A Proposed Solar Development Framework for Tomorrow: The S-REIT
The commercial real estate sector has experienced strong growth and efficiencies due to the structure provided by the REIT regime. Whether or not the solar industry could benefit from a similar structure depends, at least in part, on whether the appetites of investors and the attitudes of politicians would allow the idea to thrive. This section is dedicated to proposing a framework which could prove successful.
Although the REIT structure, with its ability to attract a broad base of investors, could be a very attractive tool for solar development, it is not clear that solar developments could, at this point, qualify for REIT status. There are some aspects of the REIT tax structure which would present little to no barrier for a solar developer. For example, the organizational and distributive requirements of REITs could effectively be satisfied with very little planning. Indeed, many solar developers likely satisfy many of the requirements already, such as having directors and transferable shares, inter alia. Additionally, it is not difficult to envision a solar developer satisfying the asset test as property is typically a significant category on many developers’ balance sheets. However, because of the novel approach of a solar development utilizing a REIT tax structure, whether or not an S-REIT could satisfy the income test as it is currently configured is less clear, and could be the largest hurdle to the S-REIT structure.
As noted in discussion of the REIT structure, an entity must earn 75% of its income from rents. There is also a provision that part of this, 15% of total income, may come from personal property related to the real property. Since the income gained by solar developments is in the form of payments based on a power purchase agreement linked to energy produced by solar panels, which could possibly be considered personal property, it is unclear whether all the income from a PPA could qualify as rents from real property. 1, 2
I.R.C. 856 is silent in regard to solar development. Additionally, the IRS has not made any published rulings on whether income from a PPA would qualify as rent. 3 However, it is possible to find some support for the proposition that PPA income could qualify as rent from real property. As noted above, it might appear that solar panels are personal property. This would be problematic as rents gained from personal income can only contribute 15% to gross income. However, this personal property rule typically pertains to moveable property used in connection with broader business activities. For example, one retail mall was able to claim rents from baby strollers under this clause. 4 Immoveable solar panels, which serve the purpose of income generation, and not just add-ons to broader corporate activities, would not seem to fit into this category. A more appropriate comparison might be to the assets that railroads use to generate income, such as tracks and bridges. Therefore, a broad reading of ‘interests in real property’ that includes income gained from solar panels would likely be appropriate.
However, despite these possible avenues it would not be appropriate or financially prudent for a solar developer to move forward on claiming REIT status without determining first whether this broad definition of interests in real property was shared by tax authorities. Because of the lack of statutory clarity on the topic and with no past rulings on point, it would be therefore be necessary for interested parties to gain a revenue ruling on whether income from PPAs would qualify as pure rents from real property. There would be two possible avenues to request the Secretary to issue a favorable revenue ruling. One would be for a Congressional Committee to request one. This would be the more effective route, as the tool of political pressure could be used to ensure that the issue received prompt attention. However, the support of a Congressional Committee may be difficult to gain, or at least may not be as prompt as solar developers would want. A second route would be for solar developers and or industry groups to apply for a revenue ruling. Though this could be done much more rapidly, it is also true that such a request would carry less political weight than one issued by a Committee.
Alternatively, a valid claim could be made that solar development should be afforded safe harbor status under the tax code, similar to the benefits given to healthcare REITs and REITs in the hotel business. This makes intuitive sense when one considers the functions of a traditional REIT as opposed to these newer forms. For example, an office REIT gains income from renting space to corporations and individuals. A warehouse REIT rents out space to companies which require large areas to hold or transfer goods. An apartment REIT makes most of its income from tenants. Each of these is a clear example of a company earning rental income from real property.
However, hotels and healthcare facilities have obvious differences. Their business models necessarily entail that much of their income is derived from sources other than rent. For example, patients at hospitals are not necessarily paying rent for their rooms; indeed most could undoubtedly find much better places to spend the night. What they are paying for is the services and care provided by the hospital staff. Similarly hotels have high staff to customer ratios and often amenities such as gyms, internet service, breakfasts and conference space which are included in the cost of a room. Additionally, larger hotels with conference space often earn significant income from event hosting. It is not clear that much of the income gained by healthcare and healthcare entities would otherwise qualify as rents from real property. Therefore, each of these entities are granted special status in IRC 856. It seems that a solar development, with similar problems meeting a strict rent from real property requirement otherwise could also be a candidate for safe harbor status. However, such safe harbor status would need to be granted legislatively, and would not therefore be the best avenue for immediate impact. This safe harbor solution should only be sought in the event that a favorable revenue ruling could not be gained.
