6 ways opportunity zone expansion can aid COVID-19 recovery
When the $600 weekly unemployment supplement provided by the CARES Act expired on July 31, millions of jobless Americans were left wondering how to make ends meet.
They still are, as state and federal lawmakers continue to haggle over ways to extend the desperately needed supplemental unemployment benefit. Residents of disadvantaged communities remain especially vulnerable to the virus as well as to COVID-related business shutdowns. Estimates are that 50 percent of restaurants may shut down and never reopen, and hotels and other hospitality service jobs may be slow to rehire, if at all.
Opportunity zones may just be the perfect vehicle to deliver economic relief to the areas hardest hit by the coronavirus pandemic — both in the short term and the long term.
In a rare instance of bipartisan support, both President Trump and Democratic Presidential nominee Joe Biden have endorsed the future of the Opportunity Zone Program. Last week Biden announced that if elected, he would focus on three key areas of the OZ Program:
1. Treasury Department oversight. This would ensure those OZ Program dollars are spent properly to improve the lives of residents living in OZ census tracts.
2. A proposed tax incentive for OZ investors to work with nonprofits and other community organizations, and
3. Increased OZ fund reporting and transparency. This would allow the government and the public to better understand how OZ funds are investing in communities.
6 ways expanding OZ can aid economic recovery
If you think about it, the opportunity zone tax incentive is perfectly structured to deliver economic recovery in the wake of the COVID-19 pandemic. Below I’ll share my six-point plan for expanding the OZ incentive to provide additional economic recovery. Please share it with your business-owner clients:
1. Expand the opportunity zone program to be more beneficial to small business. Any business under $10 million of annual revenue, regardless of its location, could take opportunity zone funds regardless of whether or not it’s in an OZ census tract. That’s because those small businesses are the ones that are going to have some real challenges restarting and surviving. The Curtis bill contains a similar provision with varying income limits based on industry. More on that bill in a minute.
2. Extend the amount of time to fund a QOF by an additional 90 to 270 days when the deadline starts on the actual date of sale. For example, this would apply to cases in which a taxpayer holds assets like stock or land directly, rather than through a partnership, S corp or trust.
The regulations provide very long timelines beyond 180 days for gains from assets held through business entities. But a direct sale has a much shorter reinvestment period. A taxpayer selling stock in early 2020 would already be beyond the reinvestment period before the full tax year has developed. IRS Notice 2020-39 already provides a COVID extension through the end of the year to reinvest, but we need this longer period for future years.
3. Allow after-tax non-capital gain investments to secure some limited opportunity zone benefits. I must get four or five calls a week asking why this is not part of the statute. My proposal is to allow those funds to be invested and OZ investors wouldn’t get the basis bumps at the five- and seven-year mark. However, they would get an exemption at the end of the holding period.
Keep in mind that the exemption would only be 50 percent of the gain. And so that would be a little bit watered down. But there’s a lot of money sitting on the sidelines. For one reason or another, many people have a lot of cash piled up, even though that money is not in the form of large capital gains. That money is sitting idle and not really helping them or their communities. This proposal would be a huge benefit to investors, municipalities, local businesses and their employees (and families).
4. Expand the number of opportunity zones. Why not let every state increase its census tracts by 20 percent? That way, no individual would have an unfair advantage. I would add a requirement that state governors would have to pick from census tracts with the highest spiking unemployment rates from the surrounding areas. The Curtis bill added this provision, and the expanded census tracts will be focused on social equity.
5. Provide a loan interest exclusion to QOZBs. One of the frustrations with the OZ program is that when you’re putting your capital stack together to finance bigger projects, there’s no incentive on the debt side. It’s all equity-driven. My proposal is to incentivize investors who just want a debt return to take a lower interest rate. Why? Because they’re going to get a tax-exempt return on their money. So, the debt component can bring down the overall cost of a project. Again, we’re talking about OZ investments in very economically challenged areas. These are essentially “synthetic” municipal bonds.
6. Exempt QOZBs from payroll taxes. There should be a way to allow both employers and employees to have a payroll exemption. I would make that exemption for the first 12 months of salaries paid to any employee who resides within an OZ census tract. By the way, it doesn’t have to be the same OZ census tract in which the employee works.
The first $48,000 of compensation would get a FICA tax exemption — both for the employee and the employer. So, the employee would walk away with more cash at the end of every pay period, and the employer’s cost of hiring that person would be reduced by 7 to 8 percent. Again, we’re just trying to incentivize people to hire local and to help people who live in OZ census tracts to get a little more take-home pay.
Long-term capital gains questions
As with any new election year, there is always uncertainty about taxes. Many OZ investors are focused on what the Dec. 31, 2026, capital gain rates will be under a potential Biden administration.
This much we know: Biden has indicated he would raise long-term capital gain rates to 28 percent for all taxpayers. And taxpayers with more than $1 million in taxable income would have to pay tax at the higher ordinary income rates. While Biden has not specifically addressed how OZ capital gain rates would be modified, if at all, I am confident that OZ rates will be grandfathered in at the rates in effect in the year originally deferred.
Even if long-term capital gains increased to 30 percent in 2026, a taxpayer setting up a QOF in 2020 would only pay an effective rate of 27 percent (vs. 23.8 percent) after factoring in the 10 percent basis increase. An investor who established the QOF prior to 2020 would only pay a 25.5 percent rate — fairly close to the 23.8 percent they would have paid at the time of sale. There are other possible fixes in process.
Rep. John Curtis, R-Utah, has co-authored a bipartisan bill, H.R. 6529, which has a number of refinements to the OZ program, including locking in the capital gain existing at the time a QOF is established. The bill would also allow taxpayers who invested in QOFs after 2019 to obtain the full 15 percent tax basis step-up for meeting the seven-year hold requirement. This would also allow OZ investors who establish funds now to obtain a net 20.2 percent (23.8 percent x 85 percent) marginal rate when they recognize their deferred gains in 2026. That’s a 3.6 percent permanent tax savings on top of the multiyear deferral and ultimate tax exemption after 10 years.
I know there’s a lot of noise about a new administration curtailing, or even shutting down, the OZ program. But it’s not your wealthy clients who will be complaining. It will be thousands of mayors and 50 state governors objecting. Even though this is a federal program, most states have adopted it. Governors and mayors love the program. It doesn’t matter if they’re red or blue.
In many ways the OZ Program is the last economic development tool many states have at their disposal. California, for example, got rid of its redevelopment program. Other states have faced severe budget constraints. OZ is a great program to revitalize neighborhoods and to help economically challenged areas in these unprecedented times. My firm’s website has more information about the program.