Value of Gain Exclusion Expected to Continue to Drive Opportunity Zones Investment in Low-Income Communities, even Without Basis Step-Up
Novogradac’s 2021 year-end report on equity raising for opportunity zones (OZ) investment showed more than $24 billion in cumulative investment–nearly $7 billion more than the June 30, 2021, reported equity raised.
However, Dec. 31, 2021, also marked the expiration of one of the four key OZ tax incentives, the 10% gain exclusion. Another tax benefit (an additional 5% gain exclusion) expired more than two years ago. Of the original four key incentives, two remain: the gain deferral to 2026 and the gain exclusion on appreciation, which raises the question of whether–with two tax benefits expired and gain deferral to 2026 losing value as we approach 2026–capital raising will continue to be strong for qualified opportunity funds (QOFs).
The answer appears to be yes–and data from Novogradac’s OZ investment survey for the first quarter of 2022 backs that presumption. The increase in tracked investment from Jan. 1 through March 31 continued at roughly the same healthy pace as the fourth quarter of 2021 (a $4.12 billion increase in the fourth quarter of 2021, a $3.97 billion increase in the first quarter of 2022).
Novogradac’s reporting is based on information from QOFs voluntarily providing information and through public sources and does not include proprietary or private funds owned and managed by their principal investors. The actual level of investment in OZs is likely three or four times that reported by Novogradac, but Novogradac’s ongoing reporting provides an apples-to-apples look at investment over time and that QOF data suggests that the end of the basis step-up benefit didn’t noticeably harm ongoing capital raising. The 10-year gain exclusion value has not diminished over time and does not diminish in the same way the value of the gain deferral diminishes.
All of the original OZ tax benefits could return, albeit briefly. Among the provisions in legislation introduced in both the House and Senate in April is an extension of the OZ incentive by two years and shortening the requirement for the 5% basis step-up from seven years to six years. If the bill is enacted this year, there would be a reinstatement of the 15% basis step-up for investments by the end of 2022 and the 10% basis step-up for investments made before the end of 2023.
Those changes would obviously be helpful, but they don’t change the most valuable tax benefit of investing in OZs: the 10-year gain exclusion.
Unless and until the extension legislation becomes law, the step-up in basis is expired and the deferral of capital gains taxes becomes less valuable with each day, due to the time value of money. But the other benefit, gain exclusion, remain fully available and is typically expected to be the most significant tax benefit of investing in QOFs.
To illustrate the above assertions, let’s look at some modeling:
Example 1: 2021 Investment
To help quantify the comparative tax benefits of an OZ investment and its component parts, Novogradac modeled a hypothetical investment of $1 million into a real estate development that is projected to yield about a 6.75% pretax cash internal rate of return (IRR) over 10 years. The model assumed annual distributions of approximately 3.5%, with the $1 million initial investment growing to a $1.5 million value at the end of 10 years. The annual distributions were assumed to be nontaxable, as they are sheltered by depreciation expense. The after-tax rate of return, absent any OZ tax benefits, is 5.87%.
If we assume the $1 million was invested in December 2021 through a QOF, such that the investment qualified for OZ benefits, including the 10% gain exclusion, and was held for 10 years, the projected after-tax rate of return goes from 5.87% to 7.90%, a 34% higher yield, or 203 more basis points.
Example 2: 2023 Investment
Using the same underlying assumptions, if we assume the $1 million was invested in January 2023 through a QOF, such that the investment qualified for OZ benefits (but not for the expired basis step-up), the projected after-tax rate of return goes from 5.87% to 7.48%. That’s a 27% higher yield, or 161 more basis points compared to a non-OZ investment.
The following chart contrasts the effect of the expiration of the 10% basis step-up, as well as the shortened length of the gain deferral to 2026.
There is value in the basis step-up, but it pales in comparison to the value of the 10-year hold. Even if legislation reinstates the basis step-up benefits, the 10-year hold remains the key OZ tax incentive.
OZ Legislation and Investment
The Opportunity Zones Transparency, Extension and Improvement Act (H.R. 7467, S. 4065), introduced April 7, would extend the OZ incentive for two years, provide reporting requirements, create an early sunset for lower poverty, higher income OZs and bring back the benefit of the five-year hold, while changing the seven-year hold benefit to a six-year hold (which would make it applicable to investments made by Dec. 31, 2022).
The headline provisions of the bill are:
- the addition of reporting requirements included in the Investing in Opportunities Act in 2017, but not carried over to the enacting legislation;
- the early sunset of the OZ designation for certain census tracts with median family income of at or above 130% of the national median family income; and
- the extension of the incentive through Dec. 31, 2028.
It is the latter provision that would reinstate the 10% basis step-up provision for two years.
Expect Investment to Continue
When the step-up benefit ended at the close of 2021 (unless or until the new legislation revives that benefit), investors lost one of the tax advantages of making OZ investments. An OZ investment without a basis step-up is obviously less profitable after-tax than one with that benefit, but the weight of the basis step-up is much less than the remaining two benefits (particularly gain exclusion). The result is that the expiration of the basis step-up is unlikely to notably adversely affect OZ capital raising, as Novogradac’s tracking of OZ investment in the first three months of 2022 details.
The actual impact of the gain exclusion on investment yield depends on a multitude of factors. If the sale price in Year 10 is greater than 1.5 times the investment, the gain exclusion benefit goes up. If the sale price in Year 10 is less than 1.5 times, the gain exclusion goes down. Also, as we get closer to the Dec. 31, 2026, the benefit of the gain deferral decreases.
In most projected scenarios, the economic benefit of excluding gain on the projected appreciation is the major factor in the higher projected after-tax IRR of OZ investments. As such, the OZ gain exclusion and deferral benefit should continue to drive greater investment in QOFs, and in turn, in low-income communities.
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