate investors and developers raising money for Opportunity Zone projects.

The program adds to a long line of tax incentives and stimuli meant to help jump-start poor neighborhoods. Chicago has used its tax-increment financing system to attack the problem and more recently has beefed up its program allowing developers in wealthier parts of town to pay for extra density in their buildings, then redirecting that money into small businesses in low-income neighborhoods.

But the new program, which was created as part of the federal tax reform law passed in December, stands to be an especially potent sweetener. Rolling over any capital gain into a Qualified Opportunity Fund and leaving it there for five years could earn an investor a 10 percent tax break, and after seven years, 15 percent. Any gains made beyond the 10-year mark would be tax-free, incentivizing long-term commitments to areas that need them.

Real estate developers and big banks are so bullish about the program's prospects that many, including PNC Bank and Goldman Sachs, are looking to raise hundreds of millions of dollars earmarked for designated distressed areas nationwide even though the IRS hasn't laid out many details about how Opportunity Zones will be regulated.

Tax incentives like New Markets Tax Credits, Enterprise Zones and Empowerment Zones have yielded mixed results, but none has provided a platform for smaller investors, family offices and high-net-worth individuals to invest in blighted areas, Jacobs says. Capital gains, he says, could give developers and companies kicking the tires on low-income neighborhoods an unprecedented pool of capital to help finalize a deal.

"Nobody's going to invest just to invest on the South Side. They need good deals," he says. "But this could be the difference for a company (thinking about) building a new factory in a corporate business park in Elk Grove Village—now instead maybe it makes sense for them to do it" in an Opportunity Zone.

SOUTH SIDE SWATHS

Chicago's zones are areas with an unemployment rate of 20 percent or more, median family income of less than $38,000 and a poverty rate of at least 30 percent, according to the city. That includes large swaths of the South Side, in neighborhoods like Englewood and Auburn Gresham, and West Side communities like Austin, as well as the former Michael Reese Hospital site in Bronzeville.

It's harder to lure tenants to distressed neighborhoods, and rents in those areas typically are lower, making real estate ventures harder to pull off and more expensive to finance. But if investors can factor deferred capital gains into their financial equation instead of simply a property's cash flow, that can drastically lower the cost of capital, says David Doig, president of Chicago Neighborhood Initiatives, a nonprofit community development organization that has tapped various tax incentives to redevelop portions of the Pullman neighborhood and to build a Whole Foods in Englewood.

"Instead of paying 15 or 20 percent return on equity, for folks we've talked to it has been closer to 4 or 5 percent" after accounting for the tax deferrals and savings, Doig says. "That's significant."

Developers say projects in Opportunity Zones will only come to fruition if they are sound deals independent of the tax benefit. But the program's 10-year incentive should get investors' attention and encourage long-term commitments that are required to turn things around for a distressed area, says Scott Goodman, co-founder of developer Sterling Bay and now CEO of Farpoint Development.

"Changing the time horizon for an investor allows things to mature in a more orderly way and takes pressure off of developers such as ourselves to quickly develop and then flip or refinance a property," says Goodman, who plans to pursue projects in Opportunity Zones and is part of the team tapped by the city to redevelop the former Michael Reese property.

ENCOURAGED BUT WARY

Economic development advocates are encouraged by the possibilities of Opportunity Zones, but as with any preferential tax treatment, they're wary they will funnel investment into projects and areas that are already on the upswing or would thrive without the incentive. Chicago's zones are mostly in areas of extreme need, whereas many of the 8,700 zones nationwide are in neighborhoods that are already gentrifying and may be more attractive to developers and fund operators.

The same effect could occur within Chicago. One beneficiary of the program, for example, could be the vacant former Sears and Allstate headquarters buildings in Homan Square, on the city's West Side, which were sold to a local investor last month. Although the buildings are in an Opportunity Zone, they are buoyed by several surrounding properties that have recently been redeveloped and filled with tenants.

Developers have shown they don't automatically pounce on low-income communities just because there's a tax benefit, says UIC Urban Planning & Policy professor Rachel Weber, noting that some tax-increment financing districts in blighted areas of the city have gone unused.

Opportunity Zones don't address "quality of infrastructure, education and workforce development programs," she says. "(The program) just treats poverty like a real estate problem. I think everybody knows it's a little bit more complicated than that."

Given that rejuvenating Chicago's poorest neighborhoods may be a heavier lift than in other parts of the country, the program's local success will hinge on for-profit fund operators that are not well-versed in distressed neighborhood investments working closely with nonprofit financial institutions that normally focus on such projects, says Peter Vilim, co-founder and vice chairman of Chicago-based real estate investment firm Waterton.

"If you look at the for-profit and nonprofit sectors as, respectively, head and heart, you need the heart in this to make it work," he says.

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Ryan Tippery