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Income tax implications for improvements using C-PACE

Brent Hendricks, CPA, CGMA
Partner, EKS&H

Colorado’s Commercial Property Assessed Clean Energy program presents a unique financing opportunity for property owners and developers. Energy-efficient improvements, renewable energy projects, water conservation initiatives and other energy-focused projects made on new construction and existing structures may qualify for secured, nonrecourse financing administered through a special assessment and lien placed on the property. The improvements are designed to improve a building’s energy efficiency, thus reducing operating costs.

Typically, a lender provides the capital to build or install the qualifying improvements and executes a promissory note with the building owner listed as the borrower. The municipality imposes a special assessment on the improvements over a stated period of time. The property owner pays the additional real estate taxes to the municipality, and the municipality pays the lender. Unlike a traditional debt financing arrangement, the special assessment attaches to the improvement itself. The property owner’s obligation is solely to the municipality, not to the capital provider. As a result, when the property’s ownership changes hands, the C-PACE obligation transfers along with it, giving rise to unclear income tax consequences.

The income tax accounting implications of C-PACE financing are uncertain, and subject to debate among tax practitioners. If the repayment obligation transfers when the property changes hands, then does the building owner truly “own” the improvement property, from a tax accounting perspective?

There are at least two alternative approaches to tax accounting for C-PACE improvements, which could produce materially different tax results. If the building owner is treated as the owner of the improvements, then he would be treated as having purchased the improvements using nonrecourse borrowing, the repayment of which is made over the property’s special assessment period. Consequently, he would be entitled to depreciation (since he would own the improvements) and imputed interest expense deductions (since he would be treated as repaying a loan). Alternatively, if the building owner is not treated as the owner of the improvements, then he would simply report additional annual real estate tax deductions over the property’s tax assessment period.

Over time, the owner’s total tax deductions generally would be the same in either case; the difference is in the timing. In the first scenario, depreciation would be deducted over 39 years (or less, if the improvements involve certain types of personal property), and interest would be deducted over the property’s tax assessment period, which is generally 20 years. In the second scenario, the additional real estate taxes would be deducted over the property’s tax assessment period, which, again, is generally 20 years.

Relative to property ownership, tax court rulings have established an eight-factor benefits-and-burdens test. This test is commonly used to determine who “owns” property for tax accounting purposes and, thus, who is entitled to the normal tax deductions related to property ownership and financing arrangements (such as depreciation and interest).

The courts have relied not only on the test, but also on the facts and circumstances in each particular case. No one factor is determinative. Instead, they are viewed in light of each taxpayer’s transaction facts, taking into account all relevant information. The test’s eight factors are:

1. Whether legal title passes,

2. How the parties treat the transaction,

3. Whether an equity was acquired in the property,

4. Whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments,

5. Whether the right of possession is vested in the purchaser,

6. Which party pays the property taxes,

7. Which party bears the risk of loss or damages to the property, and

8. Which party receives the profits from the operation and sale of the property.

While a thorough analysis of each factor is beyond the scope of this article, certain factors can be evaluated based upon a typical real estate improvement investment. Generally, legal title to the improvement property would transfer to the property owner once installed. Generally, the buyer of improvement property would treat the transaction as a purchase, pursuant to a normal commercial construction contract. Since the improvements would be installed in or on the property owner’s building, he would have the right of possession, and during his period of ownership of the building, he would be required to pay either personal or real property taxes on the property. The property owner would insure the improvements. If the improvements were damaged or destroyed, the special assessment on the real property would remain, so the owner would bear the risk of loss. If the improvements enhance the building’s overall value (for example, in the form of reduced energy consumption), then the property owner would benefit from that appreciation in an eventual sale.

In general, C-PACE financing arrangements are nonrecourse liabilities whose security is solely the underlying property, which would look similar to more conventional nonrecourse real estate borrowings. If the building owner failed to satisfy his real estate tax obligation, resulting in a failure to pay the capital provider, then the municipality could exercise the rights under its lien against the property. The capital provider would not pursue repayment directly from the building owner. This unique transaction set complicates the property ownership analysis.

To date, the tax courts have not addressed this benefits-and-burdens ownership test in a C-PACE financing case. With so little tax authority on point, it remains uncertain whether a building owner truly “owns” the improvements from a tax accounting standpoint. However, as described above, there appears to be a reasonable amount of support for the position that the building owner “owns” the energy-efficient improvements. Those interested in using this unique financing tool are advised to consult with their advisers regarding this and other financial reporting, tax, legal and economic consequences.

Featured in CREJ’s July 4-17, 2018, issue

Edited by the Colorado Real Estate Journal staff.