(Photo: Justin Day/Flickr)
When California's state legislators return to session on Monday, one of the issues they will be considering is legislation that will allow the state to take full advantage of Opportunity Zones investment in some of the poorer areas of the state. Opportunity Zones (OZs) provide a new tax incentive to spur private investments in communities of need.
The program addresses a major challenge facing California and the rest of the nation — a profoundly uneven economic recovery that is producing great wealth and income in a distinct minority of communities, while leaving many others to struggle with chronically high levels of poverty and unemployment, and lagging incomes. It addresses this inequity by incentivizing investment in struggling communities through the tax code.
How the program works
Investors may defer federal taxation on capital gains by investing the proceeds through a qualified opportunity fund (QOF) into an opportunity zone. Taxation of the gains rolled into the QOFs is deferred until the taxpayer sells his/her shares, but no later than December 2026. In addition, 10 percent of the capital gains rolled into the QOFs are excluded from taxation if the shares in the QOF are held for five years, and by 15 percent if the shares are held seven years. Capital gains on the investments made through the QOFs and held for at least 10 years are permanently excluded from taxpayer income.
The challenge facing California
California has designated 879 OZs under the federal program. According to data released by the California Department of Finance, the average poverty rate in these zones is 34 percent, and median household incomes are $37,000, more than 40 percent below the statewide average.
Normally, we would expect California to be an attractive venue for federal tax-favored investments, given its favorable location, proximity to major markets, and its overall economic strength and diversity. However, California’s high 13.3 percent maximum tax rate on capital gains (nearly two thirds of the federal rate) presents a major obstacle.
Unless California conforms to the federal law, much of the federal incentive will be offset by increased state tax liabilities that would arise at the time of the investment, making California a less attractive location for OZ investment than other states.
The benefits and costs of state conformity
Capital Matrix Consulting was commissioned to estimate the net economic and fiscal impacts of state conformity to federal OZ law. Our detailed modeling approach and results are shown here. A key element of our approach was to estimate the effects of state conformity on the after-tax rate of return on OZ investments, and ultimately on the amount of incentivized investment occurring in California.
We found that California conformity to federal OZ law would have major incentive-related impacts, producing between $745 million and $1.2 billion in new economic activity related to 2019 investments. In subsequent years, we would expect these impacts to moderate as deferral incentives lessen after 2021, but still remain in the $500 million to $700 million range.
The state would give up some tax dollars related to investments that would have occurred even in the absence of conformity. However, these tax reductions would be highly leveraged: each dollar of state revenue reduction would specifically generate between $10-$66 of private investment in low-income communities in California. Local governments would benefit from significant additional taxes related to billions of dollars in newly incentivized OZ investments and related economic activity.
California is one of few states that has not yet enacted legislation conforming to the federal program. We know that Governor Newsom likes OZs. We believe that as legislators learn more about the program, they’ll make sure California is part of this program.
Brad Williams is a partner at Capitol Matrix Consulting and is a former chief economist for the non-partisan California Legislative Analyst’s Office.