President Joe Biden's proposals to increase taxes on long-term capital gains add an extra layer of complexity to opportunity zone investments because investors may not know the long-term tax consequences of their financial decisions.
Biden in May proposed increasing the highest marginal individual tax rate to 39.6% from 37% starting in 2022 and hiking the top rate on long-term capital gains, currently 20%, to match that level. A 37% capital gains rate for those earning over $1 million would apply retroactively to April 28 and increase to 39.6% starting in 2022. [CBIZ Note: The General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals (“Green Book”) reports the effective date of the capital gains tax increase as “This proposal would be effective for gains required to be recognized after the date of announcement.” The term “date of announcement” is not defined, however.]
An increase to the capital gains tax rates may affect investors' decisions to put their money into opportunity zone projects, according to Daniel P. Ryan, a partner at Sullivan & Worcester LLP.
The opportunity zone program, created by the 2017 Tax Cuts and Jobs Act, allows an investor to reinvest capital gains into designated low-income areas in exchange for certain tax benefits that grow the longer the money is invested, up until the end of 2026. Gains on a qualified opportunity zone investment are tax-free if the investment is held for 10 years.
However, if capital gains tax rates are changed so that they are similar to ordinary income tax rates, then the gains on the initial investments going into opportunity zones could be taxed at a higher rate when they come due, Ryan said. Investors will have to do the math to see if the tax-free appreciation over 10 years is less than or more than the tax an investor would pay in 2026, Ryan said.
"When you pencil out the numbers ... if your tax is doubled, it may not be worth it," he said.
For example, if an investor puts $1 million in capital gains into an opportunity zone fund or business and defers payment until 2026, instead of paying $200,000 in taxes, the bill would be about $400,000 under Biden's proposal, Ryan said. So an investor would have to decide whether they're willing to pay $400,000 so that the investment over 10 years has gains that can be taken out tax-free, Ryan said.
"You'd have to think about and really have confidence in your project," he said. "You'd have to speculate five years down the line to do that, so it'll be tough to do."
Russell J. Stein, of counsel at Partridge Snow & Hahn LLP, agreed that opportunity zone business owners are concerned about the potential increase in capital gains tax rates and have been trying to get deals done before that happens.
"We have seen a slight uptick with interest in opportunity zone investment to try to defer those gains, but there is still some hesitancy with investing in the program," he said.
Investors are grappling with the potential tax rates in 2026 because if they are higher than the current rates, then they may actually pay more in taxes in 2026 than they would have paid if they didn't defer, Stein said.
"Investors need to weigh the potential of the exclusion from tax on appreciation with the potential increased tax on the deferred gain," he said. "Clients who are just looking to defer the gain are having challenges trying to analyze those issues."
However, Stein said he has not seen people pull out of opportunity zone investments due to Biden's proposals, in part because the investments are usually quite strong even without the tax benefits.
"So the tax benefits make a good investment into a great investment," he said. "But what the [loss of the] tax benefits don't do is make a good investment into a bad investment."
The opportunity zone program is not like other credits such as those for low-income housing or historic rehabilitation, which are designed to turn bad investments into viable ones, Stein said. The economics of low-income housing or historic property investments are not reliant upon the appreciation of the property, while opportunity zone investments seek capital appreciation, he said.
So anyone who is deciding whether to invest money into an opportunity zone will have to weigh the tax exclusion of future appreciated gains, which is risky, versus the near certainty that in 2026 they will probably pay more in taxes than they pay now, Stein said.
"Some of them are taking that risk, especially developers, real estate developers; this is their line of work anyway," he said. "They're quite comfortable doing development projects and taking the risk of them."
However, in considering opportunity zone investments, investors should not only think of possible changes to the capital gains tax rates, but whether the state where the investment is located provides the same tax benefits, Stein said. Some states such as Massachusetts don't follow the federal rules, so there are no state tax benefits from some opportunity zone investments, he said.
Marc L. Schultz, a tax partner at Snell & Wilmer LLP, said many of his clients are calling to express their concern about a possible increase to capital gains tax rates and its effect on opportunity zone investments.
Right now, many people are selling their real estate and other property to trigger capital gains at the lower tax rate, he said. Schultz said some of his clients with capital gains in 2020 and 2021 are deciding not to invest 2020 gains into opportunity zones but instead are investing their 2021 gains.
"The reason being is that they feel that the 2020 gains, that tax rate, is going to be lower than whatever we're going to see in 2021," Schultz said. "They're worried about some type of retroactive rate change for 2021, and they're saying to themselves, at least I know the 2020 tax rate, so I'd rather pay tax on the 2020 tax rate and do an OZ investment with the 2021 gains."
A spokesperson for Senate Finance Committee Chair Ron Wyden, D-Ore., confirmed to Law360 that he is working on legislation to increase capital gains tax rates on the grounds that the country's wealthiest individuals have profited immensely during the coronavirus pandemic and have not been paying their fair share of taxes.
"The capital gains rate will be higher, but the specific rate would be shared when the bill is introduced," the spokesperson said.
The details of Wyden's legislation and timeline are not yet available.
Even if capital gains rates go up this year or in 2022, deferring capital gains in 2021 to 2026 could potentially be beneficial if there's a change in administration or in Congress that prompts lowering capital gains again by or before 2026, Schultz said.
"We have elections coming up in 2024, so that can mean a change in administration … plus another two years to get legislation through," Schultz said. "There's uncertainty as to if it's even going to increase, and there's uncertainty with how long that increase will be in effect."
The uncertainty affects the financial modeling of investment choices because in examining whether to invest and understand related benefits, an investor has to take into account certain assumptions, he said. Right now, an assumption has to be made on what the rates will be to quantify the tax benefits for to investors, Schultz said.
Under the current opportunity zone law, investors will get 10% forgiveness on taxable gains if gains are held in an opportunity zone fund or business for five years and the investment is made by Dec. 31, 2021. Since there is still that 10% savings for investments made this year, Schultz advises his clients to look at any increase in capital gains tax rates through that lens.
"My advice is that historically the long-term capital gains rate has been as high as 28% and as low as 15%, so I advise people that if there's a tax rate increase, it's hard for me to believe that it would go above 30%," he said. "It's hard for me to believe you'll see something that significant. But there's a chance you'll see an increase, [and at least] you have a 10% buffer on that."
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