The Inflation Reduction Act of 2022 (the “IRA”), which was signed into law on Tuesday, August 16, 2022, includes an investment of over $369 billion in energy security and climate change. There has been a lot of discussion about the extension of the investment tax credit (“ITC”) for solar and the provision that allows the transfer of the ITC. However, there has not been a lot of discussion about a subtle change that could benefit a real estate investment trust (“REIT”) interested in owning a distributed solar facility.
Limitations REITs Have Historically Faced
A number of limitations have made it difficult for a REIT to own a solar facility or claim the ITC. These are limitations on:
i. The amount of income a REIT can generate from sources other than real estate (the “Income Test”)
ii. The value of assets a REIT can own other than real estate (the “Asset Test”)
iii. The amount of an investment in solar property that is eligible for the ITC (the “ITC Limitation”)
In general, the Income Test requires that at least 75% of a REIT’s gross income for each taxable year be derived from real estate sources (e.g., rents from real property, interest on loans secured by real property, and gains from the sale of real property) and that at least 95% of a REIT’s gross income for a taxable year be derived from such real estate sources and from certain types of passive income such as dividends, interest, and gain from the sale of securities. The Asset Test generally requires that at least 75% of the value of a REIT’s total assets at the end of each calendar quarter consist of real estate assets (e.g., interests in real property and loans secured by real property), cash and cash items, and government securities. In addition, a REIT is limited in its ability to own securities of corporations, but up to 20% of the value of a REIT’s total assets at the end of each calendar quarter may consist of securities of one or more taxable REIT subsidiaries (“TRSs”). Because of these limitations, many REITs historically have owned their solar facilities through TRS structures, which can present their own challenges with respect to solar facility ownership and operation and use of ITCs. The IRA contains a provision that makes it easier for a REIT to overcome some of these limitations.
Changes with the IRA
As noted above, the IRA includes a provision that allows certain taxpayers, including REITs, to elect to transfer (essentially sell) the ITC to an unrelated taxpayer in exchange for cash. That provision specifies that the amount received by the seller is not includible in gross income (and there is nothing that suggests that the income exclusion is limited to certain purposes). The IRA also includes a provision that would turn off the ITC Limitation in the case of a REIT that elects to transfer the ITC allowed with respect to a solar facility.
Taken together, these changes may make it possible for a REIT to own a solar facility other than through a TRS and benefit from the ITC by selling it to a third party. Below are some brief thoughts on the implications.
Implications for REITs
Income Test. If a REIT elects to transfer the ITC allowed with respect to a solar facility, the amount received from the sale of the ITC is not includible in the REIT’s gross income. Thus, it appears that amounts realized from the sale of solar ITCs would not be taken into account for purposes of the Income Test. If the REIT consumes the electricity generated by the solar facility (which is the most likely use) and assuming there is no income from the sale of environmental attributes such as renewable energy credits (“RECs”), the REIT would not have any income from the solar facility itself.
Asset Test. Depending on the solar facility’s characteristics and expected use, some or all of the assets comprising the solar facility may qualify as real property for purposes of the Asset Test. With respect to solar facility assets not constituting real property, a typical REIT would own other real estate assets, so the REIT conceivably could limit the overall value of the solar facility assets that do not qualify as real property to ensure they don’t cause the REIT to fail the Asset Test. In many cases, the value of a distributed solar facility will be a small fraction of the value of the related real estate (e.g., a rooftop solar system may have a value of less than 5% of the related building).
ITC Limitation. As noted above, the ITC Limitation would not apply if the REIT elected to sell the ITC. Importantly, however, it appears that the ITC Limitation would continue to apply to any ITCs that the REIT does not elect to sell (e.g., because it is not able to sell them). Because the appropriate ownership structure for solar facilities generally must be determined at the outset of a new project, the marketability of ITCs likely will impact a REIT’s determination of the optimal ownership structure for its solar facility assets.
We expect these changes in the IRA will make it possible for a REIT to not only own a solar facility but benefit economically from the resulting ITCs, which will be a boon to both the real estate and renewable energy industries.