The IRS may be making a huge mistake that only supports the wealthy. (But you can help fix it.)

At Cutting Edge Counsel we stand for fairness and equity. A big part of what drives us is the need to level the playing field between the wealthy and the non-wealthy. We envision an America where everyone can invest, with the same benefits available to all investors regardless of economic status.

So we were very disappointed in a recent IRS release that will lead to the opposite result. We’re talking about some of the tax benefits of investing in a Qualified Opportunity Fund — a new type of fund that is intended to incentivize investment in low-income communities designated as Opportunity Zones, which we wrote about here.

The new tax rules are contained in Subchapter Z of the Tax Cuts and Jobs Act of 2017. Section 1400Z-2 of that new law provides for three tax benefits of investing in a Qualified Opportunity Fund (a QOF): Clause (a) provides for a deferral of tax on rolled-over capital gains until the end of 2026. Clause (b) provides for a 10% or 15% step up in basis for rolled-over capital gains held in a QOF for at least five or seven years by the end of 2026. Clause (c) provides that “any investment” held in a QOF for at least ten years will get a step up in basis to market value upon a sale of the investment. This last benefit is the most valuable of them all.

While the plain language of Section 1400Z-2 says that literally any investment in a QOF, which would include an investment of after-tax capital, can get this last benefit (tax-free capital gains after ten years), the IRS stated in an October 2018 release that this benefit is available only to rolled-over capital gains. The IRS offered no analysis or reasoning behind its statement, which suggests the IRS may have simply mis-read the statute.

This is more than just a technical detail. This is a fundamental reinterpretation of the law in a way that excludes the roughly 95 percent (i.e. non-accredited investors) who may not have capital gains to roll over. As passed by Congress, the law allows for the creation of a true community investment fund that invests in real estate projects in Opportunity Zones. Taking in investment from residents of the very low-income communities that the fund is designed to serve would help to ensure not only that the profits from those projects circulate within the community, but it would also give those residents a voice in the kind of development that happens in their communities. The benefit of tax-free capital gains after ten years in the fund can be a critical factor in attracting these investors.

But this reinterpretation by the IRS changes everything. Bear in mind that, typically, it’s only the wealthiest Americans who have capital gains that can be rolled over into a QOF. From the point of view of a QOF manager, if only the wealthiest investors can enjoy any of the tax benefits of an investment in the QOF, there is no incentive at all to open up the QOF to the less-wealthy residents of those Opportunity Zones.

Hence, under the IRS’ reinterpretation of the law, QOFs will likely be only open to wealthy (accredited) investors; and those wealthy investors will then effectively determine the kinds of development that happens in low-income communities, with no opportunity for the residents of those communities to have a voice or to participate in any way. The outcomes will be very predictable. Overwhelmingly, these wealth-driven funds will invest in so-called “market rate” housing – a euphemism for unaffordable luxury housing that is not intended to serve the residents of those communities but is intended to displace them.

It does not have to be this way; it should not be this way; and the law does not say this! Our firm has written this letter  IRS-Letter-Re-Opportunity-Fund-Tax-Benefit.pdf to the IRS pointing out the apparent error, and we have asked the IRS to clarify that the benefit of tax-free capital gains after ten years in a QOF is available for any investment in the QOF, including investments of any kind of after-tax capital, whether or not an investor is sheltering or eliminating their capital gains taxes. 

But meanwhile, we are making an ask of our community — individuals and organizations. It would be easy for the IRS to ignore one letter from a small law firm based in Oakland that only serves mission-aligned businesses. It would be much more difficult for them to ignore howls of protest from around the country. If you care about leveling the playing field (and if you’ve read this far, you likely do), we strongly encourage you to write to the IRS (addressed to CC:PA:LPD:PR (REG-115420-18), Room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044), or to your Congressperson, to bring this to their attention. While the official comment period for the proposed regulations has closed, we think this is too important to ignore.

And there is urgency to this, because the IRS may be finalizing their QOF regulations at this very moment. Once they have issued final regulations, it will be much harder to get them to back away from their blunder. So the time to act is now. Together, we can make a difference.