Will Capital Gain Rate Changes Kill Opportunity Zone Investments? Quite the Opposite, in Fact…

Posted on Thu, May 20, 2021 ©2021 Drucker & Scaccetti

Commerical BuildingBy: Chris Catarino, CPA, MT


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.


So now I get it… Take a little tax hit in the short term for big savings later.

Exactly! But where we have not even gone yet is the 4th unspoken benefit of OZ investments, particularly for real estate, that makes OZ investments even sweeter. Not only is an OZ investment's appreciation excluded from tax after 10 years, but so is any tax depreciation that was previously claimed.


If we assume that $1 million OZ investment was made in a residential development project that had a three to one debt-to-equity ratio, which took advantage of cost segregation and bonus depreciation, the depreciation deductions allocated to the investor over 10 years may exceed approximately $2,300,000. This depreciation would generally be recaptured as additional gain in the year of sale, but that is not the case with OZ investments.


If 2031 tax rates are 20%, we are talking another approximate $470,000 of future tax savings (or approximately $217,000 in today's dollars). If we assume the 2031 tax rate is 39.6%, that tax savings increases to approximately $930,000 (or approximately $430,000 in today's dollars).


My calculator broke about 300 words ago… what does the final count look like?

The box-score is below:



20% LTCG Rate in 2031

39.6% LTCG in 2031

Original 2026 Tax Bill @ 39.6%



Less: 10% OZ Forgiveness



Less: 5-Year Discount



Today’s 2026 Tax Cost



Tax-Free Appreciation Savings*



Depreciation Recapture Savings*



Tax Cost/(Savings) of OZ



Less: Current Tax Cost of Non-OZ



Net Tax Cost/(Savings) of OZ vs. Non-OZ




*Discounted to today's dollars

While these numbers are certainly compelling to continue making and holding OZ investments, they are based on some significant assumptions, most notably that the OZ investment will appreciate over time and that the depreciation deductions will reduce the investor's tax and not be trapped by passive activity loss rules or other loss limitations. OZ investments in non-real estate ventures likely will not yield the same level of depreciation deductions as described above. The analysis is also different for investors that do not naturally have capital gains but are considering whether to trigger gains to make OZ investments. Changes in these assumptions would make OZ investments somewhat less attractive.


There is also a possibility the next administration will decrease tax rates back to current levels before 2026, or that tax legislation passed under the current administration will include a provision to grandfather existing OZ investments in some fashion to mitigate an increased 2026 tax hit. Oh, and it is also quite possible that tax legislation passed under this administration will be vastly different than what is currently laid out in the American Families Plan. These things may make OZ investments somewhat more lucrative.


The analysis above is focused primarily on gains that may be subject to tax at the current 20% rates today vs. a higher rate in the future. Once we get through this transition period, deferrals and exclusions will be significantly more beneficial in a higher-rate environment than they were in a lower-rate environment. If that turns out to be the case, OZ investments may see substantially more interest and investment when rates are 39.6%, than they have to date at 20% levels.


If you are concerned about potential rate increases and considering making OZ investments or decertifying existing OZ investments and would like a specific analysis done for your situation, feel free to reach out to our Tax Warrior OZ Experts or visit our Opportunity Zone Resource Center.


Topics: 39.6%, Qualified Opportunity Zones, Qualified Opportunity Funds, QOZ, QOF, capital gains tax, President Biden

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