Although Tax Day passed on April 18, 2022, for some taxpayers a
different type of tax deadline is approaching. Many tax attorneys,
like myself, know that June 30, 2022, is the last day on which
certain taxpayers who had capital gains in 2021 can defer paying
tax on those gains until 2026 by investing them in Qualified
Opportunity Funds (QOFs)-investment vehicles used to invest in
Qualified Opportunity Zones (QOZs). According to the IRS, the purpose of the QOZ
program is to “spur economic development and job creation in
distressed communities by providing tax benefits to
investors.”
One such tax benefit is that an investor who holds a QOF
investment for 10 years receives a 100% exclusion from federal tax
on appreciation on the investment. That is a 0% effective tax rate
on a potentially unlimited amount of gain. But how does the 0% tax
rate compare to that of a QOZ resident?
Today, there are 8,764 QOZs in the United States. One
of those QOZs is Central Harlem, where 29% of residents are below the federal poverty
level, 77.2% of households do not include children,
and the median household income is $57,720. The federal income tax liability for a
single filer with no children, with income of $57,720, and who takes the standard deduction ($12,550) and, thus, has taxable income of
$45,170, is $5,687. This results in an effective federal
tax rate of 12.59% for a typical resident in Central Harlem.
In the United States, we have a progressive tax system, which
means that as a person’s income increases, so too should their
tax rate. This is consistent with vertical equity-one of the
touchstones of traditional tax policy-which suggests that those who
have more income should be taxed more than those who have less
income.
Because most capital gains are realized by high-income
households, the capital gain requirement of the QOZ program
makes it more likely that QOZ investors are from high-income
households. But, when a QOF investor’s 0% tax rate is compared
to a typical Central Harlem resident’s 12.59% rate, traditional
tax policy suggests that the capital gain requirement has a
regressive effect: it causes high income QOF investors to be taxed
at a lower tax rate than low income residents of the Central Harlem
QOZ.
Traditional tax policy, however, does not shed light on whether
the capital gain requirement disproportionately impacts any
demographic groups. For that, we can look to critical tax theory, a
growing body of scholarship seeking to uncover explicit and
implicit bias in the tax system. According to Anthony Infanti, a
law professor at the University of Pittsburgh School of Law, and
Bridget Crawford, a law professor at Pace University Elisabeth Haub
School of Law, critical tax theorists use various methods of
inquiry, including the interpretation of “social science and
economic data to show how the tax law impacts groups
differently.”
In the United States, while 85% of capital gains are reported by
households with adjusted gross income of more than $200,000, only
7% of capital gains are received by households
with adjusted gross income under $100,000. According to the Institute on Taxation and
Economic Policy, “(b)ecause capital gains overwhelmingly
flow to high-income households, they also tend to flow mostly to
white households.” In Central Harlem, the median household
income is only $57,720 and 77.9% of residents are Black or Hispanic.
According to Monica Wendell and Gabriel Jones, Jr., professors at
the University of Louisville School of Public Health &
Information Science, QOF investors are not likely to reside in
QOZs.
Looking through a critical tax lens, it is unlikely that Black
or Hispanic residents of Central Harlem would have any capital
gains, and it is more likely that white taxpayers who do not reside
in Central Harlem invest in the Central Harlem QOZ. Thus, critical
tax theory suggests that the capital gain requirement is likely to
have a disproportionate negative impact on Black and Hispanic
residents of Central Harlem by creating an implicit structural
barrier that excludes them from the tax benefits of the QOZ
program, while limiting those benefits to outside investors, who
are most likely white.
It is undeniable that QOF investors risk their wealth by
investing in QOZs, which are, by definition, economically
distressed areas. It follows that if no tax incentive is provided
to investors, they would be less likely to invest in QOZs. Proponents of the program argue that it causes
significant investment in QOZs, spurring economic activity, and
creating jobs in those communities. However, the Institute on Taxation and Economic Policy has
warned that the QOZ tax rules do not have any mechanism to
ensure that the benefits of the program are allocated to the
members of QOZ communities.
According to Nancy J. Knauer, Director of the
Law & Policy Program at Temple University Beasley School of
Law, critics of critical tax theory argue that those who apply a
critical tax lens have no reliable data supporting their claims.
Knauer’s response is that such an argument assumes that the
lack of data showing a disproportionate impact of the tax system on
various demographic groups equates to proof that the tax system is
equitable. This debate highlights the need for reliable taxpayer
demographic data, which the IRS does not currently collect.
The Treasury Department has recently announced
its commitment to advancing equity analysis in tax policy by
“examining the tax system through a racial equity lens.”
The Treasury Department has proposed working
with other federal agencies to develop a reliable methodology
utilizing statistical modelling techniques to impute race,
ethnicity, gender, and other demographic characteristics for tax
data. The resulting synthetically modelled data would then be
utilized for tax equity analysis. Thus, synthetic data could pave
the way for meaningful and comprehensive critical tax analysis.
QOZs account for 12% of census tracts in the United States. If
QOZs across the country are like Central Harlem, the capital gain
requirement could have a substantial impact on racial equity
nationwide. Given that the first 10-year holding period is set to
expire in 2028, which will be the first year when the 0% tax rate
applies to QOF investors, the Treasury Department should prioritize
the synthesis of taxpayer demographic data. Those data should
measure the benefits of the QOZ program allocated among QOF
investors and QOZ residents to determine whether the capital gain
requirement advances racial equity.
The capital gain requirement highlights one instance where
traditional tax policy is insufficient to show whether the tax
system disproportionately impacts groups of taxpayers. Traditional
tax policy should not be discarded, but it can be enhanced by
critical tax theory. By adding an additional dimension-taxpayer
demographics-to traditional tax policy analysis, a critical tax
lens could help us see what traditional tax policy does not.
Originally published by Yale Journal on Regulation.
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