New York State recently enacted its 2021-2022 Budget (the “Budget Bill”)1, which contains numerous provisions designed to increase the taxation of high-income individuals and corporations. Among these provisions, the law takes aim to limit the tax benefits available to investors under the federal Qualified Opportunity Zones (“QOZs”) program which was adopted as part of the Tax Cuts and Jobs Act of 2017.
A QOZ is a designated economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Almost 8,800 QOZs have been designated across the U.S.
Investors in QOZs can achieve three significant federal tax benefits by investing capital gains in Qualified Opportunity Funds (“QOF”), which are vehicles for investing in QOZ businesses:
- Taxpayers can defer paying taxes on short- or long-term capital gains (including from the sale of securities) that are reinvested into a QOZ. This deferred gain is recognized at the earlier of (a) when the investment is sold or exchanged, or (b) December 31, 2026.
- Taxpayers can reduce the gain subject to tax by 10%/15% of their originally deferred capital gain if they hold the QOZ investment for at least 5 years/7 years prior to December 31, 2026.
- Taxpayers who hold the QOZ investment for at least 10 years can exclude from taxation the entire appreciation in their QOZ investment.
As in many states, these tax benefits were available to New York State taxpayers prior to the Budget Bill by virtue of state conformity in using federal taxable income as the starting point for New York State income tax calculations. However, certain members of the New York Legislature have been critical of certain perceived inequities in the manner in which the Opportunity Zone program has been administered, and the Budget Bill takes aim at the first two of these QOZ benefits by ‘decoupling’ New York State (and New York City) from the federal program. The Budget Bill provides that for purposes of calculating New York State taxable income, the federal QOZ deferral amount is added back (the so-called “decoupling”). Thus, starting with the 2021 tax year, New York taxpayers (including New York residents and non-residents who have NY-source gains) will not be able to defer from New York State taxation any gains in 2021 or subsequent years reinvested in QOZ businesses. Conversely, when the deferred gain is recognized for federal income tax purposes in 2026 or earlier, this gain will be excluded from New York State taxation.
Since the Budget Bill eliminates the deferral of gain from 2021 and subsequent years for New York State purposes, the 10% reduction of the deferred gain (which occurs through an increase in tax basis) would no longer appear to be relevant for New York State income tax calculations.
Although this QOZ decoupling is effective for tax years starting on or after January 1, 2021, there is still time for certain taxpayers to elect deferral for their 2020 gains, and gains that are deferred on the 2020 federal tax returns can still be deferred in New York. The period for deferring gains is generally 180 days from when the gain is realized by the taxpayer. However, if the gain is reported on a K-1 (gain from a partnership, S-corporation, or certain trusts and estates), taxpayers can elect to start the 180-day period as late as the due date of the flow-through entity’s tax return without extensions (generally, with respect to calendar year filings, March 15, 2021 for partnerships, and April 15, 2021 for S-corporations and certain trusts and estates). In addition, the Budget Bill appears not to affect deferrals made in 2020 or prior years, which remain eligible for deferral through 2026, including the 10% step-up in basis if meeting the 5-year hold requirement.
Based on a technical reading, the Budget Bill does not affect the third tax benefit – the exclusion of appreciation after holding the QOZ investment for 10 years (even for QOZ investments made in 2021 or subsequent years). Accordingly, gain from the sale of QOZ investments may still be eligible for exclusion from New York State income tax if the 10-year holding period is met. However, there is no certainty that the New York legislature might not pass other bills targeting this 10-year benefit at some point in the future.
1 A.3009-C/S.2509-C, signed into law by New York Governor Andrew Cuomo on April 19, 2021.