In an upcoming livestream, we will discuss Tax Planning opportunities from both sides of the pond. Feel free to join us.
Even before the pandemic, crypto asset investing was short-term and speculative in nature, with many crypto exchanges encouraging high-frequency trading. While professional investors have made (and lost) huge fortunes on crypto assets, many ordinary investors have also racked up substantial short-term capital gains. Those gains are generally taxed at a current 37% federal rate for high-income individuals, plus the 3.8% net investment income tax — or a combined 40.8%.
Add an additional 13.3% in state levies for higher-income California residents, and you get a 54.1% combined tax rate — which is likely to be even more painful if the Biden administration’s tax plan, or portions of it, are implemented in 2022. Further, Washington state is now imposing an additional 7% tax on the capital gains of its high-net-worth residents.
Many may be turning to the federal Opportunity Zone (OZ) programs because they’ve heard it offers many legal ways to defer, if not substantially mitigate, their capital gain tax. And because there’s a social consciousness facet to the OZ program, it has become even easier for taxpayers to rationalize crypto-fueled OZ investing to themselves and to their peers.
Here are three key considerations that we encourage practitioners and taxpayers to understand:
Capital gains timely invested into a Qualified Opportunity Fund (QOF) are deferred until the later of: (a) the time that the amounts are withdrawn or otherwise triggered under the “inclusion event” rules, or (b) Dec. 31, 2026.
After holding the QOF interest for at least five years, the taxpayer’s basis in the QOF is increased by 10% of the original amount invested, and the reportable gain drops to 90% when recognized.
Taxpayers holding their QOF investment for at least 10 years can exclude 100% of the post-reinvestment appreciation in the QOF and in the underlying assets held by the QOF — including any eligible qualified opportunity zone business property (QOZBP) into which the QOF invests.
While the OZ program was not designed with crypto assets in mind, a growing number of OZ investors are exploring ways to layer crypto assets into their OZ funds.
Crypto investors tend to be frenetic traders who aren’t content to sit on the sidelines. If OZ advisers are working with crypto investors, they should be careful to establish both the QOF and qualified opportunity zone business (QOZB) well in advance of the taxpayer’s 180-day investment deadline to avoid limiting the taxpayer’s ability to trade. The taxpayer/investor also needs to be clear that the gains and losses incurred from trading within the QOF or QOZB will generally flow out to the equity owners when using tiered partnerships (the structure used more than 90% of the time). These interim crypto gains (recognized by Dec. 31, 2026, and reinvested no later than early September 2027) can be further deferred by timely investing into another QOF. Reinvesting these gains into the same QOF will not result in a secondary tax deferral due to the circular cash flow provisions contained in the regulations.
The OZ program offers a very effective solution for deferring gains and allows investors to diversify into real estate or operating businesses. Often these investors are interested in tech, blockchain, crypto, and/or cannabis.
Many crypto investors are interested in re-investing their gains into additional crypto assets, but there could be challenges. For instance, there’s the issue of “mixed-fund” treatment when appreciated crypto is invested into a QOF in lieu of cash. Currently, there are some unsettled areas in the compliance rules for OZ entities holding crypto. For example, a limit of only 10% of the QOF’s balance can be invested into non-QOZBP at the QOF level, which may include crypto. At the QOZB (subsidiary) level there is an added limitation thanks to a 5% nonqualified financial property (NQFP) rule that generally limits QOZB-level investments to cash, marketable securities, and notes with maturities greater than 18 months.
Gray areas about crypto in the OZ final regulations
Since cryptoassets are not specifically included in the definition of NQFP, there may be some wiggle room in the final OZ regulations. However, cryptoassets may be included in the “or similar property” reference in the NQFP definition. Some OZ advisers believe that the 5% limit may not apply to crypto assets at the QOZB level and that it might be able to hold as much as 30% crypto under the QOZB 70%/30% testing rules.
Under the relevant definition, NQFP includes “debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other similar property” specified in the regulations (Sec. 1397C(e); see also T.D. 9889). Significantly, reasonable amounts of working capital (see the Bardahl formula) held in cash, cash equivalents, or debt instruments with a term of 18 months or less are excluded from the definition of NQFP. In addition, accounts or notes receivable generated in the normal course of business are excludable.
OZ investors should proceed with caution since the IRS may take a more restrictive view of how crypto does (or does not) fit into the definition of NQFP. Rather than gamble with the uncertainty of the regulations, taxpayers can pledge their QOF interest and secure a low-interest margin account and invest 50% or more of their QOF value (depending on the lender’s loan policies) outside the OZ structure.
Another potential exception to allow broader QOZB-level investment options is a short-term rule that may allow for an even greater investment percentage during the 31- to 62-month working capital safe harbor (WCSH) period. There were very differing opinions about whether the 5% NQFP limit was turned off during the WCSH period. If it was, then during the 31- to 62-month period, the QOZB might be able to invest 100% of its funds into crypto for the duration of the WCSH period.
Thankfully, the IRS issued a second set of correcting regulations in August (T.D. 9889), which provided additional clarification, including how certain tests and limitations would effectively be “turned off” during the WCSH period. The IRS made clear that in the case of a “start-up” entity, during the 31- to 62-month WCSH period, the 10% NQFP limitation for QOZB entities would not apply and such property will be treated as working capital of the QOZB. Unfortunately, neither the Code nor the regulations include a definition of a startup business, but a commonsense conclusion is that a startup business will cover the majority of OZ businesses other than a business that was acquired by a QOF or QOZB. These clarifying regulations provide some added investment flexibility for crypto-focused OZ investors.
Just remember that investing in cryptoassets (or other NQFP) long term via a QOF/QOZB structure is limited to a combined maximum 15% at the QOF (10%) and QOZB levels (5%). Additional amounts may be investable at the QOZB level during the WCSH period, but I expect further guidance from the IRS soon.
The Land of OZ may well be the next frontier for crypto investors and others generating short-term gains in the market. The OZ program may prove to be the ultimate tax tool for maximizing the after-tax economic return on these cryptoasset gains. Many are waiting to see if underserved businesses and residents in OZ-designated tracts will benefit to the extent that real estate investors do. But for those who choose well, deferring real gains from cryptoasset trading can provide substantial benefits to both the investor and to the underserved communities that see redevelopment and new growth because of that capital infusion.