Qualified Opportunity Zones With an Energy Boost

If you're a regular reader of Kiplinger, you're likely familiar with what many investment experts consider a once-in-a-generation tax advantage provided by opportunity zones.

What are qualified opportunity zones?

For those needing a primer: Qualified opportunity zones, or QOZs, were created by the Tax Cuts and Jobs Act of 2017, an ambitious and bipartisan piece of legislation aimed (as the name implies) at both the creation of jobs and the reduction of taxes.

A total of 8,700-plus U.S. Census tracts were eventually designated as QOZs, with the subsequent creation of qualified opportunity funds (QOFs) intended to facilitate new investment in these specified areas that span all 50 states and the District of Columbia, as well as U.S. territories.

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A way to defer capital gains

The Treasury Department created new rules within the Internal Revenue Code that permits investors to defer recognition of capital gains (and therefore the payment of capital gains taxes) by rolling the gain from the sale of an appreciated asset into a QOF investment within 180 days of the sale that triggered the gain. The recognition of the gain would then be deferred until Dec. 31, 2026 (implying payment of the tax by April 15, 2027), or until the sale of the QOF, whichever occurred first.

Even better, if the taxpayer chooses to hold their QOF investment for at least 10 years, the cost basis for the QOF would increase to its fair market value upon sale of the fund — thereby rendering the investment free of all capital gains taxes at the time of sale. Most investors consider the tax deferral to be the smaller of the benefits, with the largest benefit by far being the tax-free nature of the QOZ investment. Many are calling this important piece of tax legislation one of the greatest tax benefits in decades, and understandably so as billions of investment dollars have poured into QOFs over the past three years alone.

The Tax Cuts and Jobs Act (TCJA) appears to have achieved its objective of affording investors the chance to defer capital gains taxes for at least a few years, while simultaneously presenting the opportunity for an investment permanently free of all capital gains tax, provided the 10-year minimum holding period was respected. With over 8,700 opportunity zones as possible targets for investment, and with significant numbers of investors moving capital into QOZs, the objective of job creation within those zones is being realized.

Astute investors have sifted through the various QOZ investment offerings that include multifamily apartments, self-storage and other various asset classes in commercial real estate. However, some investors also have learned that energy investments are being made in QOZs.

Let’s focus on one of the more appealing and lesser-understood offerings available for QOZ investors: the energy sector.

The energy sector is broadly understood to include two classes within the sector that include fossil fuels (oil and petroleum, gasoline, natural gas and diesel) and renewable, which would encompass solar, wind, hydropower and biomass. As we delve into the possibilities within the energy markets, it becomes clear that QOZ investing may be particularly well structured to accommodate energy investments in oil and gas production.

Many designated QOZs are located in areas renowned for energy production and are conducive to QOF investment projects, especially within the oil and gas exploration and production sectors. These projects include upstream activities (drilling and exploring for oil and operating wells), midstream activities (storing and transporting crude oil and natural gas) and downstream activities (converting crude oil and raw natural gas into products consumers and businesses need).

A few QOFs already exist in well-established energy production areas of the country. These include the Permian Basin and Eagle Ford in Texas, the Haynesville Shale in Louisiana and East Texas, and the Marcellus Formation in Pennsylvania.

Synergies between oil and gas and QOF structure

Beyond the obvious synergies between the oil and gas industry and the QOF structure, the most compelling reason to contemplate an oil and gas QOF investment right now is the state of the industry itself, which is facing any number of headwinds in the eye of the public and therefore may be ripe for new investments at a reasonable price.

COVID-19 depressed valuations of virtually every oil-and-gas-related asset, including mineral and royalty interests, and while those prices are off their bottoms, they remain far off their peak valuations.

The oil and gas industry remains the preferred villain of certain quarters of the investment world, whose infatuation with ESG (environmental, social and corporate governance) and concern with the effects of climate change have tempered any enthusiasm for energy investment.

Large swaths of the automotive industry have proclaimed their intention to exclusively produce electric vehicles within the next several decades, proclaiming for all intents and purposes the death of the internal combustion engine. New York state even banned the use of gas stoves in newly constructed buildings!

Some investors feel that it may be time to summon up one of Warren Buffett’s best-known investment credos, which is to "be greedy when all those around us are fearful."

Electric vehicles are increasing in popularity, but we are learning more and more about the rare metals required to build EVs and the surge in mining activity that will be required to convert the world, or even the country, into an all-EV nirvana. We’re already aware of how the electricity required to power these EVs is produced around most of the world: in coal-fired power plants and with oil and gas. In short, EVs may well be the wave of the future, but they may not be as "green" as many consider them to be. As of 2021, just 3% of U.S. automobile sales were EVs, with only a 5% increase in 2022, according to J.D. Power.

Similarly, while climate change is a legitimate concern, the notion that we can respond as a society by immediately weaning ourselves off petroleum products and embracing an all-green power grid seems fanciful. Such a transition will take generations, if it happens at all.

It's also important to note that we may well indeed be in a "golden age" of technology within the oil and gas industry that has given the United States the ability to transform from a net importer to a net exporter of energy, and of course that will depend largely on who's in the White House at any given time. Hydraulic fracturing, or “fracking,” is the tip of the iceberg of these technological revolutions, which have also included horizontal drilling and increased use of automation and digital technology in oilfield production.

Dependency on oil and gas for the time being

The fact remains that the world remains dependent on oil and gas for the standard of living to which we’ve all become accustomed, and "green energy" initiatives are still in their infancy, despite all of our concentrated efforts to shift toward renewable energy. Fossil fuels, including oil and gas, are unlikely to go the way of the dinosaur any time soon, and certainly not in the next 10 to 20 years.

The smart money may be on their continued presence in the American and global marketplace. The even smarter money may find investment dollars flowing into oil and gas QOFs, where the tax advantages are considered a generational opportunity, and where the 10-year prognosis for the investment and energy sector itself looks promising.

Requirements for qualified opportunity funds

Consider the requirements for all QOFs, regardless of the trade or business in question: Any investment funds received by a QOF must be put to use within six months of receipt.

• The QOF must hold at least 90% of its assets in the form of a QOZ property, whether that be in the form of business property, corporate stock, or partnership interests.
• For business property in a QOZ, the property must meet three important requirements: 1) it must be tangible property used in a trade or business; 2) it must be purchased from an unrelated party; and 3) it must either be an “original use” property, beginning with the QOF, or an existing property that is “substantially improved” within 30 months of acquisition.

QOZs dovetail nicely with the kinds of investments that help an investor further diversify their portfolio, but that also come with a unique and strategic set of tax and wealth creation benefits for everyday investors seeking shelter from capital gains taxes.

Understanding the big picture is important, but choosing the right investment is even more critical. Not all QOZ funds are created equal, and it’s essential to do your homework before committing your investment dollars into any QOZ investment. (I’ve created a 50-minute Tax-Smart Masterclass to help investors master the QOZ.)

Daniel C. Goodwin, Provident Wealth Advisors and AAG Capital, Inc. are not attorneys and do not provide legal advice. Nothing in this article should be construed as legal or tax advice. An investor would always be advised to seek competent legal and tax counsel for his or her own unique situation and state-specific laws.

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