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The Current: IRS Responds to President’s Call for More REIT Investment in Energy

Published by Forrest D. Milder on Sunday, June 1, 2014

Journal cover June 2014   Download PDF

On May 9, President Barack Obama issued a statement about solar deployment and real estate investment trusts (REITs) that said, “ … in a step forward for renewable energy, the Treasury Department and IRS will shortly clarify how certain investment rules relate to renewable energy installations. This is important because real estate investment trusts (REITs), a key component of many retail investors’ portfolios, generally hold only real property. The new guidance will provide clarity regarding the treatment of renewable energy installations in REITs, thereby helping to promote investment in the sector.”

What’s a REIT?
In broad terms, a REIT provides a way for the general public to invest in real estate by owning shares in a publicly traded entity. Technically, a REIT is a special purpose corporation that, in particular, owns real estate assets, which can include real property, mortgages on real property and shares in other REITs. Many percentage tests apply to REITs, their assets and their income. For example, in general terms, at least 75 percent of a REIT’s assets must be real estate assets, cash and government securities, with additional limitations on how much can be securities; at least 95 percent of a REIT’s gross income (i.e., revenues before deductions) must come from dividends, interest, real property rent, capital gains from dispositions of real property, stock and securities, and certain other income and gains associated with real estate and mineral royalties; and at least 75 percent of its gross income must come from real estate rents, mortgages, and income and gains associated with certain real estate assets, all as described in Internal Revenue Code (IRC) Section 856. In general, REITs are not subject to tax if they distribute 90 percent of their income to their shareholders, although there are special tax rules imposing confiscatory taxes on certain prohibited transactions, and many other rules affect the taxation of a REIT.

Why Do We Want REITs to Invest in Renewable Projects?
According to the National Association of Real Estate Investment Trusts, in 2013, there were 202 American REITs with a market capitalization of $670 billion. That’s a lot of assets!

So, Why Don’t They?
First, if we cut through all of the mathematical tests and definitions, the bottom line is that REITs want most of their assets to be real estate, and renewable energy projects are mostly equipment. As a result, this enormous resource is not particularly available to the renewables industry, whose assets, while often constructed on land or on buildings, are generally equipment.

Second, a primary source of financing for renewable projects is tax equity finance. Because REITs generally don’t pay taxes, they are not a good choice to own renewable projects when they are first placed in service; they can’t use the tax credits that they generate. On the other hand, one might expect to see REITs as a takeout source, once the five-year recapture and depreciation periods have ended, provided the project is a real estate asset in which a REIT can invest.

Which brings us to the president, and his declaration that “[t]he new guidance will provide clarity regarding the treatment of renewable energy installations in REITs.” True to the word of the administration, in May the IRS released proposed regulations to provide the “clarity” that is hoped will encourage REIT investment.

Understanding the Proposed Regulations
The proposed regulations describe six basic kinds of assets that can qualify as real estate assets. These are:

  1. land;
  2. inherently permanent structures that are buildings;
  3. inherently permanent structures enumerated on a safe harbor list in the proposed regulations;
  4. inherently permanent structures that do not serve an “active function,” like the production of goods, and which pass the first facts and circumstances test described below;
  5. distinct assets which pass the second facts and circumstances test described below; in particular, they must either serve a “passive function common to real property,” or an active function, provided that active function is “utility-like” with respect to an inherently permanent structure and
  6. intangible assets that derive their value from tangible real property and which are inseparable from the tangible real property from which the value is derived, such as licenses and permits.

The first facts and circumstances test, which applies to determine whether an inherently permanent structure is a real estate asset, considers:

  • the manner in which the distinct asset is affixed to real property;
  • whether the distinct asset is designed to be removed or to remain in place indefinitely;
  • the damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed;
  • any circumstances that suggest the expected period of affixation is not indefinite (for example, a lease that requires or permits removal of the distinct asset upon the expiration of the lease) and
  • the time and expense required to move the distinct asset.

