There is a lot of chatter in the renewables industry about a provision called Opportunity Zones, which was part of the federal tax law passed in December 2017. This program may serve as a novel approach to the continual effort to optimize the capital stack for renewable energy projects.
At its most basic level, the Opportunity Zone (OZ) program is intended to drive capital to certain census tracts around the U.S., its territories, and Washington, D.C., by providing those capital sources with three federal income tax benefits:
- Deferral of federal, and possibly state, tax on a capital gain
- Potential for a reduction in that tax if the qualifying investment is held for a designated period of time
- Potential to avoid any tax on the subsequent appreciation of the investment upon sale
Therefore, the primary focus of the program is on the sources of capital and the geographies to be impacted, rather than the types of assets or industries that receive these investments.
Deferral of capital gain
As to the first benefit, the deferral of capital gain, a taxpayer that would otherwise recognize a capital gain and subsequently have to pay federal tax on it may defer the tax on the gain under this program. In exchange for this favorable treatment, an amount up to the amount of the gain must be invested in a new kind of intermediary that subsequently invests those funds in certain qualifying investments located in certain census tracts. There are approximately 8,700 census tracts that are designated as qualifying OZs, so there are plenty of locations that qualify.
Opportunity zones and New Markets Tax Credits (NMTC) interactive map
Use the CohnReznick opportunity zone mapping tool to check whether a location qualifies.Access the Tool
A key requirement to take the deferral is that the event triggering the capital gain must result from a sale made to a buyer who is sufficiently “unrelated” under the statute. Generally, the requirement is that 80% or more of the buyer be unrelated to the seller for the seller’s gain to be eligible for this program.
For the capital gain to be deferred, the investment in this intermediary, called a Qualified Opportunity Fund (QOF), must occur within 180 days of the taxpayer recognizing the triggering of the gain. A QOF can be a partnership, an LLC treated as a partnership for tax purposes, or a corporation.
Reduction of capital gain
The second benefit is potential reduction of the capital gain. If an investment in a QOF is held five years, 10% of the deferred tax is permanently eliminated, and if the investment is held seven years, another 5% is permanently eliminated. Note that the fifth and seventh anniversaries must occur prior to Dec. 31, 2026, to garner these benefits, because the original deferral of tax finally comes due on Dec. 31, 2026, no matter the date of the original investment in the QOF. Accordingly, to have the investment eligible for the elimination of 5% of the gain, the original investment in the QOF must occur prior to Dec. 31, 2019, to allow for seven years from that date to pass on or prior to Dec. 31, 2026.
Avoiding tax on capital appreciation
As to the third benefit, if the original investment in the QOF is held for more than 10 years and that investment appreciates, the OZ investor can avoid tax on the capital appreciation by electing to increase its basis in the QOF to its then fair market value.
Recent regulations issued provide an extra bonus to renewable energy equipment owners in connection with this third benefit. When used equipment is sold, the seller often recognizes depreciation recapture, which is taxed at ordinary tax rates (higher rates than capital gain rates), even though the equipment may have been owned for several years. The recent regulations have indicated that this depreciation recapture, like the tax on any appreciation, can be tax-free if the investment in the QOF is held 10 years and the election above is properly made in connection with the sale of the interest in the QOF.
Qualified Opportunity Funds
QOFs are intermediaries that receive the capital gain proceeds and subsequently make qualifying investments, holding at least 90% of their portfolio in Qualified OZ (QOZ) property. QOZ property can be:
- An investment in the stock of a corporation or a partnership interest holding a newly formed or existing business located in an OZ, or
- A direct investment in QOZ business property, which includes tangible property used in a trade or business, such as energy-generating equipment.
In other words, a QOF can own qualified property directly or invest in a second entity that owns qualified property.
That second entity is referred to as a QOZ business and could be, for example, a flip partnership that owns renewable energy equipment. The QOF’s interest could take almost any form and could be all or a portion of the sponsor interest or all or a portion of the tax equity interest. The exception is that only invested capital gains qualify. Carried interests do not.
Forming a QOF is easy. The IRS has indicated that anyone can self-certify their own fund. Therefore, a QOF need not have any community investment experience or a dedicated community service mission, as is required, for example, by the federal New Markets Tax Credit program. A solar developer could take the capital gains from sales of projects to unrelated buyers, invest the gains in a QOF related to the owners of the solar development company, then invest the QOF monies in new assets acquired from unrelated sellers.
One should be careful here, because solar developers that sell their assets in the ordinary course of their business may be treated as “dealers,” and as such, the property is treated as inventory, causing the profit from the sale of the property to be characterized as ordinary income, and ineligible for this program.
Qualified Opportunity Zones
A QOZ is defined as a population census tract that is a low-income community and designated as a QOZ.
For a tract to qualify as a low-income community, it must meet at least one of three basic requirements:
- The poverty rate for a tract is at least 20%.
- In the case of a tract not located within a metropolitan area, the median family income for such tract cannot exceed 80% of statewide median family income.
- In the case of a tract located within a metropolitan area, the median family income for such tract cannot exceed 80% of the greater of statewide median family income or the metropolitan area median family income.
Of the tracts that meet these criteria, governors nominate some to qualify for this program, and the Treasury secretary certifies them. The IRS has published a list of all the tracts that serve as QOZs in the U.S. and Puerto Rico. The mapping tool can help you easily identify whether a location is in such a zone.
