Impact of final energy credit transfer regulations to the real estate industry, including REITs and other investors

The Inflation Reduction Act of 2022 (Act) introduced significant tax incentives intended to encourage production of clean energy, reduce carbon emissions, and promote domestic manufacturing. The Act provides two methods taxpayers can use to benefit from the new credits: the transferability election or an elective payment. On April 30, 2024, Treasury and the IRS issued final regulations regarding the transferability of certain energy tax credits. The final regulations adopt, with certain modifications, the proposed regulations that were issued on June 21, 2023, and remove the corresponding temporary regulations.

Why is it relevant to the real estate industry?

In 2023, conservative estimates for the value of the tax credit transfer market were $4 billion. This is expected to grow significantly in 2024 as transferability becomes more established in the market and sellers and buyers become more familiar with the process and risks involved. The final regulations provide specific rules for partnerships and S corporations and introduce two REIT-specific provisions that relate to the REIT asset tests and the prohibited transaction safe harbor. The preamble also addresses the treatment of the sale of electricity by REITs.

Action items to consider

With this significant growth, real estate investors may want to consider transferability as an increasingly important means to monetize tax credits. Eligible entities including partnerships and REITs may consider how they might benefit from the ability to transfer such tax credits. In addition, REITs should consider how the transfer of tax credits could impact their compliance with the REIT income and asset tests, as well as other tax issues impacting REITs, such as prohibited transactions. For more information, please see our prior Insights - Regulations on transfers of energy tax credits are finalized. Regulations finalized on direct payment of energy and advanced manufacturing.

In detail

Credit transfer

Background

An eligible taxpayer may elect to transfer, for cash, all or a portion of the eligible credits to an unrelated party. The final regulations cover a variety of issues, including which taxpayer is responsible if the tax credit is subject to recapture. The final regulations provide specific rules for partnerships and S corporations and confirm that those entities are eligible to transfer such tax credits. The final regulations did not differ significantly from the proposed regulations; however, favorable rules impacting REITs were added. The final regulations apply to tax years ending on or after April 30, 2024. For tax years ending prior to April 30, 2024, taxpayers may choose to apply the final regulations provided they apply the rules in their entirety and consistently. Observation: Taxpayers that may have transferred tax credits in years prior to the effective date of the final regulations, and applied the proposed regulations to those transfers, may be reassured that the final regulations did not differ substantially from the proposed regulations. In addition, taxpayers that may have taken positions inconsistent with the proposed regulations are not required to apply the final regulations to tax years prior to the effective date but may do so if the rules are applied in their entirety and consistently.

What can be transferred

The final regulations confirm that bonus credits on a property cannot be sold separately in tranches; a seller can sell a proportionate share (including all) of an eligible credit determined with respect to a single eligible credit property of the eligible taxpayer that is specified in a transfer election. A specified credit portion of an eligible credit must reflect a proportionate share of each bonus credit amount that is taken into account in calculating the entire amount of eligible credit determined with respect to a single eligible credit property.

REIT implications

REITs are subject to several tests including those relating to the nature of their assets and the sources of their income. REITs also are subject to a 100% tax on prohibited transactions.

Asset tests

REIT asset tests must be satisfied on a quarterly basis. One of the REIT asset tests requires that at least 75% of a REIT’s gross assets consist of real estate assets, cash and cash items, and government securities. Regarding eligible credits that a REIT may own that have not been transferred, the final regulations provide that such credits are disregarded for purposes of the REIT asset tests. Observation: The provision provides much-needed clarity for REITs that may not have known whether such credits should be treated as qualifying or non-qualifying assets for purposes of the REIT asset tests. It also provides REITs with flexibility to dispose of such credits at any time during a calendar year, including at the end of any calendar quarter, when the REIT asset tests are measured.

Income tests

While the final regulations do not directly address the issue of whether the right to receive a tax credit gives rise to gross income for purposes of the REIT income tests, the preamble to the final regulations specifies that since amounts received in exchange for a tax credit do not result in gross income under the federal income tax rules, the receipt of (or the right to receive) a transferrable tax credit should not give rise to gross income.

Prohibited transactions

As noted above, REITs are subject to a 100% tax on prohibited transactions. A prohibited transaction is generally the sale or disposition of property held by the REIT primarily for sale to customers in the ordinary course of its trade or business. However, if the prohibited transaction safe harbor is satisfied, the gain will not be subject to the 100% tax. One of the prongs of the prohibited transaction safe harbor can be satisfied if the number of property sales made during the tax year is less than seven. The preamble to the proposed regulations explained that cash received as consideration for the transfer of an eligible credit would not be included in the calculation of gross income. Therefore, the transaction would not generate any net income, and would not present a prohibited transaction issue. However, because many eligible credit programs allowed a taxpayer to earn several separately transferable credits, the issue of whether the transfer of an eligible credit would constitute a sale for purposes of the prohibited transaction analysis remained. The final regulations provide additional clarification and note that the transfer of a specified credit portion is not a sale for purposes of the seven-sale prong of the prohibited transaction safe harbor. Observation: The final regulations bring clarity to REITs that may want to participate in eligible credit programs without having to be concerned whether the transfer of such credits gives rise to prohibited transactions and will not adversely affect their ability to satisfy the safe harbor for other property sales.

Electricity generation

The preamble to the final regulations also addresses issues relating to sales of energy that previously were discussed in the preamble to the regulations addressing the definition of real property (Treas. Reg. section 1.856-10). The preamble to the final regulations restates that until additional guidance is published, in any tax year in which (1) the quantity of excess electricity transferred to the utility company during the tax year from energy-producing distinct assets that serve an inherently permanent structure does not exceed (2) the quantity of electricity purchased from the utility company during the tax year to serve the inherently permanent structure, the IRS will not treat any net income resulting from the transfer of such excess electricity as constituting net income derived from a prohibited transaction. The final regulations did, however, add some additional clarification specifying that any sale of electricity that does not meet the foregoing test should be analyzed on a facts and circumstances basis to determine whether the sale is subject to the prohibited transaction rules. The preamble to Treas. Reg. section 1.856-10 defining “real property” for REIT purposes noted that under the circumstance described above, income from transferring energy to a utility company would not be treated as gross income for REIT income test purposes. Observation: REITs that may be net sellers of energy may wish to assess whether such transactions could give rise to prohibited transactions because the preamble suggests that they could, depending on the REIT’s specific facts and circumstances.