The Internal Revenue Service and the U.S. Department of the Treasury recently issued proposed regulations that may facilitate using real estate investment trusts (REITs) as vehicles for financing certain renewable energy projects. The regulations clarify the definition of “real property” for purposes of the REIT qualification rules. To qualify as a REIT, an entity must satisfy certain income- and asset-based requirements. Under the income tests, 95% of the entity’s gross income must be derived from dividends, interest, rents from real property, gains from the sale of stock, securities, or real property, and certain other qualifying items. In addition, 75% of the entity’s gross income must be derived from rents from real property, interest on real property mortgages, gain on the sale of real property, dividends from REITs, gain on the sale of REIT stock, and certain other qualifying items. Under the asset test, at least 75% of the value of the entity’s total assets must be represented by real estate assets, cash and cash items, and government securities. The term “real estate assets” is defined generally for this purpose as, among other things, real property and any interest in real property. The proposed regulations are intended to provide a framework for determining whether property qualifies as “real property” for this purpose.
Existing regulations define real property for REIT qualification purposes as “land or improvements thereon, such as buildings or other inherently permanent structures thereon (including items which are structural components of such buildings or structures).” These regulations provide that state law is not controlling for this purpose, and they contain a list of specific items that are considered real property (including plumbing systems, central heating, pipes and ducts, elevators, and escalators) and a list of specific items that are not considered real property (including machinery, printing presses, and other assets that are not structural components). The existing regulations also define real property to exclude certain assets that are “accessory to the operation of a business.” The proposed regulations are intended to provide a better framework for analyzing whether a particular item of property constitutes real property. The proposed regulations, like the existing regulations, define real property as land, inherently permanent structures, and structural components of inherently permanent structures. However, under the proposed regulations, to determine whether a particular item of property fits within any of these categories, one must first determine whether the property is a “distinct asset.” If an item of property is a distinct asset, the asset must be analyzed separately to determine whether it is land, an inherently permanent structure, or a structural component of an inherently permanent structure. The proposed regulations list a number of factors to take into account in determining whether a particular item is a distinct asset, 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 it from a larger asset, (iii) whether the item is commonly viewed as serving a useful function independent of a larger asset of which it is part, and (iv) whether separating the item from a larger asset impairs the functionality of the larger asset. The proposed regulations eliminate the category of assets that are “accessory to the operation of a business.”
If an item of property is a distinct asset, one must determine whether the distinct asset constitutes land, an inherently permanent structure, or a structural component. The proposed regulations define “inherently permanent structure” for this purpose as any permanently affixed building or other structure. The term does not include any distinct asset that serves an active function, such as an item of machinery or equipment. The proposed regulations provide that if a distinct asset does not serve an active function and is not specifically listed in the definition of building in the proposed regulations, the determination of whether the asset is an inherently permanent structure is based on all the facts and circumstances, including (i) the manner in which it is affixed to real property, (ii) whether it is designed to be removed or to remain in place, (iii) the damage that removal would cause, (iv) any circumstances that suggest its affixation is not indefinite, and (v) the time and expense required to remove the asset.
The proposed regulations define “structural component” generally as “any distinct asset that is a constituent part of and integrated into an inherently permanent structure, serves the inherently permanent structure in its passive function, and, even if capable of producing income other than consideration for the use or occupancy of space, does not produce or contribute to the production of such income.” The proposed regulations list wiring, plumbing systems, central heating and air conditioning systems, elevators, walls, floors ceilings, and integrated security systems as examples of structural components. The proposed regulations provide that if a distinct asset is not specifically listed as a structural component, the determination of whether it is a structural component is based on all the facts and circumstances, including, among other things, (i) the manner, time, and expense of installing and removing the asset, (ii) whether the asset is designed to be moved, (iii) the damage removal would cause, (iv) whether the asset serves a utility-like function with respect to the inherently permanent structure, (v) whether the asset is installed during construction of the inherently permanent structure, (vi) whether the asset will remain if the tenant vacates the premises, and (vii) whether the owner of the real property is also the owner of the asset in question. A structural component will be treated as real property only if the taxpayer holds equivalent interests in the structural component and the inherently permanent structure to which the structural component relates.
The proposed regulations contain two examples that address whether solar electricity generation property constitutes real property for REIT qualification purposes. The first example involves a ground-mounted array that consists of land, PV modules, mounts, and an exit wire. The example concludes that the PV modules, mounts, and exit wire are distinct assets, and that the mounts and exit wire, which are designed to remain permanently in place, constitute inherently permanent structures and are therefore real property. The example concludes that the PV modules, on the other hand, are not real property for REIT qualification purposes because (i) they are items of machinery and equipment and therefore not inherently permanent structures and (ii) they are not structural components of the mounts.
The second example involves a ground-mounted array similar to that described in the prior example, except that it is located on land adjacent to an office building that is also owned by the REIT. In the example, the solar array and office building are both leased to the same tenant and, except for occasional sales of excess electricity to a utility company, the solar energy property is designed and intended to produce electricity only to serve the office building. The solar array was designed and constructed specifically for the office building and is intended to remain permanently in place. Based on these facts, the example concludes that all components of the solar array constitute structural components of the office building and are, therefore, real property for REIT qualification purposes. The example goes on to state that this result would be the same if, instead of a ground-mounted array, solar shingles were used as the roof of the office building.
The proposed regulations may facilitate certain REIT investments in solar energy property. Given the relatively narrow scope of the conclusions in the examples, however, it seems unlikely that the proposed regulations will give way to a landslide of REIT investments in solar developments. In addition, the proposed regulations do not seem to provide much of a foundation for REIT investments in other types of renewable energy projects, such as wind facilities. Thus, while the proposed regulations are favorable, they do not go far enough to spur widespread REIT investments in renewable projects.