The Opportunity Zones program is an attractive option for industrial-scale solar energy producers seeking to develop new projects that receive preferential tax treatment. Designed to stimulate economic development in low-income communities by providing tax incentives to investors, the Opportunity Zones program would allow solar developers to defer capital gains taxes so long as such gains are reinvested in a qualified area. This alert provides an overview for solar developers interested in utilizing the Opportunity Zones program.
The Opportunity Zones program was established by the Tax Cuts and Jobs Act of 2017 (the “Act”). Under the Act, certain economically-distressed communities can qualify as Opportunity Zones if they are nominated by a state’s governor and are certified by the Secretary of the United States Treasury. These designations remain in effect until the end of the tenth calendar year following the designation. Currently, there are approximately 160 Qualified Opportunity Zones in Missouri, and over 300 Qualified Opportunity Zones in Illinois.1
All developers investing in economically distressed communities through the Opportunity Zones program are offered three tax incentives:
- Temporary Deferral. Investors can defer tax on prior capital gains reinvested in a Qualified Opportunity Zone until the earlier of the date of disposition of the Opportunity Zone investment and December 31, 2026.
- Step-Up in Basis. Investors receive a step-up in basis for capital gains reinvested in a Qualified Opportunity Zone. The basis is increased by 10% if the investment is held for at least five (5) years, and by an additional 5% if held for at least seven (7) years.
- Permanent Exclusion. If held for at least ten (10) years, capital gains from the sale or exchange of an investment in an Opportunity Zone may be permanently excluded from capital income.
The Qualified Opportunity Fund
To take advantage of the Opportunity Zones program’s tax incentives, the investor must establish a Qualified Opportunity Fund. An Opportunity Fund is an investment vehicle organized for the purpose of holding Qualified Opportunity Zone Property. Under the Act, a large variety of taxpayers may establish an Opportunity Fund, including corporations, partnerships, limited liability companies and individuals. However, at least 90% of an Opportunity Fund’s assets must consist of Qualified Opportunity Zone Property. Opportunity Zone Property includes the stock, a partnership interest, or the tangible property (also referred to as Qualified Opportunity Zone Business Property) of a Qualified Opportunity Zone Business.
Solar Energy Production is a Qualified Opportunity Zone Business
Most solar energy production is likely to meet the requirements of a Qualified Opportunity Zone Business under the Act. A Qualified Opportunity Zone Business is a trade or business in which:
- Substantially all of the tangible property owned or leased by the business is Qualified Opportunity Zone Business Property;
- At least 50% of the total gross income of the business is derived from the active conduct of the business;
- A substantial portion of the intangible property of the business is used in the active conduct of the business; and
- Less than 5% of the original cost to purchase all of the property for the business is attributable to nonqualified financial property (such as certain debt, stock, partnership interests, options and future contracts, but specifically excluding reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less, or similar debt instruments).
A solar energy producer can proactively satisfy items 1 and 4 above by making appropriate siting and financing choices. Whether solar energy production can satisfy items 2 and 3 above and thereby qualify as a Qualified Opportunity Zone Business requires a more nuanced analysis.
Although the term “active conduct” is not defined in the Act, recently proposed regulations released by the Department of Treasury on May 1, 2019 provide for a test which considers (i) the tangible property located within the Opportunity Zone, and (ii) the management/operational functions performed within the Opportunity Zone. Under this test, the 50% gross income requirement is met if the tangible property of the business located within the Opportunity Zone and the management or operational functions performed for the business within the Opportunity Zone are each necessary to generate 50% of the gross income of the business. These proposed regulations also provide that the ownership and operation (including leasing) of real property used in a business is treated as the “active conduct” of the business.
Therefore, most solar energy developments located within an Opportunity Zone should satisfy the requirements of a Qualified Opportunity Zone Business since (i) the substantial tangible property used in solar energy production combined with (ii) the operational functions necessary to maintain such facilities are likely to generate a substantial portion of the business’s gross income. Accordingly, solar energy producers should consider developing new projects in an Opportunity Zone through a Qualified Opportunity Fund to take advantage of the program’s tax incentives.