By Blake Christian, CPA, and Austin Bowen, The Tax Advisor
Now that the Dec. 31, 2021, funding deadline has passed to take advantage of the 10% basis step-up provision (assuming a five-year hold), some skeptics will argue that the economics of the federal opportunity zone (OZ) program have been diminished. Not so.
The long-term benefits of the OZ program have not changed for investors, municipalities, and disadvantaged communities alike. We encourage you to recommend OZ investing for clients who have substantial gains from the sale of appreciated tech stocks, family businesses, real estate, stock portfolios, and even cryptocurrency and collectibles — especially if those clients are cause-oriented and/or need tax strategy help. Even though the Dec. 31, 2021, deadline has passed, the OZ program still offers CPAs and their clients the opportunity to defer tax on 2021 capital gains for up to five years into the future.
Contrary to how it is often portrayed in the media, the OZ program is not just a game the wealthy can play for tax deferral (aka "avoidance"), and it's not just about real estate.
As we'll discuss shortly, the OZ program has already had a positive (and measurable) impact on job creation, home values, and entrepreneurship in many of the 8,700 nationwide census tracts designated for OZ investment. Most OZ tracts are in economically challenged areas often bypassed by traditional real estate developers, retailers, and even place-based government programs.
Before looking closer at the investment, tax, and society-benefiting possibilities of the OZ program for your clients, let's review the original purpose of the OZ program and look ahead to its future benefits.
While often portrayed as a last-minute addition to the 2017 law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, the OZ program was conceived under the Obama administration and finally passed in a bipartisan fashion in late 2017. The OZ program was designed to encourage taxpayers with high concentrations of wealth in tech stocks, family businesses, real estate, stock portfolios, and alternative assets to liquidate those assets to help fund development in economically challenged areas. In return for making a long-term commitment to those areas, investors receive multiyear deferral and ultimately tax exemption on their post-reinvestment appreciation.
That remains the case today. Regardless of what each investor's motivation is for participating in the OZ program, it has already had a measurable positive impact in all 50 states (as well as U.S. territories).
According to national CPA firm Novogradac, more than $20 billion in equity dollars had been invested in the OZ program as of September 2021 ("Novogradac Opportunity Fund Tracking Surpasses $20 Billion," Novogradac website (Oct. 22, 2021)). This is a conservative figure since it generally excludes "captive" OZ funds formed by family offices and high-net-worth taxpayers. Furthermore, these projects have a "capital stack" that is generally leveraged at a 4:1 ratio or greater. So, the total project funding is easily closer to a range of $80 billion to $100 billion — already meeting the White House's targeted funding through 2027.
Four years into the program, federal and local authorities are formalizing their reporting about ways in which the program is impacting OZ communities, including local residents. Increases in job growth, home values, and overall economic growth in OZ tracts are being measured. Here is an example of what we're finding:
1. Job growth: A recent Brookings Institute Report cited an estimated 780,862 new jobs in opportunity zone tracts (Arefeva et al., "Job Growth From Opportunity Zones," Brookings Institution (Feb. 19, 2021)). This employment growth took place across multiple industries ranging from construction to service industries. We agree with many researchers and policy watchers that OZ-induced employment will continue to flourish as more OZ businesses are established across the country.
2. Home price appreciation: With many investors deferring capital gains into real estate projects, housing prices have seen a higher percentage increase in OZ tracts than in comparable non-OZ tracts since the program rolled out in 2018. In other words, researchers have found a measurable, albeit modest, boost to housing prices in OZ tracts above and beyond what could be attributed to the overall spike in U.S. housing prices. Rising home values benefit areas adjacent to OZ tracts, too, by lifting the entire community and adding equity into people's homes that was previously limited or held down by their geographic location (U.S. Department of Housing and Urban Development (press release), "New Report Shows Opportunity Zones on Track to Lift One Million Americans Out of Poverty" (Aug. 25, 2020)).
3. Economic development: OZ business are continuing to flourish in more than just value. One OZ business, for instance, is addressing a need for housing. MIT Modular (MITmodular.com) in Provo, Utah, is transforming shipping containers into affordable housing. These units are easy to transport and can be taken to cities to provide affordable housing for seasonal workers and the homeless. (Full disclosure: One of the authors co-founded this business.) This is not the only OZ-based business seeking to benefit society. There are many others making great strides in green energy, new technologies, and countless other areas. These businesses will continue to boost community employment and community development (and civic pride) while offering investors substantial upside on their money.
