Window of opportunity for opportunity zones may be closing

Qualified opportunity zones allow investors to redirect some or all of their unrecognized capital gains into underserved, economically distressed communities in exchange for tax breaks assuming certain requirements are satisfied. The tax benefits of a QOZ are as follows:

• A deferral of unrecognized capital gain until Dec. 31, 2026;
• A 10 percent step-up in basis that an investor may receive for capital gains reinvested in a QOZ if the investor holds such investment for at least five years (an additional 5 percent step-up in basis is provided if the investment is held for at least seven years, and the total step-up in basis over the seven years allows for the investor to exclude 15 percent of the value of the reinvested capital gains from taxable income); and,
• A permanent exclusion of capital gains on any gains made on the original QOZ investment if the investment is held for at least 10 years.

Last year, the Internal Revenue Service provided taxpayers with deadline relief for QOZs in Notice 2020-39. Most recently, this year Notice 2021-10 granted taxpayers additional relief with respect to the 180-day window for investment, the reasonable cause exception to the 90 percent test, and additional time for any property being substantially approved. While the IRS notices have provided taxpayers with a better understanding of QOZs and deadline extensions in various areas of Section 1400Z of the Code, the gain recognition deadline under Section 1400Z-2(b)(1)(B) has not yet been extended. For taxpayers, this means that any deferred gain on assets held in a QOZ must be recognized by the taxpayer by Dec. 31, 2026.

With the tax recognition deadline of Dec. 31, 2026, still in place, taxpayers who wish to invest unrecognized gains in QOZs need to do so prior to Dec. 31, 2021, in order to obtain any step-up in basis benefit described above. Pursuant to Section 1400Z-2(b)(2)(B), an increase in the basis of the unrecognized gain is available if the unrecognized gain is invested in a QOZ for five years (10 percent basis step-up) and seven years (an additional 5 percent basis step-up). Because the gain recognition deadline has not been extended, only the 10 percent basis step-up remains available, but only if taxpayers invest prior to Dec. 31, 2021. Even if satisfying the five-year requirement for a 10 percent basis step-up is not possible, Taxpayers will still receive the benefits of a deferral of capital gains until Dec. 31, 2026 and an elimination of the tax on any gains from a QOZ investment if the QOZ investment is held for 10 years.

Factors beyond the Code

In addition to the closing window of opportunity to receive a basis step-up on a taxpayer’s unrecognized gain, the economy and political landscape are likely to play a large role in whether QOZs continue to boom in 2021. Despite COVID, the real estate, private equity and M&A markets either held steady or continued to grow in 2020 and the first quarter of 2021. As a result, more taxpayers are holding or will be holding realized but unrecognized gains. While we would prefer taxpayers have a discussion around the tax consequences of a deal long before the deal closes, the reality is that this is often not the case. Whether before or more likely after the closing of a transaction, taxpayers are scrambling to look for ways to defer and reduce long-term capital gains. Many of our clients have looked to QOZs to solve their goals, especially once the IRS released additional guidance on QOZs in 2018 and 2019. Absent any other changes to QOZs or the long-term capital gains rates, we expect our clients to continue to utilize QOZs to help defer and reduce long-term capital gains until at least Dec. 31, 2021.

While the economy is continuing to create a boom on QOZs, recent buzz around an increase in long-term capital gains rates may cause many taxpayers to reconsider QOZs. As currently enacted, Section 1400Z does not directly address whether the capital gain rate which will apply to the recognition of deferred gain will be the rate in effect at the time of the QOZ investment or at the time the gain must be recognized (i.e., Dec. 31, 2026).

Most practitioners believe that the wording in Section 1400Z and the lack of IRS commentary to the contrary means that the applicable long-term capital gain rate will be that which is in effect on either the date the investment in the QOZ is sold or exchanged or Dec. 31, 2026. For taxpayers, this means that an investment of unrecognized gains in a QOZ is a gamble. Whether the taxpayer wins the bet will be determined by any changes to the long-term capital gains rate by the current Congress and Biden administration, the members of Congress following a midterm election in 2022, and the members of Congress following the general election in 2024. While this appears to be too many variables removed from today’s tax rates to be a concern, the Biden administration has recently proposed an increase in the long-term capital gains rate to as high as 43.4 percent.

While it is uncertain if such an increase could obtain congressional approval, such a massive increase is a red flag to potential QOZ investors. Based on simple numbers, a taxpayer who received the 10 percent basis step-up and the tax-free gain for a QOZ investment held at least 10 years would need at least a 15.26 percent gain over the course of the 10 years in order to break even when compared to paying the tax owed at today’s rates.

Without an extension of the gain recognition deadline, 2021 may be the last year of the QOZ investment boom regardless of other factors. Beyond Dec. 31, 2021, taxpayers may still use the QOZ, especially if the real estate, private equity and M&A markets continue to grow. However, any tax law changes by the current or successive presidential administrations and Congress may have a significant impact on the tax benefits of QOZs. Without the tax benefits, QOZs may be destined to lose their splendor beyond a general investment in a quality real estate project or business.