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New OZ Guidance Provides Clarity but RETC Investors Must Act Quickly
The second tranche of opportunity zones (OZ) regulations have provided renewable energy tax credit (RETC) investors additional clarity. This is particularly welcome for investors wishing to claim an investment tax credit (ITC) for a solar property in conjunction with the OZ inventive and it’s possible this additional clarity will help some investors move off the fence.
About the OZ Incentive
The OZ incentive provides tax benefits for taxpayers with capital gains who invest these gains into qualified low-income areas that have been designated by the Secretary of Treasury. The benefits are available when a taxpayer invests, within 180 days, gains from a capital transaction into a qualified opportunity fund (QOF) that invests at least 90 percent of the gains in qualified OZ property.
The tax benefits realized by OZ investments include a deferment of federal taxes on the capital gains invested until 2026. If a taxpayer holds the investment for at least five years, 10 percent of the initial capital gains will be reduced. If a taxpayer holds the investment for another two years, an additional 5 percent of the initial capital gains will be reduced. This is important because the additional 5 percent benefit ceases to exist if the investment is made after Dec. 31, 2019. If a taxpayer holds the investment for 10 years in total, gains realized upon disposition are potentially federal income tax free.
Key Timeline Considerations
The way the OZ timeline for investment lines up with the ITC investment timeline, specifically the significance of Dec. 31, 2019 for both, makes quick action imperative. Dec. 31, 2019 is the date by which the beginning of construction requirement for the 30 percent ITC must be met, and the date by which the investment requirement for QOZ investments to receive the additional 5 percent capital gain reduction must be met.
A taxpayer may claim an ITC of a percentage of qualified expenditures for the solar property. Expenditures with respect to the property are treated as made when the installation is completed. The ITC for all solar property features a gradual step down in the credit value:
Pairing RETC with OZ
What does this mean for pairing the ITC for solar properties with the OZ? First, solar property can qualify as qualified OZ property. To achieve the maximum ITC, construction must have begun by Dec. 31, 2019. As detailed in IRS Notice 2018-59, there are two methods for establishing the date construction of a solar property has begun for ITC purposes: the physical work test and the 5 percent safe harbor test.
- Physical work test. Construction of the solar property begins when physical work of a significant nature begins. Work performed by the taxpayer or by other parties under a binding written contract to manufacture, construct or produce the solar property, or any of its components for use by the taxpayer, is taken into account to determine whether construction has begun. The physical work test focuses on the nature of the work performed and not the cost of the property. Both off-site and on-site work may be taken into consideration for the test but costs that are inventory by nature are not included.
- 5 percent safe harbor test. Construction of the solar property will be considered having begun if the taxpayer pays or incurs 5 percent or more of the total cost of the solar property and makes continuous efforts to advance towards completion of the property. Total cost of the solar property includes all costs properly included in the depreciable basis of the property. The total cost does not include land or any other property not integral to the solar property. Cost overruns will be included in the total cost of the solar property.
Regardless of which method is chosen, there must be continuous progress towards completion once the beginning of construction has been established. Investors can maximize the benefits of ITC and OZ incentive by pairing them, as long as they act by the end of 2019. A qualified OZ investment into solar property could be used to meet the ITC begin construction test to preserve the 30 percent ITC while boosting investor yields.
- With time ticking away to make investments before the end of 2019, the recently released regulations provide two points of clarification that would be of interest to ITC investors:
- The regulations state the 10 year basis step-up will permit basis adjustments to the QOF’s assets including assets subject to ordinary income treatment under Internal Revenue Code Section 751 (751 income), which includes recapture of depreciation of personal property. To take advantage of this benefit after Year 10, the investor should to sell its interest in the QOF, because the 751 income may not be excluded if the exit involves the QOF selling its assets. This may ease the mind of many RETC/OZ investors who were concerned about the potential ordinary income event upon the sale of their interest in the QOF followed-by an off-setting capital loss.
The expansion of the working capital safe harbor now includes the development of a trade or business as well as the acquisition, construction and improvement of tangible property. This provides additional comfort to QOFs looking to invest in businesses that will be acquiring assets, not just constructing renewable energy projects.
These developments are welcome news for investors. Time, however, is of the essence if investors want to line up their ITC investments with OZs.