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Renewable Investing in the Land of Opportunity Zones
When the opportunity zones (OZ) provisions (Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code) became law as part of 2017 tax reform, there was a lot of concern that the new tax break would not be particularly beneficial to the development of renewable energy projects.
There were many perceived problems: For example,
- These projects tend to decline in value with the passage of time.
- Their ultimate disposition can yield “deprecation recapture,” which was thought to (possibly) be ineligible for the no-tax-after-10-years feature of the OZ provisions.
- Investors start with a zero basis in their investment for a transaction that is expected to generate losses and a negative tax credit basis adjustment.
- It wasn’t clear if a renewable project is an “active trade or business” to qualify as a qualified OZ business.
A little over two years later, we have had two rounds of proposed regulations, 544 pages of final regulations, a website with frequently asked questions, tax forms and instructions. In general, we have a lot of answers to our questions and concerns. Renewables can be a worthy investment for a qualified opportunity fund (QOF), or the subsidiary qualified OZ businesses in which QOFs invest, provided the transaction is carefully structured, and the parties realize what they can and cannot get.
As always when discussing OZs, it’s a good idea to start with the OZ basics:
- A taxpayer who has a capital gain (the original gain) from the sale of some asset (which needn’t have anything to do with renewables) generally has a 180-day period from the date of sale in which to invest up to that amount in a QOF. This includes a gain from the sale of an IRC Section 1231 asset (i.e., an asset used in a trade or business, like rental real estate). There are some exceptions we won’t go into here.
- If the taxpayer does invest the gain in a QOF, then the taxpayer defers tax recognition of the corresponding income attributable to the original gain until Dec. 31, 2026, or the day that an “inclusion event” occurs, if earlier.
- The taxpayer starts with a zero basis in this QOF investment, as a somewhat clumsy way of keeping track of how much gain is yet to be recognized, and that basis will be increased by 10 percent of the invested original gain after five years. This generally has the effect of reducing the taxpayer’s gain recognized on Dec. 31, 2026, and therefore, its tax liability, by 10 percent.
- If the investment has declined in value at the recognition date (whether that is Dec. 31, 2026, or the date of an inclusion event), then the lower value is used instead of the deferred original gain to compute the taxpayer’s tax liability.
- If the investment is held for at least 10 years, then a sale of the QOF interest, a sale by the QOF of its investment or a sale of assets by a qualified OZ business in which the QOF invests, will all get a basis step-up to fair market value. This will generally mean that such a sale doesn’t generate a tax liability.
Of course, there are dozens of technical rules. In particular, both QOFs and the qualified OZ businesses in which they invest must conduct business in one of the approximately 8,000 designated OZs, and they are subject to an enormous maze of six-month, 30-month, 31-month, 180-day, 5 percent, 20 percent, 50 percent, 70 percent and 90 percent tests which must be complied with in order to get the benefits described above. The reader is reminded that you have just read the world’s shortest summary of hundreds of pages of law and IRS commentary on OZs and you should not rely on this summary without talking to an expert about your particular facts.
This brings us to investments in renewables, and a few observations:
- Timetables for Finishing the Facility. OZ rules allow a qualified OZ business 31 months in which to sit on an investment and build a facility, provided it is done pursuant to a written plan. This can be extended to 62 months in appropriate cases, and even longer where a delay is due to seeking government approvals. Consistent with the approvals, it shouldn’t be hard to undertake almost any kind of renewables project. If that amount of lead time is insufficient, it should be possible to start a project in an independent entity, and then have a QOF invest when the project gets within these timetables. Projects that can be finished in very short time frames (typically less than six months) might even be held directly by a QOF from start to finish, although this may require more diligence and attention to the six-month testing dates that apply to a QOF than most investors care to undertake.