Qualified Opportunity Funds
In exchange for the deferral of tax, there are rules that encourage an investment by a QOF to make an impact in these communities. For example, the balance sheet of the recipient of a QOF should not contain too much of a type of investment that implies the QOF investment is too heavily focused on investment speculation – for example, by holding too much cash. In its simplest terms, this rule requires that less than 5% of the average aggregate unadjusted basis of the OZ business’s property be attributable to items such as debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other similar property. Therefore, stashing the cash in CDs in an attempt to preserve capital would be problematic.
Instead, the QOF should invest in either what is referred to as a QOZ business property or a QOZ business.
QOZ business property is tangible property used in a trade or business that was acquired by purchase from an unrelated person after Dec. 31, 2017, or an equity interest in a QOZ business. In this way, a QOF could own, for example, 100% of a solar farm, and assuming other criteria are met, this could conform to the program rules.
A QOF can also be a partner in a partnership or a shareholder of a corporation that is a QOZ business. Either the corporation or the partnership should own property that must be acquired by purchase by an unrelated party after 2017 and used in an OZ. This might be the strategy used in project finance for energy transactions, where the QOF holds an interest in a tax equity partnership that meets the criteria to also be called a QOZ business (see flowchart). Note that criteria must be met for a tax equity partnership to be treated as a QOZ business.
Application of OZ to renewables investments
We envision a QOF potentially filling several different slots in the capital stack. The QOF could serve as sponsor capital, cash equity, tax equity, or owner of a renewable asset in its entirety.
However, at least two investment opportunities in renewable energy assets do not appear to align well with the OZ program. The first is in connection with assets that have previously been constructed. Our renewables practice is serving many clients involved in transactions based on mature renewable assets – that is, investments after the investment tax credit or the renewable electricity production tax credit has expired, based largely on prospective cash flows. Under the OZ program rules, however, either:
- Equipment must have its “original use” in the zone, or
- The property must be “substantially improved” for it to qualify as QOZ property.
Property moved to a zone from another tract may satisfy the original use requirement, but that would be unusual. Property is substantially improved if, during a 30-month period, additions to the property’s basis exceed the property’s adjusted basis at the beginning of the period. Existing energy property usually doesn’t meet the mathematical requirement, but a repowering of a wind farm could do so.
Investments in a QOF must include an equity interest in the underlying Opportunity Zone business, so while some degree of leverage is usually needed in a renewable deal, a loan by a QOF of any sort would not be a qualifying use of QOF monies and would likely taint any favorable tax deferral. This would apply for both project-level and back-leverage debt.
Be careful when property is leased in a transaction; separate rules apply that could trigger noncompliance under the program rules.
Project finance versus operating businesses
So far, this article has discussed OZ only in the context of project finance, such as a single or a portfolio of solar assets. The program is much more dynamic, however, and may be used to fund companies such as development companies, operating and maintenance providers, manufacturers of equipment, or, for example, a company that owns and administers electric vehicle charging stations. Separate criteria apply to these companies.
The following are additional points you should know about the OZ program:
- There is no limit to the amount of capital gains that can be deferred by any taxpayer or nationwide by all taxpayers.
- The property sold that triggers the capital gain can be located anywhere, including outside an OZ.
- The statute does not limit the class of asset whose sales are eligible for the tax deferral and does not limit the type of assets that qualify as QOF investments. Instead, the program is flexible. CohnReznick anticipates that a broad range of industries will be leveraging this program. Theoretically, this could facilitate capital leaving the renewable energy industry and capital from the sale of other types of assets, such as real estate, entering the renewable energy industry.
- Because the statute does not prescribe the class of assets that are eligible, this program broadly applies across all renewable energy technologies (such as wind, solar, hydropower, and biomass).
- The entire amount of a capital gain need not be reinvested in a QOF to achieve some tax deferral. The amount reinvested in a QOF should equal the gain to maximize the tax benefit, but could be less than the gain if the investor is inclined to defer less than the entire gain or if the new investment needed is smaller than the gain realized. There are no job creation requirements under the OZ program.
- Davis Bacon wage requirements don’t appear to be triggered by participation in the program.
- There are no minimum return requirements for or reductions in the return on the investment made by the QOF for investments to qualify.
- Cash not connected with capital gains can be invested in a QOF, but this investment receives no favorable OZ tax treatment. (These are referred to as mixed-fund investments.)
- Distributions of cash flow from the QOF may trigger unanticipated taxes via “distributions in excess of basis.” Modeling the transaction is important to understand when these events are likely to occur and what impact they will have on return on investment.
- Tax losses generated by the QOZ business may not provide a timely benefit to QOF investors because of what are called outside basis limitations. Again, modeling the fund investment would reveal whether any limitations would apply.
- OZ formation and management can create opportunities for financial intermediaries experienced in the underwriting and asset management of renewable energy assets.
- Multiple investments in more than one asset may require a series of QOFs to accurately track the timeline related to each gain.
- Caution is advised regarding state and local taxation of the capital gains. Some jurisdictions have indicated that they will follow these new federal rules. If not, tax on capital gains due to these jurisdictions may not receive the same favorable treatment.
- A trap for the unwary is one in which the assets of the QOF are disposed of, rather than an interest in a QOF. All of the program benefits may not be available in this circumstance.
This article is not comprehensive. Therefore, we encourage you to speak to your CohnReznick advisor to be sure that your strategies align with the OZ program.
Watch for future articles, which will explore other technical rules and their application to renewable energy entities.