With the IRS issuing investor-friendly draft regulations for the new Opportunity Zone (OZ) tax incentive program, investments in OZ investment funds will likely accelerate. Before they do, state lawmakers should change their personal and corporate income tax laws so their states don’t provide tax breaks on top of the new federal tax breaks. If states don’t “decouple,” they’ll forgo revenue needed to fund education, health care, roads, and other critical building blocks of robust, inclusive economies to subsidize investments that will often occur in out-of-state OZs.
The 2017 federal tax law created the OZ program to stimulate investment in economically distressed areas. It offers three distinct tax breaks to individuals and corporations that quickly invest capital gains income (that is, profits from the sale of stocks, real estate, corporate subsidiaries, and other property) in “Qualified Opportunity Funds” (a.k.a. “OZ funds”) — special legal entities established to invest in real estate and businesses located in one or more of the roughly 9,000 OZs that state governors designated in early 2018.
Those tax breaks are:
All three tax breaks lower individuals’ and corporations’ “gross income,” as the Internal Revenue Code defines it. Because nearly all states piggyback on that definition, the breaks will automatically flow through to state individual and corporate income taxes unless the state proactively “decouples” its law from the OZ provisions. Apparently, only Hawaii and North Carolina have done so to date.
That’s unfortunate. Most existing OZ funds plan to invest in OZs in multiple states, according to two lists — indeed, some describe their geographic reach as “nationwide.” Thus, states that don’t decouple will often give tax breaks to investments that their resident individuals and corporations make in other states’ OZs.
A state could amend its laws to limit the tax breaks to OZ real estate and businesses located within its borders (Arkansas already has), but this approach has two problems. First, the state would have to write regulations telling the funds and investors how to apportion the gains between in-state and out-of-state OZ investments and would have to audit those calculations itself. Second, courts might rule that limiting the tax breaks to in-state investments unconstitutionally discriminates against interstate commerce and order the state to provide the breaks retroactively to all investments in out-of-state OZ projects. Past efforts to limit other tax breaks created by federal law to in-state investments have run afoul of the courts.
Instead, states should decouple their own income taxes from the OZ tax breaks, leaving it to the federal government to subsidize OZ investments. That would be doubly wise, given serious concerns that the federal OZ tax breaks will largely provide a windfall for investments that would have occurred anyway and lead to gentrification and displacement in OZs rather than new jobs and higher incomes for zone residents.