What is Tax Equity?

What is Tax Equity?

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Tax equity is a form of investment that is made in renewable energy projects, such as solar…

But why is it called “Tax Equity”..?

Tax and Equity

The word “Tax” in tax equity refers to primary type of benefit an investor receives when making this type of investment… He or she is going to save some taxes.

The “Equity” in tax equity refers to the investor’s ownership of the investment. He or she is going to own something (at least for a little while….)

An Example of a Tax Equity Investment

Imagine your local public library has the opportunity to install solar energy on the roof of its building.

They believe it will not only save them money, but also that the science of renewable energy could be an educational tool of sorts for the patrons and their children…

The library director and the Board have run the numbers.

They have determined that solar will actually save them quite a lot of money on their electricity costs over the life of the system…

Probably for over 25 years!

And there are generous tax benefits for owners of solar systems.

However, the library is a non-profit organization… So, they cannot take advantage of the many tax benefits of installing a large solar system.

BUT…

The library also has a large and fervent base of supporters and local benefactors…  And many of the donors are wealthy and pay a lot of taxes.

Good news..!

With a tax equity structure, the library’s donors can help the library get its solar array while also helping themselves save on their taxes.

How a Tax Equity Investment Works

In this example, the library’s solar system costs $500,000.

To purchase it, the library and the donors form an LLC (or other corporate entity, structured as a partnership).

The partnership will own the solar system.

The donors would fund 40% of the $500,000, or $200,000, and own 99% of the LLC. The library would fund 60% of the LLC, or $300,000, and own 1% of the LLC.

Of course, not all public libraries may have $300,000 lying around.

That is OK because the $300,000 (non-donor portion) of the capital stack can be comprised of non-tax equity investment, or debt, such as CPACE.1

Partnerships can be structured in a way to dictate governance and decision making obligations for the operations of the system, regardless of ownership percentages.

The IRS rules require that ownership be structured this way because the tax incentives go to the legal owner of the solar system.

Also, ownership must not change for the first five years, or the owner will be required to pay the IRS a pro-rated amount of the tax incentives (aka a “recapture”).

As the owners of the system, the donors would be entitled to a 30% Investment Tax Credit (ITC) worth $150,000.

The donors would also receive accelerated depreciation (aka “MACRS”2), which is worth roughly another 30% tax benefit in after tax dollars over 5 years.

In all, with the Investment Tax Credit (ITC) and the MACRS accelerated depreciation, the library donors would receive roughly 60% of the cost of the entire solar system in tax benefits.

So, for a $200,000 investment, the donors would receive $300,000 of tax benefit, or pay $300,000 less tax in federal taxes over the five year period.

At the end of the five years, the donors and the library can conduct a transaction called a partnership flip. In a partnership flip the library would exercise a call option to buy out the donors for between 10-15% of the initial investment amount. In this case, between $20,000-$30,000.

As a result, the library gets a $500,000 solar system for roughly $330,000. They also benefit from receiving lower electricity bills for at least 25 years through the production of solar energy.

There are other benefits that the library and the investors can take advantage of, such as renewable energy certificates, aka “RECs”, that are not covered here.

 

Footnotes

  1. If the library is located in a municipality that has approved a CPACE program, it can borrow 100% of the remaining $300,000 at a relatively low interest rate, amortized over the useful life of the solar system (in this case, 25 years). A library’s tax-exempt status does not mean it can’t access a commercial property assessed clean energy (CPACE) program. Nonprofits don’t typically receive a property tax bill, however a municipality that has approved CPACE can assign a tax identification number in order to collect a CPACE benefit assessment (similar to collecting a sewer assessment). This means our library can access all the benefits of green energy improvements under the same rules as other applicants. Amazing!
  2. Referred to as MACRS, which is short for modified accelerated cost recovery system.