The Basics of Solar Tax Credits

1. The Basics of Solar Tax Credits Forrest Milder617-345-1055fmilder@nixonpeabody.com Herb Stevens202-585-8811hstevens@nixonpeabody.com © 2008

2. 1 – Solar Tax Credits • Solar credit is an investment tax credit (or ITC) • Based on cost of facility • Usually taken all in one year • Generally only available for new property (there’s an 80% test) • Mostly: depreciation over 5 years

3. 2 – Overview of ETCs • Energy Tax Credits are generally 30% of “facility” cost (e.g., transmission lines and substations are not eligible for the ITC) • Includes Photovoltaic (PV) Concentrated Solar Power (CSP) & fuel cells • Must generate electricity, heating, cooling, hot water, or fiber-optic lighting. Sale of elec. is not required

4. 2 – Overview of ETCs (cont’d) • Usually taken in the year the facility is “placed in service”, but can sometimes use “progress expenditures” over more than one year • Possible recapture for 5 years (100% in first year, 80% in second year, etc.) • Called “Energy Tax Credits” in Section 48 of Tax Code • Applies to property placed in service before December 31, 2016

5. 3 – Need for an Owner • No “sales” of credits. They are generally claimed by the owner of the facility which makes an “investment” in a partnership or LLC, or, if the developer wants “out”, the facility could be sold • No government ownership • Sometimes, a lease is used, and the tenant claims the credits (note: “anti-depreciation” for tenant). A lot like HTC.

6. 3 – Need for an Owner (cont’d) • Lengthy documents detail the relationship – addresses investment timing, allocating credits, distributing cash, and withdrawal of the investor • Usually: 5+ year relationship with investor

7. 4 – Allocations Developer Investor • IRS has elaborate rules for allocating the credits among the parties • ITCs follow the “profits” of the owner • This is NOT the same as LIHTC(they follow depreciation) • Wide range of ratios possible, not just 99-1 1% 99% Partnership Solar Facility

8. 5 – Sharing Cash and Credits • They don’t have to be shared in the same way • IRS might treat cash distributions as a share of profits or gross sales and re-allocate the credits • Must track capital accounts • Might be able to use debt, management or development fees to get cash to developer

9. 6 – Need for a Forecast • Shows how credits and cash go to the investor and the GP • Must be done by someone who knows syndication (otherwise, there may be very unwieldy projections) • Remember that Allocations are different from LIHTC • Pricing is often based on IRR, not cents per dollar of credit

10. 7 – Placed In Service (“PIS”) • When to start claiming credits – it’s not based on when the investor comes in. • If investor gets in late, ETC may be lost (possible 3-month lease exception) • ETC may be able to use “progress expenditures” to get credits earlier, and higher rate

11. 7– More on Placed in Service (cont’d) When is a facility placed in service? • Usually when completed, with licenses and after pre-operational testing • “Daily operation” can matter • Acquired property must be delivered and ready to use; mere purchase is not enough

12. 8 – Other Subsidies • Bonds and “subsidized energy financing” generally reduce federal credits on a pro rata basis • State programs usually don’t reduce solar credit, but may be taxable, e.g., state grants • IRS keeps attacking state tax credits

13. 9 -Technical Rules • Almost all investors are corporations because of “At Risk” and “Passive Loss” Rules • Basis reduction of 50% of ITC, meaning less depreciation • Profit motive – But compare Rev. Proc. 2007-65 (for wind) with Reg. 1.42-4 (for LIHTC) • AMT is eliminated, effective for years beginning after October 3, 2008.

14. 10 – Flips, Puts, and Calls • Once you’ve gotten the investor IN, you need a way to get it OUT. • Flip – reduce the investor’s percentage to make it cheaper to buy him out • Put – The investor can get out for a small amount. Less used in energy deals • Call – The developer can buy out the investor for fair market value

15. 11 -Puerto Rico Solar Tax Credit • Puerto Rico enacted legislation in August 2008 to provide a corporate or individual taxpayer with a credit for acquiring and installing "solar electric equipment." • The credit is allowed against the taxpayer's Puerto Rico income tax. • Through fiscal years 2008-09, the credit amount is 75% of the cost of the equipment and installation. • During fiscal years 2009-10 and 2010-11, the credit is 50% of the cost of the equipment and installation. • During fiscal year 2011-12 and beyond, the tax credit is limited to 25% of the cost of equipment and installation.

