Solar project development is often financed with solar tax equity. The term refers to pairing a solar project that qualifies for tax incentives, but can’t use them, with an equity investor who has a tax liability and wants to invest in solar energy.
A tax equity investor will usually invest 40%1 of the equity in a solar project in return for 100% of the tax benefits, plus additional cash proceeds, over a period of around 5 years.
The result is reduced tax liabilities and a nice return on investment for the tax equity investor and a profitable solar project generating renewable energy for a customer who buys it from the solar developer.
The tax equity investor may be an individual, business or corporation with significant “tax appetite“… Tax appetite means that the investor owes – or will owe – taxes and would like to reduce the amount of tax they otherwise would have to pay by investing in a commercial solar project that qualifies for federal tax incentives.
Because many solar developers (aka “sponsors”) do not have enough of a tax liability to be able to utilize the federal incentives, the solar developer will assign the rights to the tax credits to the tax equity investor in return for a financial investment in the solar project.
The federal government offers three tax incentives2 for commercial solar development that solar developers can assign to tax equity investors, including:
- The solar investment tax credit currently at 30% (before any bonus credits)
- Bonus depreciation currently at 100%
- MACRS accelerated depreciation
All of these federal tax incentives and project cash flows over the life of the investment are available to the solar tax equity investor who invests in the solar project.
The internal rate of return (IRR) on a typical solar tax equity investment is in the 15% range.
Once a tax equity investor has achieved a certain target return on investment, the sponsor will buy back the project from the investor. The tax equity investor would also then receive a buyout payment at the end of the project.
How Is A Solar Tax Equity Deal Structured?
If a solar developer does not have sufficient tax liability to take advantage of the tax incentives, the developer will seek out a tax equity investor.
The tax equity investor and the developer will negotiate the amount of money to be invested, the cost of the tax credits, the deal structure and the timing of payments to each party.
There are three types of deal structures that a solar developer is likely to use:
- Partnership flip: In a partnership flip, the tax equity investor owns 99% of the project until their internal rate of return is met. After that point a “flip” occurs where majority ownership of the project changes to the solar developer.
- Sale leaseback: In a sale leaseback, the solar developer sells 100% of the solar project to the tax equity investor who then leases it back to the solar developer.
- Inverted lease: In an inverted lease, the tax equity investor and the developer form two partnerships, a tenancy partnership and project LLC partnership. The tax equity investor leases the project from the solar developer and realizes the tax incentives through nature of the LLC.
Depending on the structure, the tax equity investor and the developer will agree on a minimum IRR for the investor.
Once an agreement is set, a limited liability company is formed that will own the solar project.
Tax Equity Partnership Flip Structure
The partnership flip is one of the most common solar tax equity deal structures for developers without tax appetite.
This is because the partnership flip structure provides flexibility for developers in assigning ownership of tax credits, losses and any income streams.
The partnership flip accommodates both the short-term tax incentive and IRR requirements of the tax equity investor and the long-term investment goals of the developer/sponsor.3
My cartoonish diagram above shows an oversimplification of the partnership flip process:
- Solar Developer: The solar developer identifies and forms the solar project opportunity and finds a tax equity investor.
- Tax Equity Investor: The tax equity investor contributes capital to the solar project in return for 100% of the tax incentives from the project.
- Solar Contractor: The solar project gets built by a solar contractor.
- Solar Offtaker: The solar project is brought online and the renewable energy is purchased by a customer (aka an “offtaker“) who uses the electricity.
After a period of 4, 5 or 6 years, once the solar tax equity investor has achieved the desired IRR, the investor is bought out by the solar developer.
The partnership flip deal structure allows the partners to allocate income, gains, losses, tax credits and/or deductions and cash distributions according to the terms of the partnership agreement.
An example would be a solar tax equity investor paying 90 cents on the dollar for each $1.00 of tax credits. In this case, the tax equity investor receives an 11.1% return on their money ($100,000/$900,000 = 11.1%), before any additional income streams from the solar project. The IRR of a partnership flip is usually in the 15% range.
A detailed overview of the partnership flip can be viewed in the video below by Edward Bodmer.
Understanding both the right type of tax equity financial structure helps ensure that your solar tax equity investment will be a home run financially and a success for the future of renewable energy.
Local Law 97 is a New York City law that aims to reduce greenhouse gas emissions in New York City by 40% by 2030 and 80% by 2050.
- The amount of the investment as a percentage of the total cost of the project is often affected by the amount of tax incentives available. The solar investment tax credit recently dropped from 30% to 26%. This may also reduce the percentage of tax equity investment as a percentage of the whole project. A 26% federal tax credit for the ITC may translate to a tax equity investment closer to 34.5%, as opposed to 40%.
- Government tax incentives, such as the investment tax credit and/or the production tax credit and bonus credits included in the Inflation Reduction Act are subject to change at various moments in time. Please check with your own attorney or accountant for the latest guidance for your situation.
- A detailed description of the tax and capital account implications of the partnership flip is available from Woodlawn Associates.