President Obama announced on Friday several executive actions to advance clean energy. Among them, the Internal Revenue Service (IRS) will publish new regulations on May 14th clarifying that certain solar generating assets may be eligible for inclusion under Real Estate Investment Trust (REIT) corporate structures. Please find below an ML Strategies update summarizing this proposed new rule.
Proposed IRS Rule Could Allow Solar Energy REITs
IRS Takes More Favorable View of Solar Assets as It Clarifies Definition of Real Property
Speaking at a California Wal-Mart on May 9th, President Obama announced several executive actions to advance clean energy. Among them, the Internal Revenue Service (IRS) will publish new regulations on May 14th clarifying that certain solar generating assets may be eligible for inclusion under Real Estate Investment Trust (REIT) corporate structures.
REITs pay taxes only at the shareholder level, so they provide a large pool of relatively low-cost capital for investment. Since the 1960s, 204 publicly traded and 1,100 privately held REITs have attracted over $719 billion in equity through the capital markets. By opening REITs to certain types of photovoltaic (PV) projects, the Obama Administration hopes to lower the cost of financing solar projects and drive new investment into the solar industry.
In order to take advantage of a REIT's desirable pass-through structure where no corporate taxes are paid but are "passed through" directly to shareholders, the IRS imposes a variety of restrictions and tests on the types of assets a REIT can own and the types of income those assets can generate. Historically, the IRS has clarified through revenue and private letter rulings whether or not certain assets—from railroads properties to fixed mobile homes—qualify as "real property" to meet REIT eligibility requirements. However, until this week, the IRS had not specifically addressed whether solar generating assets could meet these requirements.
For years, clean energy financing and policy circles had discussed the potential opportunity REITs presented to renewable project developers and investors. Advocates in the administration, in Congress, and in think-tanks urged the Treasury Department to allow renewable energy REITs. Sen. Chris Coons (D-DE) led a bipartisan, bicameral letter in December 2012 along with 30 members of Congress urging the Treasury Department to allow renewable energy REITs. The proposed rule is the result of sustained efforts within the Obama Administration to have the IRS clarify REIT eligibility rules.
Regulatory Analysis
A threshold test under existing IRS regulations is whether or not 75 percent of a REIT's assets are cash, securities or "real estate" assets – generally defined as real property and interests in real property. What the IRS's proposed rulemaking ( REG-150760-13) seeks to clarify is whether or not solar generating assets are "real property." What the IRS's proposed rulemaking does not clarify, however, is how the income generated by solar assets not directly delivering electricity to an adjoining building will be treated.
The IRS proposed rule offers a framework for evaluating the types of assets in which REITs may invest. The Treasury Department and IRS acknowledge that the definition of real property may differ between various provisions of the federal tax code as well as local tax codes. This recognition is important because solar developers' ability to still qualify for the Investment Tax Credit (ITC) under a REIT structure is critical, and ITC eligibility requires an asset be characterized as personal property under Section 48.
The proposed rule aims to balance the desire for consistent regulatory definitions with particular policies that favoring a broader real property interpretation. Another important aspect of the proposed regulation is Treasury's elimination of the concept of "assets accessory to the operation of a business" found in existing regulations because the IRS found the phrase only sowed confusion. Under the proposed regulations, if an asset has an active function, such as the generation, manufacture, or creation of a product, then the asset is not considered "real property" unless it is a structural component serving a "utility-like function" such as electricity, heating, and cooling for an "inherently permanent structure" of which it is a constituent part.
The proposed rule also contains a section enumerating distinct assets that are buildings or other "inherently permanent structures." Assets included in this safe harbor section require no further analysis; they are "real property" under REIT rules. If however, a distinct asset is not listed as either a building or an inherently permanent structure—and solar PV systems are not—the proposed rule provides a number of factors to be applied in a case-specific determination.
Another critical clarification included in the proposed rule is that certain intangible assets can meet the definition of "real property" and generate "good income" for REIT purposes, but only if an intangible asset (1) Derives its value from, and is inseparable from a REIT's real property, and (2) Any income generated from those intangible assets is linked to consideration for the use or occupancy of space.
On pages 25-28 of the proposed rule, the IRS applies its multi-factor, site-specific analysis to three hypothetical scenarios involving solar energy assets, two of which would qualify under the rule as real property for REIT purposes, and one of which would not.
1. Merchant Generation
In the proposed rule's first solar example, the REIT owns a solar energy asset, which is comprised of land, photovoltaic modules (PV modules), ground mounts, and an exit wire to the electrical grid. The REIT enters into a long-term triple net lease with a tenant for the solar energy site and assets, and the electricity produced is sold to third parties off-site via the transmission system.
In this scenario, the IRS concludes the PV modules will not meet REIT definitions of real property because the PV modules are (1) easily removable, (2) produce electricity for sale to third parties, and (3) the income generated by the PV modules do not represent consideration for the use or occupancy of real property. Therefore, most utility-scale solar projects with long-term power purchase agreements will not meet the required tests for inclusion in a REIT.
2. Distributed Generation
In a second example, a REIT owns both an office building and a PV energy site that is located adjacent to the property. The REIT leases the building and energy site to the same tenant, and the energy site supplies the office building's energy needs, although some excess amount is occasionally sold back to a utility on the electrical grid.
In this scenario, the PV modules serve a "utility-like" function, directly delivering power to the office building. The energy system has a passive function of containing and protecting the tenants' assets instead of an active function of generating power for sale to third parties. Thus, the income generated from the PV modules represents consideration for the use or occupancy of space within the office building. Therefore both the building and the solar energy site can be treated as real property for REIT purposes.
3. Solar Shingles
In the rule's final solar example, a REIT owns an office building whose roof is covered in solar shingles specifically designed and constructed to serve only the needs of the office building, with some power occasionally sold back to a utility on the electrical grid. For the same reasons as in the distributed generation example, the IRS concludes the solar energy assets can be treated as real property for REIT purposes.
Next Steps
The proposed rule's updated definitions and conclusions will allow some types of solar PV systems to meet a REIT's definition of "real property." It seems clear that utility-scale merchant power projects would likely not qualify as a REIT under the proposed regulations. The most likely solar projects that could initially take advantage of the IRS regulations would be distributed generation solar assets primarily serving the load of a connected building owned by the REIT.
While the proposed rule represents a significant shift for the IRS, which reportedly opposed promulgating new regulations broadening REIT "real property" classifications, its impact may initially be limited given other REIT eligibility requirements and restrictions. As the Obama Administration's announcement caveated, this proposed regulation is just a "first step" by the Treasury Department—but an important one.
Given the diverse business models proliferating across the rapidly expanding domestic solar economy, the issue of income classification generated by solar installations remains a significant, outstanding question IRS must next address in order to provide adequate regulatory certainty. In a footnote on page 8 of the proposed rulemaking, Treasury notes the agency may release guidance addressing how to treat income earned from an intangible asset such as a solar PV system generating electricity to a REIT building but also transmitting excess power to a utility. However, no time frame for this additional guidance was given.
The IRS's proposal is subject to change based on public input. Interested parties can submit comments by August 12. The agency will also hold a public hearing on the rule September 18.
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