Introduction:
Would you like to know more about Qualified Opportunity Zone Investments and Biden’s Tax Plan? Get the information here!
President Joe Biden will shortly unveil a significant change to the U.S. tax code, including the largest-ever rise in the long-term capital gains tax rate.
I’ll introduce him here briefly to those who don’t know Biden. In office as the 46th and current president of the United States, Joseph Robinette Biden Jr. is an American politician. Obama’s vice president for eight years, he previously served in the U.S. Senate from 1973 to 2009 and was a Democrat from Delaware.
At age ten, Biden and his family left Scranton, Pennsylvania, for New Castle County, Delaware, where they raised him. A year later, he got his law degree from Syracuse University after completing undergraduate studies at the University of Delaware.
In 1970, he was assigned to the New Castle County Council, and in 1972, at 29, he was elected to the United States Senate from Delaware, where he became the country’s sixth-youngest senator. During Obama’s presidency, Biden served as either the chair or ranking member of the Senate’s Foreign Relations Committee.
High-net-worth (HNW) Americans are expected to be among those most hit by President Biden’s proposed tax hikes. In this post, I examine how Qualified Opportunity Zone (QOZ) investments can be used to prepare an HNW investor’s portfolio for future tax environment volatility and what to expect from the planned capital gains tax hike.
Proposed Increase in the Tax Rate on Long-Term Capital Gains
Bloomberg recently reported that the plan contains:
- Corporate tax hikes.
- Prospective steps to boost the estate tax for the wealthy.
- The most significant increase in capital gains taxes.
However, the complete specifics of the plan have not been published as of April 26, 2021.
The top incomes in the United States are now subject to a long-term capital gains tax rate of 23.8%, which includes a 20% capital gains tax and a 3.8% surtax on net investment income imposed by the Affordable Care Act to support Medicare expansion. President Biden proposed that long-term capital gains should be taxed like ordinary income for the wealthiest Americans.
Individuals who earn more than $1 million a year will have their long-term capital gains tax rates nearly double to 39.6 percent, on top of the existing 3.8 percent net investment income surtax. Investment income would be subject to the highest rate of taxation since 1920 if the proposal is adopted in its current form by Congress.
Although the tax increases would primarily affect individuals making above $1 million a year, Bloomberg says that people making over $400,000 a year may also expect to begin paying higher taxes. They will be hit the hardest. The plan estimates that the tax increases might generate an additional $1 trillion in revenue because of the country’s large population of HNW and high earners.
When all things are equal, the present proposed increase in the capital gains tax will lower investment returns for HNW investors by up to 25.7% after taxes.
| 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% |
HNW folks, on the other hand, should not despair. While it is important to remember that tax increases are intended to help create a better future, the federal government also acknowledges that tax incentive programs can have their advantages in stimulating economic activity and constructing a better future.
Opportunity Areas Approved for Investment
The 2017 Tax Cuts and Jobs Act built Qualified Opportunity Zones (QOZ) to encourage long-term investments in areas with historically low household incomes and economic activity to spur economic growth and the creation of new jobs.
Qualified Opportunity Zone (QOZ) real estate projects offer attractive tax benefits for investors wanting to delay capital gains taxes from a previous investment while also benefiting from tax-free growth on their Qualified Opportunity Zone investment.
Much money has flowed into the Qualified Opportunity Zone market since the legislation was passed in 2018. Qualified Opportunity Zones have attracted $75 billion of private capital as of December 2020, according to a report from the Council on Economic Advisors. The U.S. Treasury believes that $100 billion of new investment might be made yearly for the next ten years.
Investors in Qualified Opportunity Zone are eligible for the following three tax breaks:
- Investing in a Qualified Opportunity Zone within 180 days of harvesting capital gains allows the investor to postpone recognition of the gain until December 31, 2026, for federal income tax purposes.
- To avoid U.S. federal income tax on 10 percent of the deferred gain, the investor must have held the Qualified Opportunity Zone investment for at least five years by December 31, 2026.
- If the Qualified Opportunity Zone investment happens, the investor benefits from tax-free appreciation of the investment.
In light of future tax increases, I evaluated two investments with identical pre-tax returns and hold durations. The first is a tax-free Qualified Opportunity Zone investment, whereas the second is a comparable but taxable one. For this comparison, let us suppose that the HNW investor had 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 Qualified Opportunity Zone 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 |
The hidden benefit of the Qualified Opportunity Zone investment’s capital gain deferment component, which may be considered a free five-year loan from the government, should be stressed.
Taxes on the Qualified Opportunity Zone investor’s deferred $1 million gain are expected to be paid at 43.4 percent, whereas the non-Qualified Opportunity Zone investor would pay the present rate of 23.8 percent. When it comes to reinvesting their $1 million gain, the Qualified Opportunity Zone investor gets to do so with all of their $1 million pre-tax gains, but the non-Qualified Opportunity Zone investor only gets to reinvest $762,000 of their $1 million pre-tax gain since they have to pay taxes first.
As a result, the Qualified Opportunity Zone investor has an after-tax return 72% larger than the equivalent but a taxable investment. The non-Qualified Opportunity Zone investor must pay full freight on any appreciation of their taxable investment experiences over the same time.
Come join us! We provide investors with reliable, diversified, and tax-efficient alternatives in an increasingly turbulent and uncertain economic climate when investing in private real estate. For our open Qualified Opportunity Zone Fund, we’ve gathered more than $200 million, and we’re looking for projects from the ground up that have the potential to generate a profit even before accounting for the Qualified Opportunity Zone tax benefits. Five Qualified Opportunity Zone assets are under due diligence, two more in the pipeline, and a strong deal flow.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.