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May 6, 2019

Stroock Special Bulletin

By: Michelle M. Jewett

The 2017 Tax Cuts and Jobs Act (“TCJA”) created a new incentive for investment in qualified low income communities known as qualified opportunity zones (“QOZs”).  The new provisions under Sections 1400z-1 and 1400z-2 of the Internal Revenue Code of 1986, as amended (the “Code”) are designed to promote long-term growth in economically distressed areas by providing special tax benefits to taxpayers that would otherwise recognize taxable gain from a sale or exchange of capital assets, provided that the amount of such gain is reinvested into qualified opportunity funds (“QOFs”) (as defined below).  Two sets of proposed Treasury Regulations provide additional guidance with respect to some aspects of the QOZ program.[1] The QOZ program provides developers in the energy and infrastructure sector with a new source of capital for investment into projects constructed in the QOZs. This bulletin provides an overview of the QOZ provisions, including the proposed Treasury Regulations, and discusses tax strategies related to using such provisions for investments in renewable energy projects.

Tax Benefits Available for Investments in a QOF

If a taxpayer reinvests all or a portion of the taxable capital gain recognized on a sale or exchange into a QOF within 180 days of such sale or exchange, the taxpayer will thereby become eligible for the following tax benefits with respect to such reinvested gain.

  • Temporary Deferral. Deferral of tax until the earlier of (i) the sale of the QOF or (ii) December 31, 2026. Unless the taxpayer disposes of its interest in a QOF prior to December 31, 2026, all deferred gains will be required to be recognized in 2026 (subject to the basis adjustment rules discussed below).
  • Partial Basis Step-Up. An increase in the taxpayer’s tax basis (of 10% of the deferred gain) in the QOF after holding the QOF for 5 years, and an additional increase (of 5% of the deferred gain) after holding the QOF for 7 years. After the investor’s deferred gain (reduced by such basis step-ups) is recognized, the basis is increased by the amount of the deferred gain recognized.
  • Exclusion of Gain From Income. If the QOF interest is held for 10 years or more, elimination of any taxable gain on ultimate sale of the QOF (i.e., no tax would be owed on the appreciation in value of the QOF interest after its initial acquisition by the taxpayer). The ultimate sale must be of the QOF rather than the QOF’s sale of its assets for the gain to be excluded from the taxpayer’s income. The proposed Treasury Regulations clarify that even if gain is recharacterized as ordinary under the depreciation recapture rules, it is still excluded from income.

An investor that reinvests gain proceeds in a QOF takes a zero basis in its QOF interest with respect to the reinvested gain. The proposed Treasury Regulations provide that a taxpayer’s basis in the QOF interest is increased by its share of liabilities of the QOF if the QOF is treated as a partnership for U.S. tax purposes. As a result, investors in a QOF taxed as a partnership will, subject to general partnership taxation rules, be able to receive certain debt-financed distributions without incurring present tax or any deemed disposition of their QOZ investments. Investments in a QOF that are not made with gain proceeds are treated separately from and not eligible for the foregoing tax benefits.

Any taxpayer that recognizes capital gain for federal income tax purposes may be eligible for this benefit, including but not limited to individuals, C corporations (including “regulated investment companies” and “real estate investment trusts”), S corporations and partnerships (including LLCs taxed as partnerships). In the case of a partnership or LLC taxed as a partnership that elects to reinvest gain in a QOF, the deferred gain is not included in the distributive shares of the partners. To the extent the partnership does not elect to defer eligible gains, each partner can elect to defer their distributive share of the partnership’s eligible gain, provided the gain did not arise from a sale or exchange with a person related to that partner.

Relevant Definitions for Purposes of the QOZ Program

Qualified Opportunity Fund. A QOF is either a corporation or a partnership established for the purpose of investing in Qualified Opportunity Zone Property (“QOZ Property”) (as defined below), other than another QOF. At least 90% of the assets of a QOF must be QOZ Property. The 90% test is determined by averaging the percentage of QOZ Property held by the QOF as of: (i) the last day of the first 6-month period of the taxable year of the QOF; and (ii) the last day of the taxable year of the QOF.

Qualified Opportunity Zone Property. QOZ Property is either (i) “QOZ Business Property” or (ii) stock or partnership interests in an entity that is a “QOZ Business” at the time such interest was acquired and during substantially all of the QOF’s holding period for such interest.

Qualified Opportunity Zone Business Property.  QOZ Business Property is generally defined as tangible property (i) used in a trade or business of the QOF, (ii) acquired by purchase from unrelated parties after December 31, 2017, (iii) during substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in a QOZ, and (iv) (A) the original use of which begins with the QOF or (B) to which the QOF makes substantial improvements. A property is substantially improved by a QOF if, during any 30-month period beginning after the date of acquisition, additions to basis with respect to the property by the QOF exceed the adjusted basis of such property at the beginning of such 30-month period in the hands of the QOF. If a QOF purchases a building on land that is wholly within a qualified opportunity zone, substantial improvement of such building does not require the QOF to separately improve the land upon which the building is located.

