The Tax Cuts and Jobs Act of 2017 (better known as the tax reform bill) created a significant—and little-discussed—economic development program that encourages long-term investments in so-called “Opportunity Zones” by offering temporary tax deferral for capital gains re-invested in the Opportunity Zone and a permanent exclusion for gains from the Opportunity Zone investment. This program has the potential to be one of the most significant economic development programs in the country and has broad applicability to a variety of industries. Any person or business seeking to invest capital, raise capital, or that will recognize significant capital gains in the next few years should be aware of the benefits of this program.
What are Opportunity Zones? Opportunity Zones are low-income areas (determined on a census tract basis), which are designated by the governor of each state as Opportunity Zones. Each governor must designate his or her state’s Opportunity Zones from the pool of eligible low-income census tracts and certain contiguous tracts. Not every low-income census tract can be designated an Opportunity Zone. States are limited to designating 25% of their low-income tracts, and 5% of their contiguous tracts as Opportunity Zones. Governors must designate their state’s Opportunity Zones by March 21; a governor may seek a 30 day extension of this deadline.
What investments qualify? Investments in Opportunity Zones must be made via “Opportunity Funds,” which are to-be created private sector investment vehicles that invest in Opportunity Zones. Opportunity Funds must then invest in stock, partnership interests, or business property of qualified opportunity zone businesses. Right now, the Opportunity Zone program is industry agnostic; any type of business can qualify. It’s possible that the IRS may issue regulations restricting certain types of businesses from qualifying (as it has in other programs), but it’s unlikely that the IRS would prohibit energy infrastructure projects from qualifying as opportunity zone businesses.
The bottom line is that energy infrastructure projects in Opportunity Zones may have access to an additional source of (lower-cost) capital than projects outside of Opportunity Zones.
What are the tax benefits? The potential tax benefits from investment are significant and include:
- A temporary tax deferral for the capital gains that are invested in the Opportunity Fund. The deferred gain is taxable on the earlier of (i) the date on which the investment in the Opportunity Fund is sold, or (ii) December 31, 2026.
- A step-up in basis for the capital gains invested in the Opportunity Fund. The benefit of the step-up increases the longer the investment is held: The basis of the original investment is increased by 10% if the investment is held by the taxpayer for at least 5 years, and by an additional 5% if held for at least 7 years.
- A permanent exclusion from taxable income of capital gains from the sale or exchange of an Opportunity Fund investment, if the investment is held for at least 10 years.
To receive the program’s tax benefits, investors must invest capital gains within 180 days of receipt in an Opportunity Fund.