The Qualified Opportunity Zone (QOZ) program was created by the Tax Cuts and Jobs Act to stimulate economic development and job growth in low-income communities across the US, DC and the five US territories by providing tax breaks to investors in the qualified zone areas. NY had participated in this program by designating certain low-income areas as QOZs and conformed to the following federal tax incentives and benefits associated with investing in those zones:
Deferral of taxation of eligible capital gains until December 31, 2026 or until the sale or disposition of investment in the Qualified Opportunity Fund (QOF), whichever is earlier, if the original capital gains are invested in a QOF within the 180-day investment period, as per the rules of the QOZ program.
Step-up in basis
Reduction of the originally deferred gain invested in a QOF from taxation through step-up in basis by:
- 10% if the taxpayer holds the QOF investment for at least 5 years prior to December 31, 2026, or
- 15% if the taxpayer holds the QOF investment for at least 7 years prior to December 31, 2026.
Permanent exclusion of the capital gain on the sale or disposition of the investment in the QOF from taxation if the QOF investment is held for at least 10 years.
New York Decouples in FY 2021-22 Budget
The recently passed New York State budget bill, which was signed into law by Governor Andrew Cuomo on April 19, decouples from the QOZ program by denying the first two benefits described above, effective for tax years beginning on or after January 1, 2021. Accordingly, taxpayers who defer their 2021 capital gains by investing in QOF for federal income tax purposes will have to add back those gains in computing their New York State and New York City taxable income. This also means there will not be a step-up in basis, and taxpayers will not be able to reduce 10% of the original capital gains from New York state and local taxation.
While the first two benefits will not be available for New York state and local income tax computation, the third benefit of permanent exclusion is not impacted by the decoupling. In other words, the gain on sale or disposition of the QOF investment will still be eligible for permanent exclusion from taxation for federal as well as New York state and local income tax purposes.
Consequently, when those gains are recognized in taxable income for federal income tax purposes, they will be excluded from New York taxable income, thereby avoiding double taxation. However, this add-back and subsequent subtraction may not always work, producing adverse tax consequences depending on the NY nexus of the QOF or the taxpayer’s NY residency at the time of add-back and subtraction.
For example, a taxpayer who is a NY resident at the time of original gain who subsequently becomes a non-resident of New York by moving to another state that has not decoupled would be subject to double taxation on such gain when the originally deferred gain is recognized. Similar unfavorable tax consequences will occur for a taxpayer who is a resident of another state that conforms to the federal QOZ rules and has a gain from NY sources. In this case, such taxpayer would be subject to NY tax on the original gain and would defer tax in his or her home state due to conformity. But the taxpayer would again pay tax on that gain when it is recognized in federal and home state income and would not have any off-setting credit from NY at that time.
Since the decoupling will take effect for tax years beginning on or after January 1, 2021, taxpayers may still have time to invest their 2020 eligible gains for NY deferral as well, depending on when their 180-day investment period begins. The 180-day investment period generally begins on the date of sale, however, partners, shareholders of S corporations and beneficiaries of non-grantor trusts may elect to treat the 180-day period to begin on the date of sale by the pass-through entity, the last day of the taxable year of the pass-through entity or the due date of the pass-through entity’s tax return, not including any extensions.