Based on the current lack of clarity regarding a potential S-REIT, a solar developer would require assurances that its development would be eligible for tax exempt status. Two different paths, one administrative, and one legislative seem to be open. The easiest and most efficient would be a revenue ruling declaring that the income gained from a power purchase agreement qualifies as rents from real property. This would come from the IRS and would be an administrative solution under the broad power given to the Secretary in defining what qualifies as rental income. Though a favorable revenue ruling seems likely and would be the easiest and quickest way for a solar developer to gain REIT status, REIT recognition could also be obtained via a slight legislative change to the code. A legislative solution where solar developments would be given treatment comparable to other niche REITs such as healthcare and hotel REITs would be a policy-based recognition of the fact that a unique revenue structure would require a unique solution under the tax code. However, the legislative solution is not likely necessary, and should only be recommended as an alternative to a failed revenue ruling. 5
Despite benefits, there could be some hurdles to this structure. For example, it is not likely that coal industry representatives would be the first in line to voice support for the S-REIT idea. Additionally, there could be some resistance to the possible tax changes recommended below. However, despite this, there is no reason to believe that utilizing the REIT tax structure to incentivize solar development would lack strong levels of investor and political support. This is truly an issue that could bring together both sides of the aisle as the goals of such a plan would satisfy everyone from environmentalists to capitalists to investor rights advocates. This breadth and depth of support would ensure that little resistance to such a plan would arise among these key constituencies and their representatives.
Though hurdles exist, the main ingredient in a successful plan is often timing. Fortunately, timing seems to favor an investment vehicle that could both benefit the investor class and help to stimulate green development. Many factors play into this. For example, both the legislative and executive branches are currently in the hands of Democrats. Just as Republican majorities wouldn’t preclude extending the REIT regime to solar development, Democratic majorities do not ensure it. However, political realities suggest that a Democratic president coupled with Democratic majorities in both houses of Congress might provide fertile ground for innovative environmental solutions. Evidence of this can be found in the American Reinvestment and Recovery Act, which provides considerable benefits to the renewable energy industry. Further evidence can be found in the proliferation of renewable portfolio standards, particularly on the local level, which indicate a desire to shift the energy mix toward renewable sources. 6
1. I.R.C. § 856 (c), (3), (A).
2. There are other core activities in which a REIT may partake to reach this 75% threshold; however they involve mostly asset sales and tax refunds and are outside the scope of this paper. In addition to the 75% threshold there are other income tests. Ultimately, a REIT must derive 75% of its income from core activities, 95% must be derived from these core activities plus dividends and interest and 100% percent must be gained from the foregoing sources with up to 5% from unrelated activities.
3. In a private letter ruling dated March 13, 2007, the IRS held that income gained from a solar array would indeed qualify as revenue for § 856 purposes using the logic found in this paper. However, the letter critically applied ‘only to the taxpayer requesting it’ and provided that the letter was not to be cited or used as precedent. A public document would be needed in order to provide certainty that the S-REIT structure could be utilized by a solar developer. See I.R.S. Priv. Ltr. Rul. 147229-06 Mar. 13, 2007).
4. Brandon at 99, citing I.R.S. Priv. Ltr. Rul. 961309.
5. Though the actual steps necessary to create a REIT are probably deserving of more attention than a footnote, for purposes of this paper it is enough note that the formation of an S-REIT would likely be structured similarly to an UPREIT. The UPREIT structure was developed as a tool to ‘avoid the federal income tax that would result upon recognition of gain on the transfer of real estate already owned by an individual or by a partnership to a REIT.’ See, William B. King, REITs as Legal Entities, in, REAL ESTATE INVESTMENT TRUSTS, STRUCTURE, ANALYSIS, AND STRATEGY, 31, 53 (Richard T. Garrigan and John F.C. Parsons, eds., McGraw Hill 1998). King goes on to explain that ‘a transfer of property directly to a REIT…would result in recognition of gain to the individual owner or partner of the transferring partnership; however a contribution by that individual owner or by an existing partnership owning the property to another partnership in exchange for a continuing interest in the transferee partnership, can be effected without recognition of gain. Id. In other words, so long as a solar developer retains an interest in an S-REIT that it forms, it can avoid a taxable sale of property. The suggestion that the UPREIT would be the model for solar developers to follow implies that most, if not all firms taking advantage of the structure, at least initially, would already be going concerns with developments established or underway.
6. More information on federal renewable portfolio standards is available at http://www.epa.gov/chp/state-policy/renewable_fs.html.