Increasing Efficiency of California State Community Development Tax Incentives

Published by Kevin Wilson on Tuesday, May 21, 2019 - 12:00am

The budget for California’s next fiscal year is expected to be completed in the next month and through the budget process, leadership will determine the extent to which the state will provide state income tax opportunity zones (OZ) incentives to encourage investment in distressed communities. This process is an important opportunity for California to leverage this new community development tool to enhance the efficiency of other state, county or city programs that have limited resources.

About Conformity

California state income tax laws generally apply a “modified conformity” to federal income tax law, whereby state law mirrors federal statute, with certain exceptions and modifications. States that use a modified conformity approach have additional flexibility and opportunities to modify the manner in which state law does (or does not) conform to federal law to enhance program efficiency and further policy objectives. Many states have used this flexibility to facilitate community goals. A growing number of states offer tax incentives to encourage investments in historic rehabilitation, underserved communities, green technology and affordable housing. At this time, the number of states in which capital gains invested in qualified opportunity funds is still subject to state income taxes is less than 10. Several of those nonconforming states are currently exploring opportunities to conform

What Conformity Could Mean for California

To offset the adverse impact on the supply of affordable housing in the state of California as a result of federal tax reform enacted in 2017, Gov. Gavin Newsom plans to commit significant additional resources for affordable housing. Newsom’s revised budget includes a $500 million increase in California state low-income housing tax credits (LIHTCs). In addition, the legislature has worked to improve the efficiency of these limited resources.

For example, by using the modified conformity concept, A.B. 10 (Chiu) would expand the pool of individual taxpayers who can benefit from investing in California state LIHTCs. Because of the mechanics of the tax law, individual investors can invest more equity than corporate investors per dollar of state tax credits and achieve similar yields from investments in affordable housing partnerships generating state LIHTCs. Under current federal and California tax law, an individual taxpayer’s ability to use federal and California LIHTCs is limited. A.B. 10 would remove these limitations with respect to California LIHTCs. This has the potential to boost the amount of tax credit equity generated by California state LIHTCs by 25 percent or more.

Increases in equity investment in California could also occur if California modifies state income tax laws to provide tax incentives for investments in qualified OZs, as was proposed in the governor’s budget.  

The federal OZ incentive is quite new, and the ultimate impact of this community development tool is not yet known. There is widespread optimism that the OZ incentive will be the largest economic development incentive in recent U.S. history. However, some community development advocates have warned that some California OZs are in areas where existing residents are at risk of displacement, and OZ investments could accelerate that displacement.

However, because of the flexibility provided through modified conformity, California is in a strong position to address these concerns by providing a state tax incentive for investments in opportunity zones and providing “guardrails” to ensure that the investments that qualify for the state OZ incentive adhere to certain standards. The leaders of the state’s 13 largest cities expressed similar sentiments in a letter they sent to the governor and leaders of each house of the legislature earlier this month. The legislature has worked to address these concerns. S.B. 315 (Hertzberg), introduced in the state Senate earlier this year, provides guiding principles for OZs, implemented through a detailed reporting framework, to help ensure that OZ investments result in inclusive growth and shared prosperity. A.B. 791 (Gabriel) provides tax incentives to maintain affordable housing units located in OZs.

Considerable attention and effort has been directed towards the potential impact of state conformity (or modified conformity) to the OZ incentive. California’s income tax rates are among the highest in the nation for both individual taxpayers and corporate taxpayers. Given these high tax rates, providing a conforming (or modified conforming) state OZ incentive would give the state of California leverage to influence the direction of these investments on a number of fronts. Without a conforming state OZ incentive:

  • OZ investors and fund managers are more likely to deploy capital in states other than California.
  • California will miss an opportunity to incent capital deployment towards businesses that result in inclusive growth and shared prosperity.
  • Taxpayers deploying capital in California OZs will do so without regard to the goals outlined in the reporting framework.

If lawmakers balance the caution necessary to protect vulnerable populations with the flexibility provided by a modified conformity approach, creating a state OZ incentive for California could enhance and extend existing community development resources and provide better outcomes for communities in need.