The District of Columbia recently enacted legislation effective on Jan. 1, 2021, that would subject gains recognized by unincorporated businesses from federal Opportunity Zone investments to tax, despite their being excluded for federal income tax purposes. Absent any subsequent law changes exempting such gains from District unincorporated business taxation, internal rates of return on District Opportunity Zone investments would be lower than such investments in states that exclude such gains for state income tax purposes.
Opportunity Zones overview
The federal Opportunity Zones initiative offers tax benefits for investments of realized capital gains into low-income areas designated as Opportunity Zones. The Opportunity Zone provisions were adopted as part of the Tax Cuts and Jobs Act of 2017 (TCJA), signed into law on Dec. 22, 2017. Section 1400Z-1 of the Internal Revenue Code (IRC) of 1986, as amended by the TCJA, essentially defines and designates the various Opportunity Zones, while Section 1400Z-2 codifies the requirements and benefits afforded for qualifying Opportunity Zone investments into various types of real estate, businesses, and property located within these designated zones.
Federal law establishes 8,766 Opportunity Zones in the District, all 50 states, and five U.S. territories (including Puerto Rico). There are 25 Opportunity Zones established in the District. The Treasury Department estimated that in 2018 there were 1,500 Opportunity Zone funds with about $75 billion raised, according to a 2020 report from the White House Council of Economic Advisers.
The most significant benefit afforded an Opportunity Zone investor is the ability to exclude from federal taxation the full amount of the gain resulting from the sale or exchange of a qualifying OZ investment that the investor has held for a period of 10 years or more. The most common form of investment has been through unincorporated pass-through entities such as state law partnerships and limited liability companies with two or more members.
D.C. amends definition of ‘taxable income’ for unincorporated business tax (UBT)
On Aug. 19, 2020, District of Columbia Mayor Muriel Bowser signed the Budget Support Emergency Act of 2020 (BSA) (L. 2020, Act 23-404) for the Fiscal Year 2021, which applies as of Oct. 1, 2020. Among other actions, the BSA provides for the amendment of the definition of “taxable income” for unincorporated businesses, pursuant to D.C. Code Section 47.1808.02(1), to include “gain from the sale or other disposition of any assets, including tangible assets and intangible assets, including real property and interests in real property, in the District, even when such a sale or other disposition results in the termination of an unincorporated business.” This amendment becomes effective Jan. 1, 2021.
This statutory definition of “taxable income” already provides specific exemptions for income related to the following items, neither of which includes gross income of a Qualified Opportunity Fund investment as defined under IRC Section 1400Z-2(d).
- Qualified community development entities defined under IRC Section 45D(c)(1)
- Qualified low-income community investments as defined under IRC Section 45D(d)(1) receiving an allocation or suballocation of New Markets Tax Credits pursuant to IRC Section 45D(f)
Consequences for District Opportunity Zone investments
The expansion of an unincorporated business’s definition of “taxable income” in its current form would result in subjecting gains recognized by District Opportunity Zone developments to UBT (currently at 8.25% based on the 2019 tax rate), with such tax liability reducing investors’ internal rates of return on such investments. While the statue does offer relief from this taxation for OZ investments held for at least 10 years, the stipulations for receiving such relief include a requirement that the Mayor certify each one individually, which leaves the door open for taxation for District investments that meet the 10-year holding period requirement but do not get that certification.
The imposition of the UBT on an Opportunity Zone investment would make the District a less advantageous geographic locale for investment compared to the more than 30 states that have adopted the federal exclusion of such gains for state tax purposes. In fact, the only jurisdiction other than the District in the continental United States that is less advantageous for an Opportunity Zone investment, from a state income tax perspective, is California. (While state and local tax laws change with great frequency, states that do not follow the federal exclusion of qualifying gains from the sale or exchange of Opportunity Zone investments are currently California, Hawaii, Massachusetts, Mississippi, North Carolina, and Pennsylvania.)
Barring an amendment to D.C. Code Section 47.1808.02(1) providing for an additional statutory exemption for recognized Opportunity Zone gains federally exempt under IRC Section 1400Z, District Opportunity Zone investment opportunities would be placed at a competitive disadvantage compared with Opportunity Zone investments in states providing for full additional state exclusion of such gains from tax, which would have higher internal rates of return on such investments.
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