The Biden administration will undoubtedly expand annual reporting of OZ fund activities and community impact. Depending on whether the Build Back Better (BBB) bill rises from the ashes or gets restructured, we may see the OZ program combined with certain infrastructure projects to maximize leverage and encourage public-private partnerships.
While many use the OZ program in connection with real estate, firms engaged in venture capital and private equity — initially reluctant to jump into the OZ investment pool due to its 10-year time horizon — have begun taking advantage of the OZ program's benefits to fund operating businesses in designated OZ tracts. These operating businesses — not all tech startups seeking "cheap rent" by the way — have the potential to expand job creation when combined with other tax program advantages in these areas. Meanwhile, private-equity investors are segmenting certain longer-term real estate investments into OZ structures.
Investment and tax benefits
While many believe the window of "opportunity" to invest in the OZ program closed on Dec. 31, 2021, clients who are sitting on large capital gains generated in calendar 2021 may still be eligible for OZ reinvestment. To the extent their gains are reportable on a Schedule K-1, taxpayers have as late as Sept. 10, 2022, to reinvest. However, if the taxpayer directly held the sold assets, such as stock holdings, a plot of land, or cryptocurrency, he or she has a much stricter 179-day reinvestment period after the date of sale.
The OZ program still has two important benefits remaining from a tax perspective:
1. Original gain deferral: There is an initial tax deferral of the original capital gains (short-term or long-term) until Dec. 31, 2026. Taxes will be payable April 15, 2027, at the rates in effect in calendar 2026. Think of this as a five-year "interest-free" loan — a valuable benefit for any taxpayer, not just real estate investors. Over the past 18 months we have seen a huge increase in crypto traders utilizing the OZ program to defer gains. Since most crypto gains are short-term, they are subject to the highest marginal rates. The benefits of deferring gains from crypto (and other alternative assets) into the OZ program can be substantially greater than reinvesting long-term gains. (See Christian, "Investors Are (Legally) Shielding Crypto Gains in Opportunity Zones," Tax Insider (Nov. 18, 2021).)
2. Tax-exempt growth: By far the most valuable benefit remaining under the OZ program is the ability to achieve tax-exempt growth of one's investment after a 10-year holding period. Upon selling the investment, there will be no federal tax on the investor's proceeds. Every state other than California, Mississippi, North Carolina, Massachusetts, and New York honors the exemption. This exemption is the primary reason why people continue to invest their capital gains into the OZ program. The exemption extends to depreciation and tax credit recapture, which only adds to the total internal rate of return on an investment.
Note: As mentioned earlier, the third key benefit of the original OZ program expired on Dec. 31, 2021. That was a tax basis increase of 10% of the fund balance after holding an OZ fund for five years. If you have clients asking about the loss of that provision, remind them that this benefit was a very small part of the OZ program. If you run the math, you'll see that even though the Dec. 31, 2021, window has closed on basis step-up, it only brought high-net-worth investors an additional savings of 2.38% (10% × 23.8% tax rate) on long-term gains and only 4.08% (10% × 40.8% tax rate) on short-term gains. That's a rounding error for most people, considering a 10-year investment period.
2022 OZ investment horizon
With the prospect of higher federal and state taxes looming on the horizon on top of inflationary pressures on the U.S. economy, there is no better time for clients to consider investing in an opportunity zone. The program will be even more appealing if certain potential tax law changes included in the recently defeated BBB bill ultimately resurface. Those changes include reducing the Sec. 1202 small business stock exemption to 50% from its current 100% level, as well as limiting Sec. 1031 transactions, raising marginal tax rates, and reducing many other deductions.
With tax rates likely to rise in the near term and with inflation boosting the dollar value of capital gains, the OZ exemption becomes even more attractive as a way to mitigate a client's tax exposure from appreciated stocks, bonds, real estate, crypto, and NFT (nonfungible token) investing. As a result, we anticipate billions of dollars of additional gains finding their way into the OZ program in calendar 2022. Remember, under current tax rules, qualified gains can be invested into the OZ program through September 2027.
A great tax incentive program
The federal OZ program remains one of the greatest bipartisan tax incentive programs to pass Congress in decades. You and your clients do not want to ignore this powerful and flexible program while it is still in place. Understanding how the program works and which fact patterns you should watch for will add tremendous value to your client relationships as you help clients optimize their investment, tax, and social impact opportunities.