16. 12 - Combining LIHTC and Solar • Project can qualify for both • 2008 Act requires States to take account of energy efficiency in the QAP • Remember that bonds can be a problem • Remember that LIHTC and Solar are allocated among partners differently (so watch out for contingent fees)

17. Combining LIHTC and Solar (cont.) • Solar credits reduce LIHTC basis (illustration follows) • Solar also offers rapid depreciation to investor --5-yr MACRS (Only 5-yr S/L if bond-financed). Also, unlike the real estate, solar is eligible for 50% “bonus” depreciation in 1st year (must be PIS in 2008). • Crucial to track capital accounts and “minimum gain” – the accelerated depreciation may drive investors negative very early; debt structure will be important

18. Example: Solar and Housing Credits *Plus 5-year MACRS (and **Plus S/L depreciation 50% bonus depreciation if PIS in 2008)

19. 13 - Pricing Solar Credits • Solar is often priced based on IRR, not cents per credit dollar, because (i) all credits in one year, plus (ii) rapid depreciation mean (iii) a different pricing model than applies to LIHTC. • The Most likely purchaser is the owner of the LIHTC project, so there may not be competitive bidding for the credits

20. 14 - Technical Rules • Bonds reduce the ETC. So, pay attention to LIHTC projects that are 51%+ bond-financed (May be able to “trace” the bond proceeds and allocate them away from the solar, so as to maximize the ETC. See PLR 200820011) • Placed-in-service date can be different for panels than for housing units. You can’t “warehouse” the ETC, so it’s important to have the investor ready (or already in) • If solar qualifies for LIHTC, it can qualify for the 130% boost too (if project is in DDA or QCT)

21. More Technical Rules • Tax Exempt Use Rules – If there’s a tax-exempt partner, make sure that its share of the deal is a “qualified allocation” or use a Section 168(h)(6) electing entity. • Profit motive should not be necessary because of Section 1.42-4 of the regulations that applies to LIHTC deals (But consider “lease pass-through” structures in which the panels are leased to a different investor which only takes the credits)

22. 15 - Things to Remember -- Solar and LIHTC ETC Issues • LIHTC and Solar are allocated among partners differently (so watch out for contingent fees and other proxies for profits that can screw up the ETC) • May be able to delay incentive fees to year 6 to avoid risk that fees will be treated as profits during recapture period

23. Things to Remember – Solar and LIHTC (cont) LIHTC Issues • If residents are charged, then solar is “commercial” and not eligible for the LIHTC • Utility Allowance rules (1.42-10) hadn’t required that cost savings from solar-provided electricity be taken into account. So: permitted tenant rents are lower than they “should” be. (Illustration follows). But: recent changes allow a building owner to hire a qualified professional to calculate utility allowances taking into account “systems” and “appliances”.

24. 16 - Utility Allowance Illustration • Assume total permitted rent is $1000, and utility allowance is $75. So, tenants can only be charged $925 by the landlord • Suppose solar panels would reduce utility cost by $25. So, instead of $75, we expect the actual utility cost to be $50/mo. • Using $1000 permitted rent, landlord should be able to charge $950 (because utility allowance should be reduced from $75 to $50), but 1.42-10 doesn’t require the utility allowance to take renewables into account. Instead, it may be “stuck” at $75 • So landlord doesn’t get the benefit of the $25 savings; instead, he still charges $925, the tenants only pay $50 for utilities, and their total expenses go down from $1000 to $975

25. 17 - Solar for Housing without the LIHTC • Solar panels can be added later by an LIHTC partnership (without getting low income credits for the solar), or • The panels could be owned by an unaffiliated owner and either: • (i) this owner could lease the panels to the LIHTC partnership, or • (ii) this owner could sell power to the partnership or its tenants • But consider the loss of the LIHTC (generally 80+% of costs). It is much larger than the ETC (30% of costs) • Having a separate owner typically avoids bond tracing rules (if applicable) and may avoid contingent fee issues

26. NMTC/Solar Investment Structure Leverage Fund NMTC Equity Leverage Loan NMTC Investor Leverage Lender NMTC Equity 99.99% NMTC CDE Solar Tax Credit Investor Solar Equity Solar Credits Loan Solar Equity Solar Project Owner Master Tenant 49% Interest Solar Credit Pass-through to Master Tenant

27. Thanks Forrest Milder and Herb Stevens