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Despite Looming Opportunity Zone Deadline, Investors Must Stay Disciplined by Arthur J. Lieberman

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Posted on October 25, 2021 by Art Lieberman

The end of 2021 brings a critical deadline for real estate developers, investors, property owners and fund managers participating in the Qualified Opportunity Zone (QOZ) program.

While a failure to meet this Dec. 31, 2021, cutoff date can jeopardize investors’ eligibility for a potential 10 percent reduction in taxable gains, it should not be the primary decision driving QOZ investments, especially with the prospect of higher capital gains rates under the current administration.

As a reminder, the Tax Cuts and Jobs Act of 2017 introduced QOZs to incentivize private investment, business development and job creation in more than 8,700 economically distressed communities throughout the U.S. In return for their capital, QOZ investors may receive the following tax benefits:

More specifically, taxpayers can defer until 2026 the payment of taxes on capital gains that they reinvest into QOZs through one or more Qualified Opportunity Funds (QOFs). Additionally, an investment in a QOF held for a minimum of five years may permanently exclude from tax 10 percent of the original rolled-over gain from taxable income, but only if the investment is made before Dec. 31, 2021. Finally, investors who hold onto their QOZ investments for 10 years or more may qualify for complete capital gains tax exemption on the future disposition of their QOF investments.

Much news has been made about the Dec. 31, 2021, deadline for taxpayers to make a QOF investment that would meet the five-year holding period and therefore qualify for a 10 percent step-up in basis on the excluded gain. However, missing from the headlines is the prospect of higher tax rates on capital gains, which the current administration proposes to increase from its current rate of 20 percent. Consequently, QOZ investors may likely pay higher tax on their deferred gains in 2026, even with the benefit of the 10 percent reduction in the original deferred gain.

For example, if a taxpayer in the top tax bracket elects to defer $1 million of gain in 2021 when the capital gains tax rate is 20 percent (plus the 3.8 percent net investment income tax), he or she would save $238,000 in tax in 2021. Should Congress agree upon a tax package that raises the capital gains tax rate to 25 percent (plus the 3.8 percent net investment income tax), the tax due in 2026 would be $259,200 ($1 million x 90 percent x 28.8 percent.) At a 28 percent capital gain tax rate (plus 3.8 percent net investment income tax), the tax liability in 2026 would be $286,200.

In general, taxpayers should remember that QOZ investments are a long-term play, and the greatest benefit comes to those who hold onto their investments for a minimum of 10 years. Not only may these investors defer tax liabilities, but they may ultimately receive the benefit of tax-free appreciation on their QOZ investments. Moreover, taxpayers should recognize that investments in QOZs, like any other asset, should be evaluated based on strong fundamentals and expected financial performance rather than on potential tax benefits.

About the Author: Arthur J. Lieberman is a director with the Tax Services practice of Berkowitz Pollack Brant Advisors + CPAs, where he works with real estate companies and closely held businesses on deal structuring, tax planning, tax research, tax controversies and compliance issues.  He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.