On August 30, 2016, the US Internal Revenue Service (“IRS”) finalized regulations that clarify the definition of real property for purposes of the real estate investment trust (“REIT”) provisions under Section 856. The final regulations generally are consistent with the proposed regulations that were released in May 2014. (See our earlier update, “Proposed Regulations Provide REITs a Framework for Solar Energy Property,” from May 14, 2014.) Certain solar industry participants were advocating for solar to be a REIT-eligible asset class in an effort to create a new market for solar projects in the event that the investment tax credit (“ITC”) declined to 10 percent after 2016. In December 2015, Congress extended the ITC with a gradual phase-down. (See our earlier update, “Certain US Energy Tax Credits Extended, But Phaseout Dates Scheduled,” from December 28, 2015.) The extension made the need to make solar a viable asset class for REITs a less pressing issue. It is fortunate for the solar industry that it does not have to rely on REITs, as the new regulations only enable REITs to own solar projects in limited situations.
The final regulations keep the facts and circumstances framework, as opposed to bright-line rules, for determining whether property is real property for purposes of Section 856. Therefore, all of the specific facts of a particular solar energy property will need to be analyzed to determine its REIT classification. The final regulations apply for taxable years beginning after August 31, 2016.
As it relates to solar energy, the two examples applying the rules to solar energy property are substantively unchanged from the proposed regulation. In Example 8, a REIT owns a solar energy site, the components of which are land, PV modules, mounts and an exit wire. The example treats the PV modules, mounts and exit wire as distinct assets because each component is severable from the solar energy site, and each component serves an independent function. The example concludes that the PV modules are not real property because they serve the active function of producing electricity, and they are also not structural components of the mounts because they do not serve the mounts in their passive function of providing support. In contrast, the mounts perform only a passive function and because the mounts are not easily removed, or expected to be removed, from the land, the mounts are inherently permanent structures and, thus, are real property. The exit wire is an inherently permanent structure and, thus, is real property because it is specifically listed as such in the regulations. In contrast, the REIT’s solar equipment in Example 9 is designed and intended to produce electricity only to serve an adjacent building that the REIT leases to a single tenant. The size and specifications of the solar equipment were designed to serve only the needs of the building. Although the tenant occasionally transfers excess electricity produced by the solar equipment to a utility company, the solar equipment serves the building to which it is constituent. Accordingly, the example concludes that the solar equipment is a structural component of the building and, thus, real property.
The final regulations confirm that a solar panel that performs dual functions—i.e., a passive function of providing shelter (e.g., a solar canopy over a parking lot) and an active function of converting energy—will not qualify as an “Inherently Permanent Structure” (“IPS”) (i.e., real estate) under the regulations because of its active function.1 If, however, a solar panel structure is composed of multiple distinct assets, then each of those distinct assets would be separately analyzed.2 The structures to which solar panels are attached—or even into which they are integrated—may qualify as IPSs.
The final regulations rejected requests to include solar panels and related equipment on the list of “Other Inherently Permanent Structures” (“OIPSs”) because of the requirement that OIPSs do not serve an active function. OIPSs are treated as real estate for purposes of Section 856. The IRS also rejected treating solar energy property more favorably than other assets in order to allow REITs to invest in solar energy as a means of furthering clean energy objectives because Congress did not provide for such a distinction.
The IRS is considering whether additional guidance is necessary to address an asset that qualifies as a structural component of an IPS and that also produces electricity that is sold to third parties, such as solar panels that are used to provide electricity to a building with excess electricity being sold to a utility. Until additional guidance is issued, if the quantity of excess electricity transferred to a utility from a distinct asset in a taxable year does not exceed the quantity of electricity purchased from the utility company during the taxable year to serve the IPS, the IRS will not treat the transfer of such excess electricity as affecting the qualification of the distinct assets as structural components of the IPS. Further, the IRS will exercise its authority to treat any income resulting from the transfer of the excess electricity as not constituting gross income for purposes of Section 856(c)(2) and (3), which require that 90 percent of a REIT’s gross income be attributable to leasing real estate, interest on real estate mortgages or certain other specified real estate-related activities. Further, the IRS will not treat any net income resulting from the transfer of the excess electricity as constituting net income derived from a prohibited transaction under Section 857(b)(6). In addition, the sale of RECs generated by the solar energy site would not affect the qualification of the asset.3 Finally, the preamble notes that wind facilities would be analyzed using similar standards as those used for solar facilities.
1 Query whether this treatment signals whether and how the IRS will treat equipment in solar installations that perform dual functions (e.g., carports) when it updates the regulations defining ITC-eligible properties. If it is a signal, it could mean all or much of the basis of the dual function property could qualify for the ITC.
2 The determination of whether a particular separately identifiable item of property is a distinct asset is unchanged from the proposed regulations. The determination is based on all the facts and circumstances, including (i) whether the item is customarily sold or acquired as a single unit rather than as a component part of a larger asset; (ii) whether the item can be separated from a larger asset, and if so, the cost of separating the item from the larger asset; (iii) whether the item is commonly viewed as serving a useful function independent of a larger asset of which it is a part; and (iv) whether separating the item from a larger asset of which it is a part impairs the functionality of the larger asset.
3 The treatment of income from the sale of RECs is beyond the scope of the regulations.