REITs can own some solar equipment, the IRS said.

An IRS proposal in early May to make it easier for real estate investment trusts to invest in solar was disappointing, but may not be the last word. The IRS is collecting comments through August 12. The proposal would let REITs that own buildings also own solar panels on the building that are used to supply electricity to the building occupants. It is not clear the proposal would allow REITs to own solar panels in other situations.

REITs are corporations or trusts that do not have to pay income taxes on their earnings to the extent the earnings are distributed each year to shareholders.

The renewable energy industry is interested in REITs potentially as a source of cheaper capital. Congress created REITs in 1960 as a way for small investors to invest in large-scale real estate projects. Small investors pool their investments in the REIT and are treated essentially as if they had invested in the real estate projects directly without a corporate-level tax being taken out along the way.

The challenge for renewable energy is that a REIT must hold at least 75% real property or interests in real property. Examples of such assets are land, site leases, buildings and mortgages secured by real property.

The IRS, with the active encouragement of the White House and Department of Energy, issued proposed regulations in May redefining what qualifies as “real property” for REIT purposes. Under the new definition, solar equipment qualifies as a “structural component” of a building if it performs a utility-like function for the building, such as providing electricity, and the electricity is part of what the building occupants get for their rent for the use of space. In addition, the REIT must own both the solar equipment and the building, and it must expect the solar equipment to remain permanently in place.

The IRS and US Treasury are still thinking about whether it makes a difference if some of the electricity is supplied to the local utility, for example, through net metering. However, in an example showing how the new definition works, the IRS said that a solar system mounted on the ground next to a building whose electricity it supplies is considered a structural component of the building, even though the tenant transfers excess electricity “occasionally” to the local utility.

The IRS said in another example that the land, underground gathering lines, concrete base and metal racks that hold the solar panels in place at a utility-scale project qualify as real property, but the solar panels do not. The agency drew a line around what qualifies at a utility-scale project in the same place as the market already draws it under the existing definition.

Some renewable energy companies have been worried that any expansion of what is considered real property for REIT purposes could undermine other positions the industry has taken. The industry treats solar projects as equipment in order to claim Treasury cash grants, investment tax credits and five-year accelerated depreciation on the projects. These tax benefits can be claimed only on equipment and not also on real property. The US renewable energy sector has attracted a large amount of foreign investment, including by prominent European utilities. These investors are not subject to US capital gains taxes when they exit US projects unless the projects are considered real property.

The IRS said it is redefining real property solely for REIT purposes and said it does not necessarily follow that real property must be defined the same way for these other purposes. It asked for comments on the extent to which the various other uses of the term real property in the US tax code should be reconciled.

The new definition will apply after the IRS republishes it in final form. The agency has scheduled a public hearing on the new definition on September 18.

Any requirement to show that rooftop systems are expected to remain permanently in place would complicate the ability to finance rooftop systems in the tax equity market. A tax equity investor must be able to prove he is the tax owner of equipment to claim tax benefits on it. It is hard to prove tax ownership of equipment that is bolted permanently to the roof of someone else’s house.