Tax Equity: The Best Investment that You (Probably) Never Heard Of
How do you define a great investment? Most people would say relatively low risk and high returns, but how do you get there? Traditional investments often require giving up one for the other, while many alternative investments over promise and under deliver.
There is one investment that can achieve this perfect balance while also eliminating a source of stress and confusion for investors, their tax bill. This investment is tax equity and it is the best investment that you (probably) never heard of.
While in existence for decades, the tax equity investment strategy has received greater attention in recent years due to its association with renewable energy. In order to promote the development of renewable energy assets, the Federal Government introduced a program providing significant tax benefits for investors who invest in these assets – and thus solar tax equity was born.
At its core, solar tax equity is an investment in a partnership. In exchange for cash put into the partnership, the investor receives the lion’s share of tax benefits associated with the partnership. These benefits are primarily in the form of the Investment Tax Credit (“ITC”) and losses due to accelerated depreciation, the combination of which helps the investor reduce, if not eliminate his/her tax liability. In addition to the tax benefits, the investor also receives cash, typically equal to at least 2% per annum on the initial investment amount. At the end of the investment period, the investor will typically receive a cash payment to buy them out of the partnership at the fair market value of the investor’s remaining interest in the partnership (the “call price”). Depending on the investor’s tax rate and the structure of the partnership, tax equity investments can easily provide after-tax returns in the mid-teens.
A typical example of a tax equity investment involving a solar project works in the following way:
- A partnership with a project contains $1,000,000 of solar property. This property is eligible for an ITC of $300,000, which provides a dollar-for-dollar offset to the holder’s tax liability.
- A tax equity investor invests $400,000 in the partnership and in exchange is provided in year 1 with $297,000 of ITC and up to ~ $510,000 of accelerated losses due to depreciation, which equates to ~ $177,000 of tax reduction at a 35% tax rate.
- At this point, the investor has received over 100% of the initial capital invested ($474,000) and is still due ~$120,000 in tax reduction due to depreciation losses, along with cash of ~$8,000 each year for 5 years.
- At the end of the required holding period (year 5) the sponsor has the right to buy out the investor at the fair market value of their interest – roughly 10% of the value of the initial investment.
The timing of the return of initial investment capital goes a long way in mitigating the risk associated with a tax equity investment, as well as the primary driver behind the high returns. Tax equity investments do contain certain risks that must be acknowledged, but can be greatly mitigated. The most significant of these risks is recapture. Although the ITC can be utilized almost immediately after a system begins operation, it actually “vests” over 5 years. If certain conditions are not met and maintained during that period, part of the ITC can be “recaptured” by the government. Other lesser risks involve generating enough cash flow to meet the 2% cash return and call price conditions, but properly selecting and contracting with an offtaker (i.e. purchaser) for the power, along with optimizing any additional local solar incentives, greatly reduce any potential concerns.
The major limitation to a tax equity investment is the type of investor who may utilize the tax benefits. Since most tax equity investments are passive (i.e., the investor does not materially participate in the management of the solar project), individuals who invest in tax equity may only use the associated tax benefits to offset other passive income. Real estate income, income from trust and other limited partner interests can all count as passive, but income from your primary business (i.e., in which you are actively involved) will not.
However, if you have passive income, you will be challenged to find an asset with better risk-adjusted returns than tax equity. Particularly in the current low rate environment with investors clamoring for yield, mid-teens after-tax returns of this nature are exceptional. Add in the tangible social impact generated by a clean energy investment and solar tax equity becomes the best investment you’ve (probably) never heard of.