There has been a lot of discussions1 recently about President Biden’s desire to increase the Federal long-term capital gains tax rate from 23.8% (20% long-term capital gains rate + 3.8% Net Investment Income Tax) to the ordinary income tax rate (currently 37% but could increase to 39.6%) for yearly taxable income above $1 million.
However, many taxpayers are aware this will likely not come to fruition. The House and Ways Committee recently countered2 the President’s proposed tax rates with lower rates, such as a 28.8% rate (25% long-term capital gains rate + 3.8% Net Investment Income Tax) on Federal long-term capital gains for taxpayers in the highest tax bracket. In 2021, the higher 28.8% long-term capital gains rate will be applied3 to single taxpayers whose adjusted gross income exceeds $523,601 and $628,301 for taxpayers filing married filing jointly. In 2022, the higher 28.8% rate will be applied4 to single taxpayers whose adjusted gross income exceeds $400,000 and $450,000 for taxpayers filing married filing jointly.
Although the new capital gains tax rate remains uncertain, it is becoming less uncertain that the long-term capital gains tax will be increasing in the coming months.
You may not be aware Congress has the authority to make a new capital gains tax rate increase retroactive to an earlier date
For example5, a bill may be passed into law on October 1, 2021, but the date the new tax rates go into effect could be retroactively dated as far back as January 1, 2021.
This type of legislation is not uncommon and has been done in the past. President Biden is currently proposing6 backdating the proposed tax rate increase to either April or May 2021. However, the House and Ways Committee is currently proposing7 backdating the proposed tax rate to September 13, 2021.
All investors who generated long-term capital gains after this effective date would be subject to the higher proposed rate on their 2021 and 2022 tax returns.
Although there is still uncertainty about the effective date the tax rate would be implemented, it appears if the legislation is passed capital gains will be taxed at a higher rate.
Investors who are stuck paying a higher long-term capital gains tax could be put in a difficult position next tax season.
One option you have to defer this tax liability is by reinvesting your capital gains into a Qualified Opportunity Zone Fund (QOZF).
Even if your capital gains are subject to higher rates, rolling them over into a QOZF could potentially be a good move. The tax would be deferred at a higher rate and the capital gains rate could go down in the future, depending on how long you keep your gains in the fund.
Qualified Opportunity Zones (QOZs) were created to incentivize investment into distressed areas of the country. An investment into a QOZ Fund must be made using short or long-term capital gains and includes the following benefits:
- Capital gain deferral until December 31, 2026, or when the investment is sold, whichever comes first
- A 10% increase in the basis of the deferred capital gain, if the investment is held for at least 5 years
- Tax exclusion on the sale of the investment if the investment is held for at least 10 years
The capital gain deferral is a potentially great benefit for investors, however, the largest and most impactful benefit that comes from investing in Opportunity Zone Funds is the permanent tax-exclusion on the appreciation of the investment.
This is best illustrated through an example:
A taxpayer has a $1 million long-term capital gain on December 31, 2021, and invests it into an Opportunity Zone Fund. Assume the Federal capital gains tax rate in 2026 becomes 28%. On December 31, 2026, the taxpayer will receive a $100,000 (10%) step-up in basis, so the 28% capital gains tax rate will be applied to $900,000 of the deferred gain. This will result in $252,000 of tax due by April 15, 2027. Under the above scenario, if the Federal capital gains tax rate in 2026 was still at the current 23.8% rate, there would have only been $214,200 of tax due by April 15, 2027. This results in an additional $37,800 of tax the investor would need to pay.
However, assume the value of the investment grows from the initial $1 million to $2 million over a ten-year period. When the taxpayer exits the fund, the entire $1 million of appreciation will be tax-free. Assuming the long-term capital gains tax rate does not continue to increase above 28%, the taxpayer will save $280,000, the tax on the $1 million of appreciation, when the investment is sold after 10 years. This results in a net savings of $242,200 in federal tax when combined with the additional $37,800 of tax paid in 2027.
Investors will need to pay close attention when the new rate is implemented. If the new tax rate is implemented retroactively, investors could be stuck with a higher tax bill than they initially planned.
An investment in a QOZF allows an investor to defer the tax payment requirements until as late as April 15, 2027. In addition, the investor has the ability to completely exclude the gain on the sale of the QOZF investment if the investor chooses to sell the investment after holding it for at least 10 years.
This permanent tax exclusion on the appreciation inside the fund is the greatest Opportunity Zone tax benefit.
As the Wealth Development Company, we are a leading U.S. sponsor with approximately $500 million in assets under development and management. These investments are comprised of alternative investments, which include private funds and syndications, externally managed real estate investment trusts (REITs) as well as public funds. We conduct substantially all business through our Sponsor, CaliberCos Inc., a vertically integrated platform that is strengthened by more than 70 professionals with decades of institutional experience in commercial real estate, capital markets, alternative investments, and mergers and acquisitions.
We allocate our alternative investment strategies and align them with investors’ investment objectives, risk profiles and liquidity preferences to offer an optimal balance of risk-adjusted returns and attractive investment performance. It is because of this thoughtful, intentional approach, and our unwavering pursuit of performance, that we have been deemed The Wealth Development Company.
We strive to build wealth for investors by offering a diverse host of investment solutions that fit our investors’ needs. With a primary focus on key middle-market growth areas, such as Arizona, Colorado, Nevada, Texas, Utah and Alaska, we evaluate other U.S. markets that possess the same attractive demographics and macroeconomic trends as our targeted markets, such as highly skilled labor, emerging population and job growth. In addition, we utilize our institutional full-service operating platform to generate operating efficiencies while enhancing the value of our investments through dedicated asset management strategies.
We create value through a combination of internal and external growth channels. Bringing together the benefits of real estate, deep asset-class, and capital markets expertise across public and private investments. We seed, develop, and manage a broad range of liquid and illiquid alternative strategies for a diverse group of investors who comprise approximately a $4 trillion alternative investment market, which includes high net worth, accredited and qualified investors, as well as family offices and smaller institutions. This strategy allows us to opportunistically compete in an evolving middle-market arena for alternative investments that range between $5 million and $50 million.
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If you would like to speak to someone about diversifying your retirement accounts, contact us at [email protected] or call (480) 295-7600 to schedule a call with a member of our Wealth Development Team.