The second facts and circumstances test applies to distinct assets that serve an inherently permanent structure, and it includes:

  • the manner, time, and expense of installing and removing the distinct asset
  • whether the distinct asset is designed to be moved;
  • the damage that removal of the distinct asset would cause to the item itself or to the inherently permanent structure to which it is affixed;
  • whether the distinct asset serves a utility-like function with respect to the inherently permanent structure;
  • whether the distinct asset serves the inherently permanent structure in its passive function;
  • whether the distinct asset produces income from consideration for the use or occupancy of space in or upon the inherently permanent structure;
  • whether the distinct asset is installed during construction of the inherently permanent structure;
  • whether the distinct asset will remain if the tenant vacates the premises and
  • whether the owner of the real property is also the legal owner of the distinct asset.

The proposed regulations provide two renewable energy examples, each of which involves a solar installation. Usefully, the IRS doesn’t just describe the facts and state a conclusion, it describes whether the particular facility passes each of the tests described above, again providing some clarity that should assist in the tax analysis of other fact patterns.

The first solar example involves a solar farm. It concludes that the land underlying the facility, and installation mounts that are fixed to the ground with concrete are real estate assets that can be owned by a REIT, as is the exit wire that is buried in the ground. The proposed regulations reach this conclusion because the installation mounts are inherently permanent and passive, and they pass the first facts and circumstances test; the exit wire is a transmission line included in the safe harbor list. On the other hand, the photovoltaic (PV) modules and other equipment are not “inherently permanent structures” and, even as distinct assets, they have an active function that does not passively serve the other inherently permanent assets. Accordingly, they are not real estate assets. Of course, while these distinctions are useful, one has to wonder whether a REIT would consider owning, in addition to the land, just the mounts and exit wire associated with a solar facility, or whether a developer would want to give up the tax credits normally associated with those assets anyway.

The second example considers solar panels mounted on land adjacent to an office building. Although the tenant “occasionally” transfers excess electricity to a utility, the solar assets are “designed and intended to produce electricity only to serve the office building.” Here, the IRS concludes that the solar facility is a distinct, active asset that serves a utility-like function to the building. As a result it is a real estate asset that can be owned by a REIT. In a slight change to this example, the regulations reach the same result where the solar assets are solar shingles, similar to roofing shingles, but with built-in PV modules. The shingles, which were specifically designed and constructed to serve only the office building with only occasional transfers of excess electricity to a utility, are also active assets serving a utility-like function and therefore, real estate assets that can be owned by a REIT.

Effect of the Proposed Regulations
Will the proposed regulations encourage more REIT investment in this sector?

The proposed regulations do provide a certain amount of “clarity” called for by the president. By providing multi-factor tests to determine whether a particular asset is “real estate” and two examples that deal specifically with solar, and even showing how the multi-factor tests are applied, the IRS is helping REITs and their tax advisors have greater confidence that their analysis will be respected.

On the other hand, in the case of renewables, these rules and the new facts and circumstances tests do not appear to provide a broader definition of real estate assets than existing private letter rulings from the IRS. For example, the IRS chose not to define a complete solar farm as a passive real estate asset that might be entirely REIT eligible.

What’s Next?
One purpose of proposed regulations is to provide a first cut of the IRS position, giving taxpayers and their advisers an opportunity to comment. In this case, the IRS is accepting public comments on the proposed regulations until Aug. 12, 2014, and it will hold a hearing on Sept. 18, 2014. Requests to speak at the hearing must also be received by Aug. 12.

Forrest David Milder is a partner with Nixon Peabody LLP. He has more than 30 years’ experience in tax-advantaged investments including the tax credits that apply to affordable housing, energy, new markets and historic rehabilitation, as well as the tax treatment of partnerships and LLCs, tax-exempt organizations, and structured financial products. He can be reached (617) 345-1055 or [email protected].

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