Opportunity zones: post-election outlook
The tax platform of the Biden administration proposes significant changes that should increase interest in the opportunity zone (OZ) program, which was created by the Tax Cuts and Jobs Act of 2017 (TCJA).
If passed by a unified Congress, four tax planks could potentially increase taxes on capital gains, affect estate planning and eliminate the 1031 like-kind exchange. Specifically, the Biden platform calls for:
- The current federal long-term capital gains rate for assets held 12 months or longer is 20% (plus the 3.8% net investment income tax when applicable). The Biden platform calls for increasing the capital gains rate to his proposed ordinary income rate for taxpayers with income of more than $1 million, which would be 39.6% (the pre-TCJA rate), and the same as the current short-term capital gains rate. An increased capital gains rate would have two OZ-related impacts: (1) Deferred capital gains could be subject to higher tax rates in 2026; and (2) more importantly, increased tax savings on the appreciation in the value of an OZ investment after the 10-year hold period.
- The 2017 TCJA narrowed the use of a like-kind exchange, which was implemented in 1921, to defer capital gains to only real estate. Eliminating the like-kind exchange for real estate will likely face resistance from both sides of the aisle, but if approved, all sales of non-homestead real estate will face capital gains taxes, with OZ investments as the only remaining deferral strategy. This change would also end Delaware Statutory Trust (DST) investments, which facilitate 1031-exchange benefits for investors looking to participate passively in a real estate investment while deferring capital gains.
- Under current tax law, when someone has passed away, the assets of the deceased are “stepped up” to market value. The stepped-up value of assets in excess of the estate tax exclusion are subject to the estate tax. For taxpayers that will not have an estate tax liability, this is a benefit to their heirs as they will inherit those assets at the current market value without an embedded (unrealized) capital gain. Taxpayers with assets in excess of the exclusion are taxed on the higher value, so those assets effectively pass to their heirs net of capital gains since the estate paid a tax on their market value.
- The TCJA temporarily doubled the exemption level to $10 million from $5 million. The rate was indexed for inflation occurring after 2011, so in 2020, the exemption was $11.58 million per person and will be $11.7 million in 2021. Under the TCJA, the exemption will return to its previous level after 2025. Unless reduced sooner by legislative action, the increase in the estate tax exclusion is expected to sunset as schedule in the TCJA, which will expand the number of taxpayers engaging in careful estate planning for the benefit of their heirs.
Since the TCJA introduced the OZ program in 2017, OZs have become a popular investment tool. OZ investments are poised to be one of the only (possibly only) tax-efficient reinvestment strategies that provides a hedge against rising capital gains rates and powerful estate-planning benefits.
Given broad bipartisan support for the OZ program, the Biden platform calls for reforming the OZ program rather than eliminating it. His proposal essentially calls for:
- Incentivizing qualified opportunity funds (QOFs) to partner with not-for-profit or community-oriented organizations to jointly produce plans for each investment focusing on job creation and other community benefits to residents within the OZs
- Having the Treasury Department review the community benefits resulting from the OZ investment to ensure that clear economic, social and environmental outcomes are evident
Please contact your Baker Tilly tax advisor to learn more about how an OZ investment can provide a tax-efficient reinvestment strategy and enhance your estate planning.