By Scott Toussaint, Esq., General Counsel at Capital Rivers Commercial.
The California Legislature’s failure to pass “conformity” legislation marked the end of its chance to align State income tax law with Federal law for Qualified Opportunity Zones.
Opportunity Zone Background
Most of the commercial real estate world is at least vaguely familiar with Qualified Opportunity Zones, or QOZ’s. Created by the Federal 2017 Tax Cuts and Jobs Act, QOZ’s are census tracts selected to receive investor tax incentives. The goal is to spur economic development in distressed communities. Investors benefit by placing capital into QOZ funds. These funds invest in QOZ businesses and real estate located within a QOZ.
A total of 8,764 QOZ’s have been designated. A national map may be viewed here. Of these, 879 QOZ’s are in the Golden State.
QOZ investors can defer capital gains, similar to a “1031 exchange.” However, the “like-kind” property requirement is eliminated. The “same taxpayer” requirement is also removed. The deferral period is capped. If the investment is held long enough, a portion of the deferred gain may be forgiven. Capital gains within the QOZ fund may also be fully forgiven if the investment is held for at least 10 years.1
Recent federal policy discussions include elements within the Big Beautiful Bill Act. Proposed provisions aim to extend Opportunity Zone timelines and the deferral period for capital gains. They also introduce stricter reporting requirements for funds. An extension could preserve certain tax benefits. However, added compliance requirements may reduce flexibility and increase administrative burdens for investors. The legislation signals continued Federal support for place-based economic development. It also shows a shift toward tighter oversight of Opportunity Zone investments.
These rules apply only to Federal income taxes. States control their own income tax treatment.
California’s Approach
States follow, or “conform to,” the Federal Tax Code to varying degrees. While details differ, most States have adopted the general QOZ concept. Despite the Governor’s interest, the California Legislature did not pass a QOZ conformity law.
What about a future legislative cycle? The full QOZ benefit requires long-term investment within a defined timeframe. This created a limited window to capture the maximum benefits. By not acting during that period, the Legislature missed the strongest opportunity. However, given the remaining benefits, the issue may return. Future legislation could also be made retroactive.
If California adopts Federal QOZ law, it will likely target specific public policies. Proposed legislation required two conditions. First, the QOZ must be located in California. Second, the QOZ fund must meet standards tied to public policy goals. These include affordable housing and green energy.
California QOZ’s remain valid for Federal purposes. However, the State has not adopted conforming legislation. As a result, California does not provide these tax benefits. California also has some of the highest tax rates in the nation, and the State taxes capital gains at the same rate as ordinary income.
Other States
In evaluating the effect of State income taxes on an investment, it is helpful to keep in mind the basic, albeit simplified, approach of California and many other States that tax income: the income that is subject to taxation is (a) for residents, all income, and (b) for non-residents, income “sourced” in the State, such as gain on the sale of a building located in-State. Following deductions, credits, deferrals, and other adjustments, State tax rates are applied to this income.
According to a compilation by Novogradac, 46 States either have adopted conforming legislation for personal income tax purposes or don’t tax personal capital gains to begin with. It appears that most of the conforming States conform fully, not even conditioning qualification on investment in their own State’s QOZ’s. So for example, a resident of Oregon would be able to invest in an Arizona QOZ and receive the full QOZ benefits at the State level from both Arizona, the source-of-income State, and Oregon, their State of residence.
California’s QOZ’s will be less attractive to QOZ investors in any of the 46 conforming States than other QOZ options that are available to them. California will tax the QOZ fund’s income at its source, California, no matter where the investors live. For California taxpayers, the FTB will tax income invested in QOZ’s without any of the benefits, regardless of whether the QOZ is located inside or outside of the Golden State. The best a California investor can expect is a credit to avoid double-taxation at the State level.
Conclusion
With most of the other QOZ’s in America offering the benefits of QOZ’s at the State level, and given California’s tax rates, QOZ investors, all else being equal, will stay out of California. Billions of dollars are being assembled and invested in QOZ funds, and by its inaction the California Legislature has made QOZ’s a less attractive option for its residents and made the QOZ’s within its boundaries less attractive to non-residents.
For a savvy California-resident investor, given that (a) there’s no getting around the State’s failure to recognize QOZ tax benefits, (b) there should be less demand for California QOZ’s from out-of-State investors, and (c) the substantial Federal tax benefits still apply, investment in California QOZ’s may actually be a smart play. And if the State ends up adopting conformity legislation as it could, there could be a windfall of sorts at the other end. But even if it does, the fact that there will probably be some sort of public policy strings attached that are currently impossible to predict makes that an extremely speculative proposition.
Capital Rivers Commercial advises clients on investment strategy, site selection, and market positioning across California. For guidance on Qualified Opportunity Zones or to explore available opportunities, contact our team or browse current listings to start a conversation.
1 A pair of good starting points for understanding QOZs is the IRS FAQ webpage and an overview prepared by the Staff of the Congressional Joint Committee on Taxation.
