Opportunity zones have been a recurring topic in investment news lately, and for good reason. Created by the Tax Cuts and Jobs Act, new tax incentives now exist to stimulate investments in designated distressed areas known as Qualified Opportunity Zones (QOZ) throughout the United States and its possessions.

We woke reasonably late following the feast and free-flowing wine the night before. After gathering ourselves and our packs, we headed down to our homestay family’s small dining room for breakfast, where we enjoyed scrambled eggs, toast, mekitsi (fried dough), local jam and peppermint tea.

Opportunity zones: Tax incentives

Internal Revenue Code Sections 1400Z-1 and 1400Z-2 (and to date, two sets of clarifying proposed regulations) provide rules permitting taxpayers to defer recognition of capital gains from the sale of a property, in some cases permanently. To qualify for these incentives, you must invest cash from capital gains in a qualified opportunity fund (QOF), which is an investment vehicle organized as a corporation or partnership having the purpose of making qualified investments in a QOZ.

Gain deferral

If you are generating capital gains from the sale or exchange of property, you may elect to defer recognition of such gains and invest them in a QOF within 180 days of the sale or exchange. More lenient investment timing rules are available for capital gains flowing through Schedules K-1 related to partnership investments. This deferral opportunity applies to capital gains from sales or exchanges occurring on or before December 31, 2026. You may defer elected capital gains until the earlier of December 31, 2026, or the date of a partial or complete sale or exchange of a QOF investment.

Deferred gain exclusion

In addition to deferral, special-basis rules have the effect of permanently reducing the original deferred gain when your QOF investment meets specified holding periods:

• 10 percent gain exclusion – QOF investment held for a 5-year period ending on or before December 31, 2026.
• Additional 5 percent gain exclusion – QOF investment held for a 7-year period ending on or before December 31, 2026.

Post-QOF investment gain exclusion

If you hold a QOF investment at least 10 years, you are eligible for an additional tax incentive. By statute, your basis in a QOF investment increases to its full fair market value upon sale, which renders 100 percent of post-QOF investment appreciation tax-exempt. This exemption of post-QOF investment gain is the centerpiece of the tax incentive package offered in the opportunity zone provisions.

State jurisdictions have taken different tacks relative to the tax treatment of QOF investments, with some adopting the federal rules in full, and others decoupling from federal law. In some cases, states have rejected both the capital gain deferral provisions and post-appreciation gain exemptions.

Opportunity zones: Energy applications

Energy executives experiencing capital gains from monetization events may wish to consider taking advantage of these new QOZ tax incentives. An investment in a QOZ can be a tax-efficient way of realizing and enhancing investment returns, while at the same time achieving the government’s policy objective of providing relief to economically distressed areas.

For those familiar with like-kind exchanges, QOZ investments are in some ways more flexible than such exchanges in that sellers may receive sales proceeds directly, replacement assets do not need to be of like kind, and the deferral election for partnership gains is available at the partner level. On the other hand, QOZ investments require certain maintenance and compliance testing on an ongoing basis, which make them more administratively burdensome.

Many designated QOZs are located in energy-producing areas conducive to QOF investment projects. In the upstream space, the QOZ tax incentives may be available for acquisitions and development of leasehold interests. Acquisitions of undeveloped leasehold interests are generally easier to navigate than acquisitions of developed leasehold interests because of the potential for meeting the “original-use” requirement discussed below. Acquisitions of developed leasehold interests elicit larger challenges because they fail the “original-use” requirement, and therefore must be “substantially improved.” Questions exist as to the application of the original-use and substantial improvement rules to oil and gas leasehold interests, requiring analysis on a facts and circumstances basis. Midstream infrastructure build-outs and renewables projects may also be viable QOF investment candidates.

Opportunity zones: Requirements

QOFs must comply with a number of detailed rules prerequisite to your enjoyment of the above-described tax incentive benefits. These rules are designed to ensure elected capital gain dollars invested in QOFs accomplish the primary purposes of the opportunity zone legislation, which are to stimulate designated distressed areas through, among other things, new job creation and commercial activities, aesthetic upgrades, and incremental tax revenue sources. Following is a brief summary of the requirements:

• The QOF serving as the investment vehicle must be properly established, which is a relatively simple process.
• A QOF receiving investment dollars must put those dollars to use within 6 months, holding at least 90 percent of its assets in the form of QOZ property, which includes QOZ business property, QOZ corporation stock, and QOZ partnership interests.
• QOFs investing in QOZ business property must meet the following requirements:
  • Property must be tangible property used in a trade or business.
  • Property must be purchased from an unrelated party.
  • The original use of the tangible property must begin with the QOF, or if not original use, the property must be “substantially improved” within 30 months of the acquisition of the property.
• QOF’s investing in QOZ corporate stock or QOZ partnership interests must meet the following requirements:
  • Shares of stock or partnership interests must be acquired directly from the corporation or partnership solely for cash.
  • The corporation or partnership must operate a QOZ business, passing:
    • A test requiring at least 70 percent of all owned or leased tangible property be used in a QOZ.
    • An income and assets test requiring:
      • At least 50 percent of gross income be derived from the active conduct of a trade or business in the QOZ.
      • A substantial portion of any intangible property be used in the active conduct of a trade or business in the QOZ.
      • Less than 5 percent of the aggregate unadjusted bases of the property of the trade or business be attributable to portfolio assets.

Our energy team stands ready to help you assess QOZ incentive opportunities. Please contact us to discuss how we can help.

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.

We envision a Qualified Opportunity Fund (“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 a property is leased in a transaction; separate rules apply that could trigger noncompliance under the program rules.

Project Finance Versus Operating Business

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 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.