Leased tangible property is treated as QOZ Business Property for purposes of satisfying the 90-percent asset test and the requirement that substantially all tangible property be QOZ Business Property, so long as: (i) the leased tangible property is acquired under a lease entered into after December 31, 2017; (ii) substantially all of the use of the leased tangible property is in a QOZ during substantially all of the period for which the business leases the property; and (iii) the lease is a “market rate lease” (i.e., the terms of the lease must reflect common, arm’s-length market practice in the locale that includes the QOZ). Additional requirements need to be satisfied if the lessor is a “related party.”

Qualified Opportunity Zone Business. A QOZ Business is a qualifying trade or business: (i) in which substantially all (more than 70%) of the tangible property owned or leased by the taxpayer is QOZ Business Property; (ii) at least 50% of the total gross income of such trade or business is derived from the active conduct of such trade business; (iii) a substantial portion of the intangible property of such trade or business is used in the active conduct of such trade or business; and (iv) less than 5% of the average of the aggregate unadjusted bases of the property of such trade or business is attributable to nonqualified financial property.

With respect to the income requirement, the proposed Treasury Regulations provide a facts and circumstances test and the following three safe harbors for purposes of determining whether at least 50 percent of its total gross income is derived from within a QOZ: (i) at least 50 percent of the services performed (based on hours) for such business by its employees and independent contractors are performed within the QOZ; (ii) at least 50 percent of the services performed (based on amounts paid for the services performed) for the business by its employees and independent contractors are performed in the QOZ; or (iii) both (1) the tangible property of the business that is in a QOZ and (2) the management or operational functions performed for the business in the QOZ are each necessary to generate 50 percent of the gross income of the trade or business. Note that for businesses that do not have their own employees, this still leaves open the question of how to determine the source of its income.

Nonqualified financial property generally includes stock, debt, partnership interests, options, futures, forward contracts, notional principal contracts and other similar property but does not include reasonable amounts of working capital. Proposed Treasury Regulations provide a working capital safe harbor for investments in QOZ Businesses that acquire, construct or rehabilitate tangible business property. As long as a QOZ Business has a written plan that identifies cash being held for a project and there is a written schedule for deployment of the cash that the business substantially complies with, the committed cash will be considered reasonable working capital for up to 31 months.

Renewable Energy

One type of investment that has attracted considerable interest for the QOZ program is renewable energy. An interest in a renewable energy facility located in a QOZ generally should be a qualifying asset for a QOF assuming that the facility satisfies the other requirements to be QOZ Business Property or a QOZ Business. Many QOZs are located in rural and urban areas that would be ideal for renewable energy projects. Since energy projects have useful lives far in excess of ten years, investors should be able to take advantage of all of the QOZ program’s tax benefits. Moreover, developers are eager to access an alternative source of capital because investors should be willing to accept lower pre-tax returns given the tax benefits available under the QOZ program.

The following is an example of how a renewable energy facility could be developed to take advantage of the QOZ program. A developer forms an LLC that will become a QOF and the LLC purchases land located in a QOZ in 2018. The QOF then forms an LLC treated as a disregarded entity (“ProjectCo”) and contributes the land to ProjectCo. ProjectCo in turn constructs a solar energy facility using contributions made by investors to the QOF with reinvested capital gain proceeds that are contributed to ProjectCo. ProjectCo has a written plan that identifies cash being held to construct the facility and complies with a written schedule for deployment of the cash. ProjectCo finishes construction of the facility within 31 months. The solar facility is actively engaged in generating electricity that is supplied to the grid and sold to a utility.

An investor in the QOF that reinvests gain proceeds in the QOF in 2019 will get a basis step-up equal to 10% of its gain after 2023 and an additional basis step up of 5% after 2025. 85% of the investor’s gain will be recognized in 2026. Thereafter, if the investor holds the investment until 2029, it can sell its interest in the QOF or have its interest in the QOF redeemed without paying tax on the appreciation.

There are a variety of ways that the economics could be structured. Since the investor can avoid paying any tax on gain if it holds its investment for 10 years, it has a strong incentive to have most of its return from the investment be in the form of appreciation rather than current cash distributions. The developer may prefer getting a disproportionate share of operating cash flow in exchange for facilitating a structure that is providing the investor with significant tax benefits and agreeing to pay the investor a disproportionately high purchase price upon redemption. However, the investor may want sufficient cash distributions to allow it to pay taxes on its allocable share of the QOF’s income. Note, however, that it is possible that the IRS will create anti-abuse rules to address situations where the QOF investor receives no cash flow from the QOF and has a significantly increased upside on the residual value of the QOF’s investment.

