August 18, 2010Blog

New Possibilities in the Hunt for Financing

Renewable Energy World

A lack of financing for renewable energy projects is a common lament for most renewable energy developers. As many developers already know, new market tax credit financing is a phenomenal way to get cheap financing for certain renewable energy projects, if you can get the attention of a small group of banks with interest.

Fortunately, a recent taxpayer-friendly ruling by the IRS creates new opportunities to attract individual investors. Before explaining how this ruling can help developers, it may be helpful to take a moment to explain what new market tax credit financing is about for those unfamiliar with the program, and why it should never be overlooked.

The new market tax credit program was created over a decade ago as a way to direct funds to businesses located in low-income census districts. To encourage lenders to make loans to these businesses, the program gives these lenders a federal income tax credit equal to 39% of the loan. The credit is spread over a 7 year period.

To get the credit, a lender must charge an interest rate at least 25% below a market rate, and offer interest-only payments for at least 7 years. As if these terms aren't good enough, under certain structures, a lender can essentially discharge a substantial portion of the principal after 7 years (after all, the lender has recouped its investment from the generous 39% tax credit and often doesn't need to also get a return of principal).

Nearly all renewable energy projects qualify for this financing as long as the project is located in a low-income census district. A liberal definition of "low-income census district" covers almost 40% of the United States, including many rural districts.

The bottom line is that this program provides financing at better than market terms. Unlike the production tax credit ("PTC"), or investment tax credit ("ITC"), a developer doesn't need to monetize the credit by selling equity in a project entity, because the credit is claimed at the lender level (via an intermediary known as a community development entity). Thus, new market tax credit financing can be coupled with traditional renewable energy project financing, such as the PTC, ITC, or the federal 1603 grant.

However, as you can imagine, not every bank is willing to participate in the program. One key barrier is that the return to a lender comes in large part from the federal tax credit. As anyone who has read a newspaper in the last 2 years knows, most banks have plenty of losses these days to offset taxable income. While banks may not be looking for tax credits, there are still plenty of individual investors who are interested in offsetting taxable income. Until now, the ability of individual investors to serve as the lender has been limited, because it has been assumed that these credits were subject to the restrictive passive activity tax limits (as is the case with the PTC and ITC), which limits the use of these credits for most individuals.

In a June 2010 ruling, the IRS clarified that new market tax credits are not subject to these passive activity rules, meaning that individual investors with taxable income can benefit from this credit. For a potential lender, the expected returns would be comparable to a typical loan, except that a portion of the return comes in the form of a tax credit rather than a cash payment from the developer.

This ruling creates opportunities for project developers by allowing them to raise funds by finding one (or multiple) investors who would loan funds to the renewable energy project. While developers are usually wary of issuing debt because of cash flow needs, the developer should remember that the debt service obligations of a new market loan are substantially better than market rate loans.

So if you are a developer thinking "hey, this new market thing sounds great, but how do I get started?" there are three key steps. Step 1 is to figure out if the project is in a low-income community. You can do that by plugging in the address for your project on a US Treasury website ( Step 2 is to get an allocation of credits for your project from a community development entity. You can find community development entities operating in your state from the following list posted to the US Treasury's website: Step 3 is to find a money source, which can be a bank or one or more individuals willing to lend to your project. While there is very little that is easy about financing a renewable energy project, our friends at the IRS made the process a slight bit easier.

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