Like everything else in the Land of OZ, these three incentives come with complications. First, a gain deferred in 2021 will be recognized on December 31, 2026, but it will be taxed at the then-applicable tax rates—which, if Biden is successful, may be increased substantially. Is that even a “tax benefit” if the capital gain taxed at 20% in 2021 is ultimately taxed at 28% (or even higher) in 2026? Our calculations show that if a taxpayer recognizes gain and pays tax in 2021, and then sells the investment and recognizes a second gain in 2026, the taxpayer would be better off using the opportunity zone tax incentives in full, as long as the compounded investment rate of return over five years is at least 6.5% or higher. If the investor plans to hold the investment for 10 years or more and enjoy the third incentive, then almost any positive rate of return will reward the opportunity zone incentives over immediate taxation at a lower capital gains tax rate.
More important, the third benefit, which provides a tax-free exit from the investment as long as it is held for at least 10 years, is only available if the gain is invested in a qualified opportunity fund. So it’s clear that the opportunity zone incentives should be very attractive for a successful investment even if the tax rate rises substantially.
There is a caveat: The opportunity zone tax incentives are all about reducing taxes—which assumes you have tax liabilities in the first place. I often describe it as “frosting on the cake”—the incentives can turn a good investment into a great one, and a great one into something fabulous, but they cannot turn a bad investment into a good one. The opportunity zone tax incentives might be the frosting, but there needs to be some “cake”—meaning a sound and successful underlying business. On the other hand, if your qualified opportunity zone business is successful and provides the cake, then the opportunity zone tax incentives can provide a lot of frosting!
Doing Well By Doing Good
Tax incentives are the “doing well” part of opportunity zones, but there’s also a genuine “doing good” part.
Opportunity zone tax benefits have drawn political fire and been called a bigger benefit to the wealthy than for the ostensible low-income residents of the zones themselves. But for the most part, the concept has strong bipartisan support.
For one thing, the process of designating the zones by the governors was handled in a capable and relatively fair manner. A comfortable majority of city and town mayors approved of the zones their governors designated within their cities, according to the 2019 “Menino Survey of Mayors,” (published by Boston University). That’s probably as positive an endorsement as one could expect or hope for in any selection process with big political and tax ramifications.
Various reports on opportunity zones acknowledge that the tax incentives are doing what they are intended to do, which is move money into locations where it wouldn’t otherwise go. A June 2020 report by the Urban Institute made the telling comment, “Most observers appear to agree that a primary benefit of the program is that it elevates the visibility of neighborhoods in deals that the investors might not have considered otherwise.”
The bottom line is that opportunity zone tax incentives accomplish a clear social good—pushing investment funds into areas that both desperately need capital and that would be unlikely to attract investment without the incentives. In this strangely polarized political world, doing “good” is still likely to be encouraged, and therefore the incentives seem likely to survive all the trimming and pruning that the Biden administration intends to do to the Internal Revenue Code.
So take advantage of the opportunity to “do well by doing good”—and seize the opportunity to make an OZ investment in 2021.
Joseph B. Darby III, Esq., is an adjunct professor at the Boston University School of Law and the founding shareholder of Joseph Darby Law PC, a law firm that concentrates on sophisticated tax and estate planning for individuals and businesses. Jill Homan is president of Javelin 19 Investments, an opportunity zone-focused real estate development, investment and advisory firm.