In recent weeks, details of President Biden’s tax reform plan have surfaced, causing investors to consider how their investment portfolios may be impacted if the proposal were to be enacted. Most notably, investors have focused on the Administration’s proposal to nearly double the tax rate on long-term capital gains. While specifics are still unclear, and the proposal will meet opposition in Congress, we believe that proposal signals a much smaller, but likely increase in taxes in the near term.

With taxes likely to increase in some form, investors will increasingly look to tax-efficient investment strategies and structures to help reduce their tax burden. One such program that is likely to garner increased attention is the Qualified Opportunity Zone (“QOZ”) program, and in particular, real estate-driven QOZ funds.

The Tax Cuts and Jobs Act of 2017 created QOZs to offer sizeable tax breaks to investors who make qualified long-term investments that have the potential to promote economic growth in zones designated for economic development. The tax benefits can be summarized as follows:

  • Tax Deferral: Investors can defer payment of capital gains taxes on realized investments until as late as December 31, 2026, if those investors elect to reinvest their realized gains in Opportunity Zones.
  • Tax Reduction: There is a step-up in basis, up to 10%, applied to the original capital gain, resulting in a corresponding percentage reduction in capital gains tax due (as long as the investment is made by the end of 2021 and held past the end of 2026).
  • Tax Elimination: No tax will be due from profit generated by QOZ investments if the investments are held for 10 years.

Not only do real estate investments offer an inflation hedge, but they are highly tax efficient investments as well. The depreciation and interest tax deductions typically offset most, if not all, of the rental income. Furthermore, these tax deductions are worth more in a rising tax rate environment.

While we believe there will likely be changes to the tax system that result in modest tax increases, we also believe that real estate QOZ funds are a more valuable strategy for tax planning and mitigation in a rising tax environment. As you can see in our analysis below, the after-tax net value of a $1,000,000 re-investment of qualifying capital gains into a QOZ fund is more beneficial than a traditional investment in the event of a capital gains tax increase.

Although investors will potentially pay a higher tax rate in 2026 on their prior gain, we believe the benefit of tax-free compounding growth on the QOZ investment will more than offset this increase. As a result, the overall economic value of the QOZ program is greater if capital gains are to increase. To further make the point, the analysis above does not include: (1) the greater benefit of the depreciation and interest expense deductions, and (2) the avoidance of the potentially higher depreciation recapture taxes upon sale. As such, the benefit is expected to be even greater in a higher tax rate environment.

In addition to the long-term capital gains tax rate increase, the Biden proposal contemplates a number of other changes to current programs or exemptions that would potentially increase taxes on investors. For example, the proposal calls for the elimination of the step-up in basis that is typically used by heirs to reduce their capital gains taxes upon inheriting property and investments. Related to the elimination of the step-up, there has also been some discussion about eliminating the Section 1031 exemption, a tool commonly used by real estate investors to buy and sell property without paying taxes. These concepts also signal a likely increase in taxes and a potential reduction in the programs available to investors to limit their tax exposure. QOZs have the potential to remain as one of the few such programs that allow individuals to reduce their capital gains taxes and to make tax-efficient long-term investments.

For investors with qualified capital gains, the Cresset Diversified QOZ Fund II (the “Fund”) seeks to generate returns commensurate with an institutional-quality real estate fund, further augmented by the QOZ tax benefits. The Fund invests alongside seasoned development partners in institutional-quality, core real estate assets located in high-growth, urban markets benefiting from positive job growth and significant net migration through the Covid-19 pandemic.

Learn more about Cresset Partners’ Opportunity Zone Fund, and contact us to invest.