With President-elect Joe Biden set to take office in January, many taxpayers would admit they are experiencing some level of heartburn on what may happen to our nation's tax code as a result of the change in political power in Washington. After all, every president since Bill Clinton has signed into law a new tax bill within twelve months of the beginning of their first term.
One area that many taxpayers and practitioners alike are focusing on is the qualified opportunity zone (QOZ) incentive, which was part of the Tax Cuts and Jobs Act enacted into law in December 2017. The concept of qualified opportunity zones was very much a bipartisan idea even before the Tax Cuts and Jobs Act, with Senators Cory Booker (D-New Jersey) and Tim Scott (R-South Carolina) acting as the program's main supporters. Despite this initial bipartisan support, the qualified opportunity zones incentive has been viewed by many as a Republican tax policy and has received more than its share of negative press as the incentive has unfolded over the past couple of years.
Let’s examine a few areas in particular that qualified opportunity zone stakeholders are focusing on when it comes to the potential for new tax law changes.
Increase in Capital Gains Tax Rate
The top Federal tax rate on capital gains is currently 20%, and in many cases, the additional 3.8% net investment income tax also applies. Meanwhile, the top Federal tax rate on ordinary income is currently 37%. Since the taxpayers who are recognizing capital gains are typically wealthier than the average taxpayer, the capital gains tax rate has been scrutinized by Democrats who believe the wealthiest taxpayers in the country are not paying their fair share of taxes. President-elect Biden has stated in his tax plan that he would like to see the capital gains tax rate be equal to ordinary rates for taxpayers whose income exceeds $1,000,000.
How is this relevant to qualified opportunity zone stakeholders? In order to make a qualified investment, one must have realized a capital gain that is eligible to be contributed into a qualified opportunity fund. By doing so, they defer recognizing the income on their capital gain, which must be recognized at some point in the future, but in any event not later than the 2026 tax year. Which begs the question - what tax rate will apply to the capital gain when it must be recognized in a future tax year?
In a perfect world, the equitable answer would be for those investors to recognize their capital gains at the same tax rate that was in place at the time they deferred their gains into a qualified opportunity fund. However, there is currently no such provision in the tax code.
Residential Rental Real Estate and Other Businesses Not Qualifying as a QOZ Trade or Business
Senator Ron Wyden (D-Oregon) had previously introduced the Opportunity Zone Reporting and Reform Act in the Senate as a proposed bill (S. 2787). The bill has sat on the docket for a while, but if it were to be enacted into law in its current form, residential rental real estate would not qualify as an eligible QOZ business unless a minimum of 50 percent of the units available for rent are rent-restricted and occupied by lower income individuals. In addition, the bill would also exclude self-storage property and stadiums from qualifying as eligible trades or businesses. A shift in political power within Congress could serve as a catalyst for this type of change to qualified opportunity zones.
Since the enactment of the Tax Cuts and Jobs Act, the vast majority of qualified opportunity zone businesses we have seen are residential rental real estate projects. If these projects were to no longer qualify as QOZ businesses, further guidance would be necessary for qualified opportunity funds and their investors to understand what the best course of action could or should be.
Increased Reporting Requirements
It may come as a surprise that both sides of the aisle in Congress agree on something - anything - these days. But there is, in fact, bipartisan support for the reporting requirements of both qualified opportunity funds and qualified opportunity zone investors. In addition, the U.S. Government Accountability Office recently issued a report indicating the need for additional oversight of the qualified opportunity zones tax incentive, which could be provided in part by the Treasury Department collecting data on qualified opportunity zones on an annual basis.
Democrats have argued since the inception of the QOZ incentive that it has unfairly benefitted the wealthiest taxpayers in the country and has not made meaningful strides towards improving the most economically distressed opportunity zones. Republicans, on the other hand, want to see the codification of increased reporting requirements in order to substantiate the impactful change that is being created within the designated opportunity zones.
While we will likely see tax law changes taking place in the next 12-18 months, QOZ stakeholders its stakeholders should remain focused on the bigger picture. Don’t forget – the most significant benefit of a QOZ investment is the ability to step-up your basis to fair market value upon disposal of the qualified investment and/or underlying property after a minimum ten-year holding period. Despite the increased likelihood for the promulgation of new tax law, any changes that may impact QOZ’s and their stakeholders are not expected to be significant enough to exclude QOZ’s from being part of the tax planning conversation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute an accountant-client relationship.