Using REITs To Finance Solar Power Development

Using REITs To Finance Solar Power Development REQUIRED READING: Investment in solar energy projects is being threatened. A number of factors are contributing to this situation. The investment tax credit (ITC), which has helped fuel the growth of the solar power industry, is facing increased criticism as an example of the government picking winners and losers contrary to market signals. Proponents of the ITC are concerned about how they will fare under the weight of growing budget deficits.

Compounding these difficulties are the structural challenges created by the tax-based nature of the ITC. The ITC is a credit against income tax liability. Most developers of solar projects, however, do not have enough income tax liability to fully use the credits. As a result, the developers need to monetize them.

Monetization involves bringing outside investors with tax liability from other income into the project. These outside investors, referred to as tax equity investors, provide the bulk of the equity for the project in return for being allocated the bulk of the credits and depreciation as part of their investment return.

Because the group of investors that have both the tax liability and the expertise needed to participate in these complicated transactions is quite small, finding a tax equity investor to invest in a project can be difficult and expensive.

The question is how to meet this growing demand for solar energy without the need for costly tax-based incentives such as the ITC. One idea that has received increasing attention in recent years is the real estate investment trust (REIT). A REIT is a company that owns primarily income-producing real estate or real estate-related assets.

To qualify as a REIT, a company must make an election with the Internal Revenue Service (IRS) to be treated as a REIT. It also must meet certain requirements relating to corporate structure and diversification of its assets and income, derive the bulk of its income from passively owning its assets and not from using them in the active conduct of a trade or business, and distribute at least 90% of its taxable income annually to shareholders as dividends.

A company that meets these requirements is permitted to deduct the amounts distributed to its shareholders from its corporate taxable income. As a result, most REITs historically distribute at least 100% of their taxable income to their shareholders and therefore owe no corporate-level income tax. A REIT's distributed income is subject only to a single level of tax at the shareholder level.

REITs can offer significant benefits to investors and projects alike. From an investor's perspective, income from an investment in a REIT can offer relatively higher yields than income earned on non-REIT stock, whose issuers must pay dividends net of corporate-level income tax. REITs can also offer more predictable income streams through rents collected from tenants who have signed long-term lease agreements with the REIT.

Finally, because many REITs trade on a national securities exchange, shares of such REITs tend to be highly liquid. The combination of these factors means that REITs have the potential to offer solar energy projects equity capital with a lower cost.

Here comes the sun?

Drawing upon REITs as a source of capital for solar projects, however, is not without its challenges. The first challenge is to determine how much of a solar project's assets qualify as the type of property that must comprise the majority of a REIT's assets.

The REIT rules refer to this type of property as ‘real property’ and then define it as land and improvements on the land, such as buildings and other inherently permanent structures. The REIT rules specifically exclude from real property ‘assets accessory to the operation of a business.’

When the REIT rules were enacted in 1960, Congress listed individual homes, apartment houses, office buildings, factories and hotels as types of property that REITs were intended to own. Since then, the IRS has taken the position that this list is not exclusive and that other types of property can be treated as ‘real property’ based upon how permanently the property is attached to land.

Questions that the IRS asks when determining whether property is ‘inherently permanent’ include the following: Is the property intended to be moved, is it capable of being moved, and has it, in fact, been moved? Are there circumstances that tend to show how long the property will be affixed to the land? How difficult is it to move the property and will there be damage to the property if it is moved?

Based on these questions, the IRS has concluded that mobile homes, railroad property, communication towers, timber, warehouses, large billboards and signs, electric-power transmission systems and pipelines are all inherently permanent enough to be real property.

The question of what assets are excluded from real property because they are ‘assets accessory to the operation of a business’ is much more difficult to answer. The IRS' guidance in this area is both spotty and inconsistent. Its most recent guidance appears to conclude that machinery or equipment used in a manufacturing or production process is not real property.

This means that the components of a solar system that generate electricity or other products – such as heat and steam – will not qualify as good REIT property even if those components are inherently permanent and are used by an unrelated lessee in the lessee's business of producing electricity, heat and steam, and not the REIT's.

Additional questions

Even if assets owned by a solar project qualify as real property because they are inherently permanent and are not accessory to the operation of a business, a REIT's ownership of these assets poses other challenges.

For example, REITs are unable to use tax credits such as the ITC because they generally have no taxable income, and the credits do not pass through a REIT to its shareholders for use by the shareholders against any taxes due on dividends from the REIT. (Of course, this issue may become moot if tax credits to encourage investment in solar projects are eliminated.)

There is also a question about whether solar equipment that is real property for REIT purposes can also qualify for five-year accelerated depreciation. Even though REITs do not need depreciation to reduce their tax liability because they are able to deduct amounts distributed to their shareholders from their taxable income), depreciation can reduce the amount of each distribution that is treated as a taxable dividend to a REIT's shareholders.

This can result in a REIT shareholder's receiving a distribution from a REIT that may, in part, be tax-free to the shareholder. The catch to this situation is that for every portion of a dividend from a REIT that is tax-free to a shareholder, the shareholder must reduce its tax cost in its REIT shares.

If the shareholder then sells those shares, it will have to recognize as taxable gain the difference between the price it receives for those shares and the reduced tax cost of those shares. At this point, however, the shareholder may qualify for the 15% capital gains tax rate rather than the higher rate applicable to income that is not capital gain.

Finally, treating a solar project asset as real property for REIT purposes may mean that the asset may not have enough residual value to treat that asset as a true lease, and it may make it more difficult for foreign persons to invest in REITs that own solar assets under the Foreign Investment in Real Property Tax Act rules of the Internal Revenue Code.

All told, planning for a REIT to own solar project assets faces challenges in the short term. However, many of these challenges can be resolved or planned around. Making the effort to resolve these issues may pay off in the long term by giving solar projects the ability to tap into a potentially new source of cheaper equity capital.

Kelly Kogan is a senior attorney in Washington, D.C., office of Chadbourne & Parke. She can be contacted at An earlier version of this article appeared in the December edition of Solar Industry magazine.

Photo credit: First Solar


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