Opportunity Zones Provide a Way to Hedge Expected Tax Hike

Joe Biden’s call to roughly double top capital gains tax rates—even though not yet in a bill, let alone passed into law—has sent many CRE investors looking for ways to avoid the potential impact.

One option several experts suggest is looking at qualified Opportunity Zone investments. They can’t make the pain of paying capital gains taxes completely disappear, but they offer some solace. But there are some issues of timing and risk that a deferral of tax today could mean a higher bill later.

The Opportunity Zone program was part of the 2017 Tax Cuts and Jobs Act. The intent was to create incentive for long-term investment in designated low-income communities.

“In order to be eligible for the tax benefits, an investor needs to have eligible capital gains,” Jessica Millett, partner and chair of the tax department at NYC real estate-focused law firm Duval & Stachenfeld, tells GlobeSt.com. “Ordinary income doesn’t count.” And the OZ program “doesn’t seem to be on the chopping block,” she adds.

Investors still will pay tax on the initial capital gains. There is a deferral, but that ends on December 31, 2026. “When the deferral ends in 2026, investors have to pay tax at the capital gains tax rate in effect then,” Millett says.

If the rate is higher than currently, the investor would pay a larger percentage in taxes. However, there are some additional considerations.

One is a partial step-up in basis, according to Steve Wyatt, senior counsel at Chamberlain Hrdlicka. “If I hold [the original capital gains] for five years in that opportunity fund, I get a basis step-up of 10% [of the realized gain],” he tells GlobeSt.com. Effectively, capital gains tax would apply to only 90% of the initially invested capital gains. There was an additional 5% step-up available, but only if the gains were held in the fund for at least seven years before the 2026 deferral date. That is no longer possible, as 2026 is only five years away.

Then there is an additional advantage. “The bigger tax benefit is if your qualified opportunity fund invests in some new project and if you’re in the fund for at least 10 years, there’s no taxable gains tax imposed on the sale of that new investment,” says Millett. The new capital gains on that initial investment of previously existing capital gains are tax free.

Jake Harris, a managing partner and co-founder of investment company Harris Bay, explains it to GlobeSt.com this way: “You have a $1 million long-term capital gain in 2021. You invest in an Opportunity Zone deal rather than paying a 23.8% capital gain.”

Assume for a moment that the capital gains rate is 40% in 2026. Instead of paying $238,000 in 2021 taxes, the investor would owe $360,000 in 2026, which is 40%, taking the basis step-up of 10% into account, so 40% of $900,000.

It’s a risk, but the investor must take the OZ additional capital gain from the investment into account.

“So that $1 million investment in the OZ grew over a decade but could see a three to four times equity multiple,” which Harris says is typical in a 10-year plus deal profile. That would translate into between $2 million and $3 million tax-free.

But it all depends on the specifics of the deal and future tax rates. “It may make paying the tax on the original gain at the end of 2026 a bigger challenge which might lead to overall investment declining,” Reid Thomas, managing director and chief revenue officer of JTC Americas, tells GlobeSt.com.