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Tax equity definition

Many energy-generating assets, from solar to wind power, are financed using a form of investment called tax equity. Here’s how tax equity financing comes into play, both from an investment and project management perspective.

What is tax equity?

Tax equity offers a form of project financing, using a combination of project-generated cash flow and federal tax benefits. These benefits include both tax deductions and tax credits. For solar energy projects equity tax would come from benefits including:

  • Investment Tax Credit (ITC)

  • Interest deductions

  • Accelerated depreciation deductions

For example, imagine an investor puts money into a new solar energy project in exchange for the financial incentive of federal tax credits. As the solar project gets up and running, it would also generate positive cash flow returns which could be put back into the investment’s financing. The investor not only makes money from these returns but can also reduce income taxes due to credits and deductions.

While traditional financing includes owner equity, tax equity applies to those types of projects that qualify for federal tax incentives. This is why it usually goes hand in hand with renewable energy developments. In fact, within the United States alone it’s estimated that tax equity makes up roughly half of all renewable energy investments.

How does tax equity work?

Projects are funded in several ways.

  • Developer equity: developers pay for project costs not covered by outside investors and lenders

  • Debt financing: the developer secures construction financing from lenders

  • Tax equity: between 40% and 60% of the project costs are covered by investors in exchange for tax credits and cash returns

Tax equity is considered a passive investment, with the investor banking on receiving a target internal rate of return based on current federal tax benefits. Investors might include insurance companies, corporate bodies, banks, and even wealthy individuals.

Types of equity tax benefits

When answering the question of what is tax equity and how does it work, it’s important to understand the types of tax benefits on offer. The US government offers federal income tax benefits to subsidize renewable energy projects and hit its climate-friendly targets.

There are two main types of credits that would be of interest to a tax equity investor:

1. Investment tax credits

The government offers investment credits for clean energy projects. Examples of eligible projects could include things like:

  • Fuel cells

  • Wind energy property

  • Solar equipment

  • Geothermal energy

  • Geothermal heat pump property

  • Microturbines

These are calculated and distributed as a percentage of the project’s total cost, available in a single payment for the same tax year the equipment is put into operation. The amount will vary depending on the project’s year and the type of technology. For example, for solar projects beginning construction by the end of 2021, the credit is 26% of project costs.

2. Production tax credits

The second type of tax incentive sure to be of interest to tax equity investors are related to production. While the investment tax credit helps cover the costs of getting the project up and running, production tax credits are paid out over a 10-year period from the date the project is functional. Examples of this type of investment include:

  • Wind

  • Biomass

  • Landfill gas

  • Hydropower

  • Municipal solid waste

  • Geothermal

The tax credit amount depends on how much energy the project produces, adjusted for inflation each year.

Another factor that weighs into tax benefits is the cost of depreciation. Investors receive an annual tax deduction for the normal wear and tear associated with project-specific equipment. For renewable energy assets, some equipment qualifies for 100% depreciation in the year it goes into service.

Tax equity financing structure

These income tax credits and deductions are only useful for parties that owe income tax. Developers are often structured as corporations, which makes them ineligible to claim certain tax credits or depreciation benefits. As a result, developers enter a partnership with tax equity investors. One example of this would be a partnership flip

In a partnership flip, the developer forms a partnership with the investor. The developer then donates or sells the renewable energy project to this partnership, while the tax equity investor contributes cash. Under the terms of the partnership, the investor receives the majority of the tax benefits and cash up to a certain fixed date, typically five years. After this date, the partnership terms flip. The developer instead receives the bulk of the tax benefits and cash.

The bottom line

Tax equity financing helps fund important renewables projects, enticing investors with an attractive combination of tax savings and cash returns. For developers, it provides a way to get new projects off the ground without resorting to debt. Yet with numerous partnership structures to choose from, it’s important to read all terms carefully before investing.

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