Meanwhile, the developer would benefit from the low-cost ?nancing in a number of ways. The investor’s contributions could enable the developer to fully complete project ?nancing

without incurring debt or contributing substantial equity. Alternatively, the lower cost financing could enable projects generating less cash flow to be economically viable for the sponsor. In addition, raising capital through a QOZ structure could allow a renewable energy project sponsor to finance the project without needing to deal with the complexity, costs and risks associated with tax equity structures. In addition, the QOZ program could provide tax benefits for investments in renewable energy property that would not be eligible for the federal renewable energy tax credits, such as storage and transmission assets.

Utilizing the QOZ Program and Other Renewable Energy Tax Incentives

It is also possible to combine use of the QOZ program with the traditional tax incentives[2] available for renewable energy, possibly using traditional structures involving tax equity investors. Note, however, that this will entail significant complexity in terms of optimizing cash flows, tax benefits and technical partnership tax issues.

For example, the back leverage in a partnership flip structure could be replaced with an investor seeking to roll over gains into a QOF. The developer would form a partnership that would elect to be treated as a QOF. The QOZ investor would contribute rollover gains to the QOF and the developer would contribute additional capital. The QOF in turn would invest in a partnership with a tax equity investor. As would be typical, the partnership allocates 99% of income, loss and tax credits to the tax equity investor until it reaches a target yield. Cash is shared in a different ratio. After the yield is reached, the investor’s share of everything drops to 5% and the developer has an option to buy the investor’s remaining interest. The cash distributed to the QOF and income allocated to the QOF after the initial five-year period would be disproportionately allocated to the developer. The QOZ investor would be able to benefit from the QOF’s retention of 95% of the value of the project in addition to the tax benefits from the QOZ program.

An inverted lease structure could be used for a solar ITC project if the tax equity investor is interested less in the depreciation deductions generated by the project. Since the ITC can be passed through to a lessee, the tax equity investor could own the lessee and receive the ITC. The depreciation deductions would then be claimed by the QOF and could offset operating income of the QOF from the lease payments. This structure also permits the QOF to retain the project after the lease has expired, thereby allowing the QOF investor to capture the residual value when it sells its interest in the QOF after ten years.

The obvious way to marry the QOZ program with the tax incentives for renewable energy projects would be to form a QOF where the QOF investor also acts as the tax equity investor. Although conceptually it would be ideal to allocate substantially all of the tax credits and depreciation to the QOF investor, the partnership would be unable to do so because the investor would have a zero tax basis in its QOF interest as a result of contributing rolled-over capital gain and therefore could not be allocated any accelerated depreciation. Moreover, if the QOF investor is an individual, there would be other limitations, including the at-risk rules and passive activity loss rules that would also limit the ability of the investor to use these incentives. The developer would be subject to the same loss limitations. If the QOF incurs debt, the investor’s allocable share of such debt would increase its tax basis in the QOF interest and may allow the investor to utilize some of the renewable energy tax incentives. However, there would still be inefficiencies because there would be a portion of the tax incentives that would go unused. Accordingly, it may be difficult for the same investor to use the tax benefits of the QOZ program and the renewable energy tax incentives.


For More Information

Michelle M. Jewett


[1] For a discussion of the proposed Treasury Regulations, see “Stroock's Take on the New 'Qualified Opportunity Zone' Guidance,” available here; “They're Out! Stroock's Take on the Second Set of Proposed QOZ Regulations,” available here.

[2] The primary federal tax incentives available for renewable energy are the production tax credit (“PTC”), investment tax credit (“ITC”), and accelerated depreciation. PTC under Section 45 of the Code is available for each kilowatt hour produced from wind and certain other renewable technologies for a period of 10 years from the date the facility was placed in service. If a wind facility begins construction on or after January 1, 2017, the PTCs are phased out by 20% per year until they are completely phased out for projects that begin construction after December 31, 2019. Alternatively, taxpayers may elect to use the 30 percent ITC in lieu of the PTC with the same phase down schedule. The solar ITC under Section 48 of the Code currently awards a tax credit equal to 30 percent of a project’s qualifying capital expenditures. The ITC is subject to an annual phase down of the credit to 10% for projects commencing construction after January 1, 2020, with all projects required to be “placed in service” by January 1, 2024. Renewable energy property is generally depreciable over five years on an accelerated basis.  However, changes under the TCJA permit the immediate expensing of renewable energy property in the year in which the property is placed in service.

This article is for general information purposes only. It is not intended as legal advice, and you should not consider it as such.


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