The federal opportunity zone program (26 U.S.C. Sec. 1400Z et seq., the “OZ Program”) provides tax benefits to encourage private investment in economically distressed areas. More than 8,700 census tracts, located in every state, Washington, D.C., and five U.S. territories, were designated as opportunity zones. Proponents hoped that investments in these communities would spur economic development and job creation in needy communities. Many states and localities, including New York City and New York State, aligned their tax codes with the incentives provided under the OZ Program.
However, critics have noted that some projects have failed to generate the social benefits promised by the OZ Program. Legislators in New York have removed some of the benefits of the OZ Program for residents of New York and some non-residents with gains from New York property. This blog post gives a brief overview of the benefits provided through the OZ Program and how these benefits were incorporated into New York’s tax code, and then describes how new legislation will strip some of these benefits for purposes of New York State and New York City taxes, while retaining others.
OZ Program Tax Benefits
Broadly speaking, the OZ Program provides taxpayers who invest qualifying gains in an opportunity zone and hold their investment for at least ten years with three benefits. First, under 26 U.S.C. Secs. 1400Z-2(a) and (b)(1), the recognition of the qualifying gains is deferred until December 31, 2026 (the “Deferral Benefit”). Second, pursuant to 26 U.S.C. Secs. 1400Z-2(a) and (b)(2)(B), as of this year, the amount of gain subject to tax is reduced by 10% (the “Reduction Benefit”). No Reduction Benefit is available for investments made after 2021.
Finally, any gain on investments in opportunity zones held for at least ten years is entirely excluded from gross income for tax purposes as a result of 26 U.S.C. Secs. 1400Z-2(a) and (c) (the “Exclusion Benefit”). Generally, to take advantage of the OZ Program, investments are made in qualified opportunity zone funds (“QOFs”), which are established as corporations or partnerships to permit taxpayers to take advantage of the OZ Program benefits by investing in opportunity zones and following certain rules.
By way of example, if an individual sold stock held for at least one year in 2021 and thereby generated $1 million of gains, these gains would typically be subject to tax. If the individual instead invested their gains in a QOF in 2021, did not sell the investment for at least ten years, and then sold the investment in 2031 for a further $3 million gain, the individual would (i) defer recognition their $1 million in capital gains until December 31, 2026 by applying the Deferral Benefit; (ii) be required to pay tax on only $900,000 (i.e., $1 million reduced by 10%) as a result of the Reduction Benefit; and (iii) not pay any tax on the subsequent $3 million gain by virtue of the Exclusion Benefit.
New York Conformity
Historically, New York automatically followed changes to the federal tax code through its use of federal adjusted gross income as the starting point for determining New York taxable income for personal income tax purposes, and federal taxable income for determining the New York corporate franchise business income base. This “rolling conformity” normally simplifies filings for New York taxpayers and thus permits New York taxpayers to immediately apply taxpayer-favorable changes to their federal and New York taxes. As a result, prior to passage of the new law, New York taxpayers could obtain the same benefits of deferral, reduction, and exclusion for New York tax purposes, because state income would be deferred, reduced, or excluded to the same extent as it would be under federal law.
However, New York can choose to diverge from its rolling conformity policy by selectively “decoupling” from federal tax provisions. Such decoupling alters application of federal rules to taxes levied by New York. By way of its authority to amend the New York City Administrative Code, the New York State Assembly can decouple the income definitions at both the state and city level.
Decoupling under New Legislation
New York’s FY 2022 budget (the “Budget”), signed into law on April 19, decouples from part of the OZ Program for purposes of New York State and New York City taxpayers. This decoupling was achieved by changing the definitions of certain key provisions of the New York State Tax Law (the “NYSTL”) and the New York City Administrative Code (the “NYCAC”).
Sections 208(9), 612, and 1503 of the NYSTL define “entire net income” and “New York adjusted gross income” as generally equivalent to entire taxable income and adjusted gross income, respectively, as calculated under federal law, comporting with New York’s general rolling conformity policy. Equivalent provisions are found in NYCAC Sections 11-602, 11-652, and 11-1712. Nevertheless, each of these sections also provides for further New York State- or New York City-specific adjustments, thereby allowing New York State and/or New York City to decouple from federal tax law in particular areas.
The Budget amends each of these sections of the NYSTL and NYCAC to (1) add back to entire net income any amounts deferred or reduced with the Deferral Benefit or the Reduction Benefit for New York corporate franchise tax purposes, (2) add to New York adjusted gross income any income that otherwise would have qualified for the Deferral Benefit or the Reduction Benefit for New York State and New York City personal income tax purposes, and (3) require inclusion of any amounts deferred with the Deferral Benefit or reduced with the Reduction Benefit in the computation of entire net income for purposes of New York City business corporation tax. Finally, the Budget makes clear that these changes apply to taxable years beginning on or after January 1, 2021.
The changes made by the Budget to the NYSTL and the NYCAC effectively decouple New York State and New York City tax policy from federal tax policy, at least as far as the Deferral Benefit and the Reduction Benefit are concerned. Going forward, a resident of New York State and/or New York City will not be able to defer payment of New York State and/or New York City taxes on capital gains through the OZ Program, even if those funds are invested in a QOF in compliance with federal law. Such resident would also not be able to use the OZ Program to reduce the amount of taxes on capital gains owed to New York State or New York City.
It also bears noting that these rules could even apply to a nonresident of New York State or New York City. If the source of the gains that a nonresident individual sought to invest through the OZ Program resulted from the sale of New York real or tangible property or as the result of business conducted in New York. The changes made by the Budget are wide-reaching in scope and application and even nonresidents of New York State or New York City should be aware of them.
Nevertheless, several important OZ Program benefits still remain even for residents of New York State or New York City. First, the Exclusion Benefit is not altered by the Budget. This means that a resident of New York State or New York City who invests qualifying gains in a QOF, holds the investment in the QOF for at least ten years, and follows all other applicable rules can still exclude from their future income, for purposes of New York State and/or New York City taxes, the capital gains on the sale of their investment in the QOF. The Exclusion Benefit is arguably the most important benefit for investors using the OZ Program, as investments in opportunity zones by their nature provide the possibility for large returns upon exit, and these returns would be completely tax free at the federal, state, and local levels. Second, even New York City residents who would stand to lose the most from the changes included in the Budget still benefit from the Deferral Benefit and the Reduction Benefit on their federal taxes.
As a taxpayer’s federal tax burden is often much larger than their state or local tax burden, this means that the bulk of the benefits of the OZ Program still remain available for residents of New York State or New York City. However, such taxpayers should be aware that the decoupling caused by the Budget will likely increase the complexity of their tax filings, and should work with their tax advisors to ensure that city, state, and federal rules are properly followed. Nevertheless, if Congress passes President Biden’s proposed tax increases, which among other items dramatically increase tax rates for capital gains and eliminate the step-up in basis upon death, the tax benefits provided by the OZ Program could become much more attractive even following the changes discussed in this post.