Recapture Rapture: Can Revised Tax Credit Policies Attract More Capital to Solar?

Michael Mendelsohn's picture

For developers trying to monetize the federal tax benefits for a given project, finding a tax equity partner can be a lonely process. Tax equity investors consist of a limited pool of suitors—investment bankers and a few other firms—who can tolerate the array of risks associated with this type of investment, including:

  • Current and future tax liability (that enables use of a project's tax credits),
  • The creditworthiness of the power purchaser
  • A shifting tax policy environment [1].

Investors also tend to be put off by IRS rules that limit the resale of solar assets. Investors claiming the investment tax credit (ITC) are required to maintain ownership until the sixth year of the project's operation [1]. If the asset is sold before the fifth year elapses, the IRS will "recapture" the remaining tax credits that have not yet vested over the five-year schedule (i.e., 20% of the total tax benefit per year) [2].  Accordingly, sale of the asset in that timeframe may cause investors to forfeit a significant portion of the tax credit benefit and, subsequently, a portion of their expected return. This constraint results in illiquidity, which incentivizes investors to seek other investment opportunities or to increase the required return.

The Treasury's 1603 program is widely recognized as easing the financing of renewable energy projects and supporting a general buildout of renewable energy capacity from 2009 through 2012 [1].  Prior to its existence, U.S. solar deployment was roughly 200 megawatts (MW) per year. This year, annual deployment is expected to reach roughly 3,000 MW, driven in part by the continued effects of the program even though it officially terminated at the end of 2011 [3].

A little known fact about the Treasury's 1603 program is that it relaxed the recapture rules. Under the program, sale of the asset did not result in a recapture event, greatly easing investor illiquidity concerns.  A new paper by Joel Meister—a law student and employee of Solar Energy Industries Association—provides valuable insight in the more flexible recapture criteria under 1603 [4]. According to the paper, the 1603 rules only contemplate three narrow circumstances that trigger recapture. Importantly, these circumstances exclude sale of the asset as a relevant event so long as the sale is to an entity that qualifies for the 1603 payment (i.e., to someone who pays taxes) and the project continues to produce renewable energy [4].

The rigidity built into ITC regulations was designed to constrain abuse by providing for "safeguards against the quick turnover of property" and the associated fallout that could occur if investors were not interested in a project's long-term operation [4].  This seems a reasonable rule, though research by the National Renewable Energy Laboratory has found no evidence that 1603 projects—which would presumably allow for quick turnover abuses—currently have operational problems.

Flexible recapture rules were written into the extension offered to low income housing tax credits. In this case, Congress provided an exception to an asset sale-as-recapture event so long as "the asset was reasonably expected to remain in operation" over the recapture period [4]. Industry insiders were expecting a 50% increase in investment in low income housing tax credits due to the relaxed regulation [5].

Although the ITC declines to 10% in 2017, when combined with accelerated depreciation, the tax benefits in total represent about 35% of the installed costs of a solar project [6]. That could be too high for solar projects to monetize internally. Accordingly, solar project developers will continue to knock on the doors of investment banks and other tax equity investors. Relaxing the recapture rules offers the potential for more doors opening up when the solar industry comes a-courtin'.

References:

[1] Mendelsohn, M.; Harper, J. (2012). §1603 Treasury Grant Expiration: Industry Insight on Financing and Market Implications. Golden, CO: National Renewable Energy Laboratory. http://www.nrel.gov/docs/fy12osti/53720.pdf

[2] Technically, the IRS refers to "disposition," in which ownership of property is transferred or otherwise relinquished.

[3] "U.S Solar Market Insight Report, Q2 2012", Solar Energy Industries Association, 2012, http://www.seia.org/research-resources/solar-market-insight-report-2012-q2

[4] Meister, J. (2012). Sunny Dispositions: Modernizing Investment Tax Credit
Recapture Rules for Solar Energy Project Finance After The Stimulus. The George Washington University Solar Institute (September 2012). www.solar.gwu.edu/Research/Meister_Sunny_Dispositions_ITC_Recapture.pdf 

[5] "Low-Income Housing Tax Credit" Enterprise (2012). http://www.enterprisecommunity.com/low-income-housing-tax-credits-policy

[6] "Will Solar Projects Need Tax Equity in the Future? Yes, but Baby Steps Toward Securitization Improve the Situation." Michael Mendelsohn. Accessed January 9, 2012: https://financere.nrel.gov/finance/content/solar-PV-photovoltaics-value-tax-credits-equity-accelerated-depreciation-securitization