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States That Do Not Conform with QOZ Tax Benefits
We’ve spent a lot of space in this guide outlining the benefits of a QOZ investment for investors who are seeking a unique investment coupled with a generational tax deferral opportunity. In addition to deferring the payment of Federal capital gains tax on a realized gain until December 31, 2026, investors can also profit from the subsequent QOZ investment being entirely free of Federal capital gains taxes, provided it’s held for at least ten years.
We’ve also mentioned that state capital gains taxes are almost always deferred and/or eliminated in most states as well.
Almost always . . . in most states
It’s time to drill down deeper into how the various states treat QOZ investments for the purposes of capital gains taxes. Let’s start with the fact that while Federal capital gains taxes are consistent across all 50 states, capital gains taxes vary widely on the state level, ranging from having no tax at all on capital gains to 13.3%. Not surprisingly, it’s California that’s the dubious winner in this category, though New York State is a close second at a top rate of 12%.
There are eight states having no income tax: Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, and Wyoming. These states also do not tax capital gains.
Of the eight, only New Hampshire has an investment income tax, but it is aimed at interest and dividends instead of capital gains and is on a pace to be phased out by 2027.
Strategies aimed at the deferral or elimination of Federal taxes are still appropriate to pursue, but it’s not necessary to focus on non-existent state taxes for these states.
For the remaining 42 states, capital gains tax rates range from 2.9% to 13.3%, though the majority falls within the 4-6% range. Of these 42, an overwhelming majority have state laws that conform to the Federal law by offering deferral of capital gains taxes on any gain reinvested into a QOZ fund, and freedom from any capital gains tax on the QOZ investment itself, provided it is held for at least ten years.
There are, however, a handful of non-conforming states, and once again, the Golden State is at the top of the list (or the bottom, depending on your perspective).
California
There are many reasons to live in California, but their tax code isn’t likely to be one of them. California treats capital gains the same way as ordinary income, meaning that depending on a resident’s earnings, the capital gains tax rate ranges from as low as 1% to as high as 13.3%.
Most investors seeking the benefits of a QOZ investment are almost certainly closer to the higher range, so the state’s lack of conformity to the Federal laws surrounding QOZs is a significant factor, rendering QOZ investments less compelling for California residents.
Importantly, the state taxes any QOZ fund’s income at its source, irrespective of residency. This makes California-based QOZ funds less attractive for any investors, not just California residents.
Given the nearly 900 U.S. Census tracts designated as opportunity zones in California, including 274 in Los Angeles alone, it’s an opportunity lost (or at least watered down) for QOZ investors in general, and California residents in particular.
California came close to enacting conformity legislation in 2019, but the legislation failed when Gov. Gavin Newsom insisted on the inclusion of several policy initiatives as a condition of his support, including limiting conformity to opportunity zones in California only, as well as linking it to investments in green technology or affordable housing.
Mississippi
Like California, Mississippi does not conform with the Federal QOZ tax benefits. Their most recent legislative initiative was HB 133, a bill in the Mississippi House in 2022 that would have brought state tax benefits in conformity with Federal guidelines in 19 of the state’s 82 counties. But even that limited conformity died in committee less than two months later.
Mississippi also taxes capital gains as ordinary income, though its top tax rate of 5% is considerably lower than California’s, as is the number of opportunity zones (100) available in the state.
North Carolina
North Carolina’s top tax rate of 4.99% virtually mirrors that of Mississippi.
Also like Mississippi, North Carolina has no conformity legislation, and in fact, defied Gov. Roy Cooper’s veto in 2019 to enact an explicit decoupling of their state tax code from the Federal QOZ provisions.
Under the law, taxpayers are required to add back any Federally deferred gains into the state income for the purposes of calculating taxes, in addition to any subsequent gains in a QOZ investment, as well as any benefits related to a step-up in cost basis. 252 of the state’s 2,195 Census tracts are designated as Opportunity Zones.
In addition to the three states with no conformity whatsoever, Arkansas and Hawaii conform to Federal QOZ benefits, but only for opportunity zones located in their respective home states.
Several states initially resisted conformity, either intentionally or through legislative inaction, but with the exceptions noted above, all have come to embrace the QOZ tax benefits on the state level. Most recently, Massachusetts issued TIR-23-5, which extended QOZ benefits to all taxpayers after originally restricting conformity to corporate taxpayers only (the reverse image of Pennsylvania, which conformed at the personal income level only before relenting in 2019 to include all taxpayers).
Finally, there are states with additional incentives built into their conformity legislation, geared towards encouraging their taxpayers to look to their own state first before seeking QOZ funds elsewhere.
Ohio, for example, offers an income tax credit for investments in Ohio-based QOZs; West Virginia permits deductions from income from business activity that takes place in West Virginia opportunity zones. Wisconsin offers a pair of incentives: for individuals, a subtraction from income for an investment in an in-state QOZ fund, and for corporate taxpayers, an additional capital gain exclusion or adjustment in cost basis, for an investment in a Wisconsin QOF. Investors would do well to examine the situation in their own state before looking elsewhere for QOZ fund opportunities.
As we have emphasized repeatedly, it’s critical to have an experienced and knowledgeable advisor on your team to address these complexities.
Residents of a conforming state who invest in a QOZ fund that is based (in whole or in part) in a non-conforming state may find themselves with an unexpected tax bill. This is especially important because, while many QOZ funds are limited to properties in a specific state or locality, a number of them feature properties in several states.
Remember that accredited investors already have access to our Qualified Opportunity Zone Masterclass, an excellent primer that will prepare you well for QOZ investing and educate you more extensively on the benefits of QOZ funds while also enabling you to avoid potential pitfalls. Make sure to check out the trailer for the masterclass that follows.
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