Pairing NMTCs with Opportunity Zone Incentives
Question: Can a new markets tax credit (NMTC) qualified equity investment (QEI) also qualify for qualified opportunity zones (OZ) incentives?
Answer: There is nothing in the OZ statute that precludes a QEI from qualifying for OZ incentives. However, OZ is a new tax law and it is expected that guidance will be issued by Treasury. This guidance could impose restrictions.
About Opportunity Zones
The OZ incentives allow investors to defer (up to nine years) paying tax on gains if those gains are invested in qualified opportunity funds (QOFs) that in turn invest in OZ. OZs are generally 25 percent of a state’s low-income communities designated by the governor. To qualify, the gain must be invested in the QOF during a 180-day period that begins on the date of the sale or exchange that generated the gain. The deferral is temporary, as H.R. 1 (the legislation enacting opportunity zones) requires the gain be recognized on the earlier of Dec. 31, 2026, or the date the investment in the QOF is sold or exchanged. The amount of gain includible is the lesser of the amount of gain originally deferred or the excess of the fair market value of the investment over the taxpayer’s basis in the investment. For this purpose, the taxpayer’s basis in the QOF is deemed to be zero except as adjusted as discussed below.
In addition to the deferral of gain, the provision incentivizes long-term investment by allowing for partial forgiveness (up to 15 percent) of the deferred gain. This is accomplished by allowing for a modest step-up in basis for investments that are held beyond five and seven years. For investment held at least five years, the taxpayer’s basis is increased by 10 percent of the original gain. For investments held for at least seven years, the taxpayer’s basis is increased by an additional 5 percent of the original gain.
Furthermore, as an additional incentive to make long-term, patient capital investments, taxpayers holding QOF investments for a period of at least 10 years are exempt from any additional gains beyond that which was previously deferred. This is accomplished by allowing taxpayers to elect for the basis of their investment to be equal to its fair market value on the date the investment is sold or exchanged.
How it could work
In order to pair NMTC with OZ, a community development entity (CDE) would need to obtain the status of a QOF (CDE/QOF). A QOF is any corporation or partnership organized for the purpose of investing in qualified opportunity zone property (QOZP) and that holds at least 90 percent of its assets in such property. QOZP includes equity investments made to qualified opportunity zone businesses (QOZB). Although the definition of a QOZB under OZ is different from a qualified active low-income community business (QALICB) under NMTC, there are similarities and many QALICBs are likely to meet the definition of QOZB.
A significant difference between NMTCs and OZ is that NMTCs are generally used to subsidize loans to QALICB, while QOF are required to use funds to make equity investments in QOZB. As a result, CDEs seeking to pair OZ incentives with NMTCs will be required to make their qualified low-income community investments (QLICIs) in the form of equity investments to QALICBs, which may not be generally consistent with their approved business strategy. As a result, some CDEs may need to obtain approval from the CDFI Fund to make equity investments.
Equity QLICIs could give investors concern over their preference to minimize NMTC recapture risk through reliance on the reasonable expectation safe harbor. Treasury’s definition of control frustrates an investor’s ability to rely on this safe harbor if a CDE makes a majority interest equity investment in a QALICB. However, the added benefits of OZ may outweigh investor preferences for reliance on reasonable expectations.
Longer Holding Period
Investors normally exit NMTC transaction after seven years, when the investor has received all of the NMTCs for which it is eligible. OZ investors are required to hold investments for 10 years to be exempt from any gains realized when the investment is sold. Although, it is not customary for QEIs to appreciate in value, NMTC investors normally recognize capital gains at unwind due to a negative capital account caused by required NMTC basis adjustments. Investors holding QEIs in CDE/QOFs may want to extend their investment-holding period for an additional three years to take advantage of additional deferral and possible gain exemption.
Investors investing gains as QEIs into CDE/QOFs initially have a zero basis in their investment. If an NMTC investor doesn’t have sufficient basis in its QEI to absorb the NMTC basis adjustment, then the investor may not be able to claim the NMTC. As a result, investors looking to pair NMTC with OZ may not be able to elect deferral on the entire QEI. It is common for investors to use a leveraged structure when making NMTC investments. Under the leveraged structure, NMTC investors borrow a portion of their QEI. Investors limiting gain deferral to the equity portion of a leveraged NMTC investment should have sufficient basis in the debt portion of their QEI to absorb the NMTC basis adjustment.
Pairing NMTC with OZ incentives can be complicated; however, the added benefits may be well worth the added complication. Please consult your Novogradac & Company LLP tax credit adviser for any questions regarding pairing OZ with NMTCs.
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