Worried About an Increase in The Capital Gains Tax Rate? Find a Qualified Opportunity Fund You Like.
In case no one has mentioned it to you yet, Election Day is on Tuesday November 3rd. One of the major topics as usual is the conversation around taxes. This post will not focus on the politics surrounding Election Day. It will be centered around the possibility of an increase in the capital gains tax rate and what that means for investors across the nation. Opp Zone Capital has been getting a lot of questions regarding this issue as of late and specifically what we think it means for the Opportunity Zone program. We think it is the only free lunch, other than diversification of course.
Some investors are concerned that an increase in the capital gains rate will drastically affect the returns of their Opportunity Zone investment. While I’m sure none of us want to see the increase, and it will in fact have an affect on your overall post-tax earnings, the exclusion of gain after the ten-year hold period in the Opportunity Zone program is a powerful incentive that should not be ignored. Some will argue that they are better off paying the tax now at the current, lower long-term capital gains rate. I would say that they are wrong, and not looking at the whole picture. As investors, we all know that we are not just going to hoard cash after paying our tax bill. That money will be reinvested. Those reinvested dollars will now grow, hopefully, and when we dispose of the investment in the future, we are going to pay taxes again. Now, instead of having a vehicle that would allow us to exclude our capital gains, we are paying that tax again in an environment where the capital gains tax has increased to 39.6%.
To illustrate my point, I am going to tell you a story about an investor named Mrs. Traditional. Mrs. Traditional realized a long-term capital gain of $500,000 earlier in the year. She did not want to use a Qualified Opportunity Fund to make an investment and instead paid tax in the amount of $119,000. We are going to assume Mrs. Traditional has a modified adjusted gross income of over $200,000 and was taxed with the additional 3.8% for net investment income tax added on. Mrs. Traditional is now left with $381,000 to invest. She invests her money into a property that she holds for ten years and is able to get an annualized rate of return of 10%. Mrs. Traditional really knows how to pick them! At year ten, her investment is now worth $988,216 leaving her with a taxable amount of $607,216. At the new proposed capital gains tax rate of 39.6%, Mrs. Traditional will be paying $240,457 in taxes leaving her with $747,758. In this scenario, the total tax paid on the two transactions was $359,457. If you were not keeping up with the math do not worry, I have added an illustration below.
Now I am going to tell you a story about an investor named Mrs. OZ, no relation to The Wizard. Mrs. OZ also realized a long-term capital gain of $500,000 earlier in the year but she opted to make an investment into a Qualified Opportunity Fund. Making that investment allowed her to defer her tax liability out until 2026 and therefore there is no current liability. We fast-forward to 2026 and Mrs. OZ has met the requirement to receive a 10% step-up in basis. That is the good news, the bad news is, she must satisfy her tax liability now. Mrs. OZ will be paying tax on $450,000 (remember, she got a $50,000 step-up in basis) at the increased capital gains tax rate of 39.6%, a total of $178,200.
With all this happening in the background, Mrs. OZ’s investment in the Qualified Opportunity Fund has been growing. She was able to get the same 10% annualized return as Mrs. Traditional and she held her investment for the same ten years. Because Mrs. OZ held her investment for the ten-year period, she is now eligible to receive the exclusion of gain incentive when she exits her QOF investment. Her investment under the same assumptions mentioned above has now grown to $1,296,871 and Mrs. OZ will not realize a capital gain or have a tax liability. In this scenario, the total tax paid was $178,200 leaving her with a total amount of $1,118,671 after the ten years.
It may seem daunting to defer your tax liability out into the future if you believe there will be an increase in the capital gains tax rate; however, that alone does not paint the whole picture. As with any investment you make you cannot think in a silo. It is imperative that you step back and take a wholistic view of the situation. Do we want to see the capital gains tax rate increase? No. Do we think there are some viable options available to investors should it happen? Yes.
Opp Zone Capital is an Opportunity Zone fund sponsor, third-party fund manager, and advisory services firm based in Clearwater, FL. Investors interested in Opportunity Zones should always consultant their tax and legal counsel before making an investment in a Qualified Opportunity Fund. For more information about the OZC – Southern US RE QOF visit us at oppzone-capital.com/funds/. For more information about third-party fund management or advisory services, click here.