President Joe Biden will soon roll out a sweeping overhaul to the U.S. tax system, most notably including what could turn out to be the Nation’s largest-ever increase to the long-term capital gains tax rate. While there are valuable merits to the planned tax hikes, such as utilizing the higher tax proceeds to fund a large initiative to improve our Nation’s education system and addressing long-standing social inequality, it’s no surprise that high-net-worth (“HNW”) Americans are poised to be one of the most heavily impacted groups under President Biden’s plan. In this article, I highlight what is expected of the planned capital gains tax hike and discuss how Qualified Opportunity Zone (QOZ) investments can be utilized to position a HNW investor’s portfolio for the future tax environment uncertainty.
Proposed Long-Term Capital Gains Rate Hike
Although the full details of the plan have not been revealed as of April 26, 2021, Bloomberg recently reported that it includes corporate tax hikes, potential measures to enhance the estate tax for the wealthy, plus the most notable capital gains tax increase.
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Today, the Nation’s highest earners are subject to maximum tax rate of 23.8% on long-term capital gains, which includes a 20% capital gains tax and a 3.8% surtax on net investment income created by the Affordable Care Act to fund Medicare expansion. President Biden’s proposal calls for treating long-term capital gains like ordinary income for America’s highest earners. More specifically, taxes on long-term capital gains could nearly double to as high as 39.6% for Americans earning over $1 million per year, coupled with maintaining the additional 3.8% net investment income surtax. If the proposal were to make it through Congress as is, it would result in the highest tax rate on investment gains since 1920.
While those earning over $1 million per year would be the most impacted by the tax hikes, Bloomberg reports that those earning upwards of $400,000 per year can also expect to start paying higher taxes. With over 20 million HNW and high earner individuals in the U.S., the plan indicates the hikes could boost tax revenue by roughly $1 trillion.
All else equal, the currently proposed capital gains tax hike would reduce a HNW investor’s after-tax investment returns by up to 25.7%.
| Current Tax Rate | Proposed Tax Rate | |
|---|---|---|
| Hypothetical Pre-Tax Return | 15% | 15% |
| Less: Capital Gains Tax | (20.0%) | (39.6%) |
| Less: Net Investment Income Tax | (3.8%) | (3.8%) |
| After-Tax Return | 11.43% | 8.49% |
But this is not all doom and gloom for HNW individuals. While we must not forget to recognize the intent of tax hikes to help build a better tomorrow, the Federal Government also recognizes that tax incentive programs can have independent merits of their own in driving economic activity and building the better tomorrow.
Qualified Opportunity Zones
QOZs were created under the 2017 Tax Cuts and Jobs Act, to stimulate economic development and job creation, by incentivizing long-term investments in neighborhoods that have had historically low household income and economic activity.
The tax advantages available for QOZ real estate projects are quite compelling for investors looking to defer taxes on capital gains from a prior investment and achieve tax-free appreciation on the QOZ investment itself. Since QOZ legislation was enacted in 2018, capital has poured into the space. A report released by the Council of Economic Advisors in December 2020 estimated that $75 billion in private capital had been deployed into QOZs by the end of 2019, and the U.S. Treasury estimates over $100 billion in annual new investment could move to opportunity zones over the next decade.
There are three primary tax benefits for QOZ Investors:
- By investing capital gains generated from a prior investment into a QOZ within 180 days of harvesting the gains, the investor is permitted to defer recognition of the capital gain for U.S. federal income tax purposes until December 31, 2026.
- If the investor has held the QOZ investment for at least five years come December 31, 2026, the investor will not be subject to U.S. federal income tax on 10% of the deferred gain.
- The investor receives tax-free appreciation on the QOZ investment itself if the investment is held for at least 10 years.
Considering potential tax hikes on the horizon, I compared two investments with equal pre-tax returns and hold periods. One is a QOZ investment and the other an equivalent but taxable investment. This comparison assumes the HNW investor is starting with a $1 million pre-tax capital gain.
Scenario 1: Qualified Opportunity Zone Investment
| Sale of Original Investment | |
|---|---|
| Capital Gains | $1,000,000 |
| Capital Gains Taxes Due @ 23.8% | – |
| Reinvestable Capital Gains | $1,000,000 |
| Sale of QOZ Investment | |
| Deferred Tax Due in 2027 @ 43.4% (Includes 10% step-up for 2020 investments) |
$(390,600) |
| Total Return on Invested Capital | $1,500,000 |
| Capital Gains Taxes Due in 10 Years @ 43.4% | N/A |
| Total Return (after-tax) | $1,109,400 |
| Multiple on $1 million Gain (after-tax) | 2.11x |
Scenario 2: Equivalent Taxable Investment
| Sale of Original Investment | |
|---|---|
| Capital Gains | $1,000,000 |
| Capital Gains Taxes Due @ 23.8% | $(238,000) |
| Reinvestable Capital Gains | $762,000 |
| Total Return on Invested Capital | $1,143,000 |
| Capital Gains Taxes Due in 10 Years @ 43.4% | $(496,062) |
| Total Return (after-tax) | $646,938 |
| Multiple on $1 million Gain (after-tax) | 1.65x |
What’s important to highlight here is the hidden value in the capital gain deferral component of the QOZ investment, which could otherwise be described as a free five-year loan from the government.
The QOZ investor is subject to paying the future assumed tax rate of 43.4% on their deferred $1 million gain, while the non-QOZ investor would be paying the current rate of 23.8% on their $1 million gain today. Even though the QOZ investor ultimately has a higher tax liability on the $1 million gain than the non-QOZ investor, the QOZ investor gets to reinvest every dollar of their $1 million gain today, whereas the non-QOZ investor first has to pay taxes before reinvesting, resulting in only $762,000 of their $1 million pre-tax gain getting reinvested.
Compounding this, the QOZ investor receives 10+ years of tax-free appreciation while the non-QOZ investor is required to pay full freight on any appreciation achieved by their taxable investment over the same period of time, resulting in an after-tax return for the QOZ investor that’s a whopping 72% higher than that of the equivalent but taxable investment.
At Origin, we provide investors with stable, diversified, and tax efficient private real estate investment solutions in this increasingly volatile and uncertain economic environment. We’ve raised more than $200 million for our open Qualified Opportunity Zone Fund, which targets ground-up development projects that can produce viable returns before factoring in the QOZ tax benefits. The Fund currently has five QOZ assets located across fast growing U.S. markets, two under due diligence, and a robust deal pipeline.
