On April 28, 2021, President Biden unveiled the American Families Plan, which includes significant provisions that would increase taxes for wealthy taxpayers. Among a litany of proposed tax changes is a call to increase the tax rate on long-term capital gains from the current 20% to 39.6%, for households making over $1 million. While the proposed legislation has a way to go before enactment, and is likely to see significant revision, many are concerned with the currently proposed rate increase, especially those investing in Qualified Opportunity Zones (OZ).
Current OZ investors face a unique conundrum due to the nature of OZ investments, whereby current capital gains, taxed at a maximum 20% rate, are deferred and subject to tax in 2026 at the prevailing rates in effect at that time—possibly 39.6% under Biden's proposal. Many are wondering whether the OZ tax "benefits" as they are billed, may cause them to pay more tax under the proposed regime. Investors with 2020 and 2021 capital gains are considering whether new OZ investments will still make sense if rates increase, and those who have already invested are contemplating pulling out or decertifying their QOZ funds. We have put pen to paper, crunched the numbers, and are here to tell you OZ investments still yield tax savings in most situations, and may be an even better tax saving tool than previously expected, given the right circumstances.
What is all the panic about?
The cause for concern is summarized best by a simple example. Let’s assume an OZ investor defers $1 million of long-term capital gains incurred in 2021 into an OZ fund. Since all signals coming out of Washington indicate rates will not rise retroactively this investor fears they may be trading a $200,000 current tax bill for a $396,000 tax bill in 2026.
If that sounds like a good deal, I have a bridge to sell you… What are we missing?
Quite a few things. Let's go through them one by one.
First, remember OZ investments come with a second tax benefit in addition to gain deferral: 10 percent of gains invested in OZ funds by 12/31/2021 will be forgiven before they are taxed in 2026. So, the investor in our example would only be subject to tax on $900,000 of gains in 2026, not the $1 million she deferred, which would fully be subject to tax currently absent the OZ. Assuming a 39.6% rate, her future tax will be $356,400 in 2026.
Note for those that made OZ investments prior to 2019, 15 percent of deferred gains will be forgiven instead of the 10 percent noted above.
Still not excited about this… what else you got?
It is also important to keep in mind a $356,400 tax bill five years from now is not the same as $356,400 tax bill today. If we assume the investor can earn 8% annually, today's cost of her future tax bill is approximately $240,000.
OK… so paying $200k of tax under today's rates still seems like the better bet. You got anything better?
OZ investments come with a third tax benefit, which is really the holy grail of OZ investments. If an OZ investment is held for 10 years or more, any appreciation is excluded from tax when the investment is sold. If we assume our investor's $1 million investment yielded a 10% annually compounded return, its value after 10 years would be ~$2.6 million. With OZ benefits, $1.6 million of gains would be excluded from tax when the investor sells after 10 years. A similar non-OZ investment would yield $1.6 million of taxable gains.
That sounds pretty good, but do the math for me - how much tax is that 10-year exclusion saving?
Well, we do not know what capital gain rates will be in 2031 or beyond, but if we assume they will come back down to the current 20% rate, that exclusion will save approximately $320,000 of tax in 10 years, or approximately $148,000 in today's dollars.
If we assume capital gain rates in 2031 will be 39.6%, that is approximately a whopping $634,000 of tax or approximately $300,000 in today's dollars.