Expanding the development of renewable energy facilities, such as solar power, has become a growing domestic priority in recent years. In 2012, $30 billion was invested in renewable energy in the U.S. However, the sunset of existing tax incentives may stunt industry growth. With partisan gridlock at an all-time high and natural gas prices at record lows, the industry needs novel ways to facilitate the continued growth of renewables.
One emerging concept, supported by both the renewable energy and real estate finance sectors, is the application of the real estate investment trust (REIT) structure to solar development. For purposes of this article, an “S-REIT” means a REIT that is predominately invested in the ownership and operation of solar systems, independent from ownership of the underlying real property, and derives income primarily from the sale or lease of such assets to third-parties. Whether existing REIT rules allow for such a structure is unclear, and there are growing calls for clarification. San Francisco-based Renewable Energy Trust Capital, Inc. recently requested that the IRS classify solar projects as “real property” to facilitate their inclusion in S-REITs. Also, in December 2012, twenty-six members of Congress asked the Treasury Department to issue a broad ruling approving the use of REITs for renewable energy. While there are several arguments that support the eligibility of S-REITs under existing rules, formal clarification may be necessary to provide sufficient certainty to promote widespread S-REIT development.
The REIT Structure
REITs were created by Congress in 1960 to facilitate the pooled ownership and operation of income-producing real estate. REITs may be invested in different types of real property such as commercial office buildings, apartment complexes and shopping malls and are traded (both publicly and privately) in individual investment units like stock. The REIT structure provides increased capital flows and efficiency, and allows facilitates the fractional ownership of diverse portfolios of income-producing realty. Most importantly, REITs are “pass-through” entities that avoid taxation on the entity level. According to NAREIT, as of the end of 2012, REITs had a combined market value of $603 billion.
Unsurprisingly, REITs are subject to specific requirements in order to maintain their tax-favored status. A REIT (i) must invest at least 75 percent of assets in qualifying assets, such as real estate, (ii) derive at least 75 percent of its income from “rents” from real property (and derive 95 percent of its income from rents, interest and dividends) and (iii) distribute at least 90 percent of taxable income to shareholders.
Issues for Solar REITs
Is the System a Real Property Asset?
A threshold issue is whether solar assets constitute a “real property asset.” Treasury Regulations provide that real property includes land or improvements, such as buildings or other inherently permanent structures. Under the regulations, “real property” includes, for example, plumbing, HVAC, ducts elevators or other structural components of a building. However, the term does not include “assets accessory to the operation of a business”, such as machinery, office equipment or furnishings, even though such items may be fixtures under local law.
The IRS uses the following questions to distinguish between “inherently permanent” real property assets, machinery and other assets “accessory to the operation of a business”:
- Is the property capable of being moved, and has it been moved?
- Is the property designed or constructed to remain permanently in place?
- Are there circumstances that tend to show the expected or intended length of fixation, or that show the property may have to be moved?
- How substantial a job is removal of the property, and how time consuming is it?
- How much damage will the property sustain upon its removal?
- What is the manner of affixation of the property to the land?
Answering these questions with respect to solar systems is a mixed bag: The systems (particularly the modules) are capable of being moved, without substantial damage or difficulty. On the other hand, they are designed for site-specific application with an expectation that they remain in place for the useful life of the system (e.g., 20-30 years or longer). The manner of affixation varies, but generally involves the mounting of panels to racking systems that are bolted or ballasted to a roof or ground-mounted structure. Arguably, PV installations are inherently permanent since they are designed, constructed, operated and financed with the expectation that they will not be moved during their useful economic life.
A related issue is whether the IRS would view the solar system as a unified asset, or evaluate the individual components as separate assets. In an oft-cited ruling, the IRS determined that microwave transmitting and receiving towers are considered real property, but antennae and related transmitting equipment affixed to the towers were accessory assets (and not real property) even though they were bolted or welded and not intended to be removed. More recently, the IRS looked at LED billboards and cellular towers, bifurcating its analysis with respect to immovable assets (e.g. the billboards and towers) and accessory equipment. These rulings indicate that equipment is more likely to be deemed “accessory” when it may be removed and operated independently from the real property asset.
Analyzing the individual components of a solar system, it seems clear that the structural mounts and related infrastructure would be viewed as real property assets. Similarly, any transmission and distribution assets (and arguably inverters) would likely be viewed as real property in accordance with the logic of existing PLRs covering transmission systems and other passive conduits. The leasehold or license underpinning the right to own and operate the solar system is undoubtedly a real property asset. However, the case is less clear with respect to the solar panels and other equipment. Nonetheless, the solar system may be viewed as an integrated asset because of the interdependent nature of its components.
Also relevant is the extent to which the asset is passive in nature. The IRS has determined that a passive system that allows the output of a generation source to flow through a system to end-users is a real property asset. Analogizing to an earlier ruling that railroad tracks are real property assets, the PLR notes that the system is a “passive conduit” and is distinct from the active machinery that generates the commodity being conducted through the system.
A PV system may be likened to a conduit for the passive conversion of sunlight into electricity. Unlike thermal generation units (which are generally not considered real property assets), solar panels have no moving parts, generate no mechanical energy and require little active operation and maintenance.
While a PLR on the issue will undoubtedly bring clarification, a case may made for the treatment of solar systems as passive, integrated and inherently permanent real property assets.
Is Revenue from PV Systems “Rents from Real Property”?
Rents from real property include (i) rents from interests in real property, (ii) charges for services customarily rendered in connection with renting real property and (iii) rent from personal property, but not exceeding 15 percent. Regulations generally define the term “rents from real property” as the gross amounts received for the use of, or the right to use, real property of the REIT.
With respect to solar systems, revenue could take two forms: (i) income from the sale of energy by the REIT to on-site customers or to the local utility, or (ii) lease payments associated with the lease of the solar system from the REIT to a host customer.
Existing IRS precedent supports the inclusion of lease income as rents from real property, provided certain criteria are met. Among other things: (i) the lease must be a true, “hell or high water” lease in which the lessee retains all rights to use, and responsibility with respect to, the system and (ii) the lessee must be unrelated to the REIT. Within these structures, it is possible to envision a solar REIT model where the REIT develops and owns solar PV systems that are leased to the site host or tenants to a third-party that sells the power under a PPA to such entities, with the lessee assuming responsibility for the operation and maintenance of the system.
It is less certain whether PPA income would constitute rents from real property. Rents may include “customary” charges for services furnished to tenants of a building (such as water, heat, light and, if customary in the geographical region, electricity), however such services must be provided to tenants of the REIT and must be provided through an independent contractor or a taxable REIT subsidiary. In sum, the income tests under existing REIT rules favor a solar lease model, where the primary REIT income consists of lease payments associated with the passive system ownership.
Although a handful of REITs have taken the initiative to invest in solar power, there is significant uncertainty surrounding widespread REIT investment in solar systems. The outcome of the recent PLR request by RETC will bring helpful clarification on the issue; a favorable ruling would justify the deployment of capital into an S-REIT. Despite the fact that such rulings lack formal precedential value, it would nevertheless provide a signal to the industry that the IRS would rule favorably on future requests.
Justin Boose is a member of the Project Development & Finance Group at Troutman Sanders LLP and focuses on renewable energy transactions. Sascha Yim and Philip DiMola also contributed to this article.
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