- One Investor or Two? Remember that there is no requirement that the QOF investor be the one claiming the tax credits. On the other hand, without credits, the investor’s return will be based entirely on getting enough of a share of cash flow and the residual to justify the investment. With the actual project likely declining in value over the years, this may require giving the OZ investor a larger share of the residual than the project sponsor would like. It probably makes more sense for the OZ investor to also be the tax equity investor.
- Need for Debt. Investment tax credit projects done using the single-tier “flip” model call for a basis reduction equal to half the credit. For example, a $100 project that generates a $30 credit gets a $15 basis reduction. If all of the cost of the project comes from sponsor-managing member and QOF-investor member (IM) capital, say, $70 and $30, and the investor’s basis in its QOF interest is zero, then the investor can’t absorb the $15 basis reduction. So, QOF investing makes more sense with a little debt. On our facts, just $15 of nonrecourse debt can be 99 percent allocated to the IM giving it enough basis to cover its 99 percent of the $15 basis reduction. Of course, this will still result in the losses (associated with depreciating the facility) being suspended (because using them also requires basis), but it also assures that the IM will have losses available to absorb any profits that may be allocated in future years.
- Active Trade or Business. It’s not clear whether the operation of an energy generating facility is an “active trade or business.” Much of the IRS commentary to date has centered on triple-net leases (which do not qualify). This suggests that either a qualified OZ business (owned as a subsidiary of a QOF) should undertake the actual power sales and maintenance of the facility, or the QOF should directly acquire the facility, since the “active” requirement only applies at the qualified OZ business level.
- The Lease Pass-through Method. Lease pass-through or inverted lease structures, where the investor invests in the lessee of the facility are unlikely to work with OZ investing. The lessee will have little in the way of tangible assets, as generally required to meet the OZ requirements, and it may even hold an interest in the landlord, which is likely to fail the no-more-than-5 percent test that applies to nonqualified financial property held by qualified OZ businesses.
- Reduced Tax Bill. Investing in a QOF will enable the investor to delay the tax liability until the 2026 tax year, and that tax liability itself may be substantially reduced. By 2026, the tax credits will have been claimed and the facility will be a few years old, with the investor’s interest scheduled to flip to something smaller (often a lot smaller) than the 99 percent that it was in the first five or six years. For example, our IM in the example above invested $30, but the interest might be worth $2 or $3 (based on an IM flipped-to-10 percent interest in our $100 facility being worth $50 a few years later). Even without the flip, the investment is pretty certain to be worth less in 2026 than when it was made.
- The No-Tax-After-10-Years Benefit. The other benefit associated with OZ investing is not paying tax if the investment (or, thanks to the final regulations, the underlying assets) are sold 10 or more years later. Of course, in renewables the typical IM is bought out by Year 6 or so. That doesn’t mean that OZ investing doesn’t work with renewables, but it does mean that either (A) one of the OZ benefits will go unused, or (B) we may see a new kind of investor prepared to pay a bit more at the beginning in exchange for a share in the facility’s value at Year 10, for which it won’t have to pay tax, even though (outside the OZ world) this would give rise to depreciation recapture taxed at ordinary rates.
- Individual Investors. Remember that many of the OZ funds are populated by individual investors, for whom the many complications associated with the passive activity and at-risk rules apply. These limitations don’t disappear because of the OZ tax rules. Some investors may have passive income from other sources that can be offset with these losses and credits, and there are deal structures to address the at risk rules, at least as to tax credits, while we’ve already observed above that the losses will be suspended anyway. In short, these are limitations that can be worked with, but expert advice is probably required.
Bottom line: Renewables and OZ investors can make a fine combination provided there is appropriate attention to the fine details of the investment.
Forrest David Milder is a partner with Nixon Peabody LLP. He has more than 30 years’ experience in tax-advantaged investments including the tax credits that apply to affordable housing, energy, new markets and historic rehabilitation, as well as the tax treatment of partnerships and LLCs, tax-exempt organizations, and structured financial products. He can be reached at (617) 345-1055 or [email protected].
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