• The investor understands the Related Party Rule, and
• The investor understands that, if leverage is used for the QOF or QOB, how that leverage will be applied to the stepped-up basis in years five and seven.
One uncertainty is that if the capital gains tax rate increases in the next seven years, where is the break-even point on the investments in the QOF or QOB? Does the taxpayer have the same amount of after-tax-cash in year seven as they would have if they had paid the tax in year one? Here is the breakeven point for various rates after seven years:
• If the tax rate rises to 38.6% (the lowest tax rate proposed by Senator Elizabeth Warren) the fund will break even in seven years at a return of 5.5%.
• If the tax rate rises to 52.8% (the lowest rate proposed by Senator Bernie Sanders) the fund will break even in seven years at a return of 12%.
• If the tax rate rises to 59.8% (the highest rate proposed by Sanders) then the fund will break even in seven years at a return of 19%.
The final regulations on Qualified Opportunity Zone investments generally follow the proposed regulations, adding some important clarification on how the investments work. The investments still require due diligence by both investors and their advisors.
But keep in mind that if Sanders is elected and is able to raise the capital gains rate to 59.8%, the fund will be unable to generate a rate of return to break even in seven years. On the other hand, if the tax rates remain at or below the 38.6% proposed by Warren, a much more doable 5.5% return is all that is needed to break even.
As I said, a QOZ can be a powerful, if uncertain, tax tool for clients with realized capital gains.
Matthew Erskine is managing partner at The Erskine Company LLC, which provides legal and fiduciary services for unique assets.