Real estate ventures are swarming the 2017 tax law’s opportunity zone incentives, and renewable energy investors may soon join the party.
The first round of proposed rules (REG-115420-18) for the tax breaks predominantly paved the way for, and favored, real estate investment. The second batch (REG-120186-18), released April 17, outlined how the new tax incentives will work for operating businesses—with a game-changing clarification for capital-heavy industries like clean energy.
The new rules provide some certainty that certain tax benefits, like accelerated depreciation, won’t come back to haunt investors later. That could spur a surge of new interest in using the incentives for renewable projects, according to tax and finance professionals.
“We were not seeing the flood of capital that we’d wanted to see” prior to the release of the proposed rules, said Jon Bonanno, an Oakland, Calif.-based renewables venture capital nonprofit executive. Referring to the April 17 release of the regulations, he added, “That tide has shifted.”
Renewables investors like Cody Evans, a Stanford Business School graduate student who has set up his own fund for investing in clean energy in the Bay Area, applauded the government’s interpretation.
“This was really helpful for unlocking clean energy investment,” he said. “That previous treatment was not aligned with the intent of the bill.”
Real Estate Focus
The tax incentives reward investors who place their profits from stock and other assets in designated census tracts.
The tide so far has gone in the direction of real estate, and the new tax breaks have gained a reputation in some circles as little more than a subsidy for that sector.
Under tax code Section 1400Z-2, investors can defer capital gains tax on the profits they invest in state designated opportunity zones for eight years, and see some of it forgiven if they hold onto the investments for at least five years, a perk that grows after seven years. If they hold onto the investment for a decade, its appreciation is tax-free.
The incentives are subject to geographical limits on asset location and income sources that can render them more friendly to an apartment complex than, say, an e-commerce business. Of the more than 100 funds set up, more than 80 percent are geared toward commercial or residential real estate, according to a list compiled by the accounting firm Novogradac & Co. LLP.
Just over half a dozen of the projects on that list appear to involve renewable energy. That may be about to change.
Capital-intensive industries tend to take advantage of a tax perk known as accelerated depreciation—the ability to quickly write off the cost of tangible asset purchases rather than reduce taxable income by those amounts piecemeal over a longer time period.
The capital required for renewable energy projects, such as wind turbines and generators, can amount to massive overhead costs—some of which is alleviated by upstarts’ ability to shrink their taxable income by the amount of those expenses sooner rather than later.
Shareholders of partnerships and S corporations who sell their stakes can be taxed at relatively higher ordinary income rates on the accelerated depreciation they received through those holdings, something known as “depreciation recapture.”
Some current and potential renewables investors were worried that they would get hit with income taxes on their accelerated depreciation tax benefits upon selling their opportunity zone fund stakes after 10 years. The investors would otherwise generally help them avoid tax on the gains from the sale of the fund’s assets—the major draw of the new incentives.
But the proposed regulations stipulate that when the partnership interest is adjusted to equal fair market value prior to the sale—another way of saying the shareholder’s gains are erased for tax purposes—the value of the investment in the partnership’s assets are similarly brought to fair market value, as occurs with an adjustment under Section 743(b).
“There’s no reason for those two things to be treated differently,” said Steve Glickman, who helped create the incentives and now runs his own opportunity zone advisory firm. “All the assets the fund owns—their basis gets stepped up.”
An Interpretive Sweetener
The New York State Bar Association’s Tax Section had urged the Treasury Department and the Internal Revenue Service not to protect opportunity fund investors from depreciation recapture, according to the group’s comment letter from earlier this year.
But the government sweetened the deal, taking what the group wrote in the letter would be “the only clear path for achieving such as result.”
Bonanno’s nonprofit, My OZ Fund, is helping people and firms with capital gains set up clean energy funds and follow the rules for a relatively low fee, with pro-bono help from KPMG and DLA Piper.
He said the industry worried about the threat of treatment of depreciation recapture as income. But Treasury’s decision, he continued, could kick off activity in an industry that has been slow to catch on to the new tax breaks.
“We identified that very few clean energy entrepreneurs were even aware that opportunity zone tax incentives existed, and the ones that were aware were not very well informed,” he said. “What we’re seeing is way more solar investors chasing too few projects. At this moment, it’s a seller’s market.”