Recent proposals from the White House consider raising the long term capital gains tax rate to over 40% for high income earners (over $1M of annual income). While a change in the capital gains tax rate is becoming more likely, consensus seems to be that this increase will be more modest than the current proposal from President Biden.
President Biden also has other important tax proposals, most notably the possibility of eliminating 1031 like-kind exchanges for investors who earn over $400K in the same tax year.
It’s clear that the Opportunity Zone investment benefit of tax free appreciation becomes even more valuable if there is an increase in the future capital gains tax rate. However, this increased value warrants some explanation and is a question we often receive. The net outcome is positive, albeit nuanced, as long as you are making sound investments.
Consider an investor who realizes a capital gain today, and after investing in an OZ Fund, the capital gains tax rate increases. Assuming the new capital gains tax increases to 30% instead of the proposed 39.6%, we have calculated the following example (We are only considering federal capital gain tax for this example although most states conform to the federal incentive). To keep this simple, let's also assume an investor has $1M in capital gains. The added 3.8% on the current and example future rates is the existing Obamacare surtax.
One of the incentives of making an OZ investment is that the capital gains tax an investor would have paid today is deferred until 2026 and the amount of deferred gain that is taxed is reduced by 10%. Therefore, an increase in the capital gains tax rate results in the deferred capital gains tax paid in 2026 becoming more expensive than paying it today. This is the only negative effect an increase in capital gains tax has on an OZ investment. What is interesting to compare is whether this is offset by an even greater benefit on the tax free appreciation of the investment.
Below compares a Non-OZ Investment and an OZ Investment at Current Tax Rates, as well as a Non-OZ Investment and OZ Investment at Increased Tax Rates. We assume that both the Non-OZ and OZ investments have the same performance to isolate the tax effects. It’s also important to point out that OZ investments pay no depreciation recapture tax.
The net positive difference between the current and increased tax rates, shown below, is not massive. However, the purpose of this article is to exemplify that an increase in capital gains tax does not negatively affect an OZ investment made today. This also serves as a great example of how substantial the OZ benefits are in general.
It is also important to note, that even in a changing tax environment, President Biden continues to express confidence in the potential of Opportunity Zones proposing three modifications to improve the incentive.The proposed reform calls to incentivize OZ Funds to partner with nonprofit and community organizations, require Treasury to review OZ benefits to collect data on the benefits to the community, and, most importantly, require detailed reporting and public disclosure of OZ investments. Four Points Funding strongly supports these changes as they validate the intent of the legislation.