Dechert LLP recently obtained an IRS private letter ruling (“PLR”) on behalf of an asset manager concluding that certain C-PACE assessments are “obligations . . . secured by an interest in real property” for purposes of the REMIC provisions of the Internal Revenue Code (the “Code”). Accordingly, the PLR concludes that those C-PACE assessments will be permitted assets for a REMIC.
The PLR is consistent with prior statements from the IRS regarding the treatment of special assessments as debt. Those statements, coupled with the property owner’s obligation to pay the C-PACE assessment and the foreclosure rights in the event of a failure to pay the C-PACE assessment, make the conclusion of the PLR unsurprising.
The PLR can be relied upon only by the party that received it.1 Although the PLR cannot be relied upon by others as a matter of law, it provides valuable insight into the IRS analysis of C-PACE assessments. As a result, the PLR provides comfort on an issue that may have prevented using REMICs for C-PACE financings previously and is likely to expand the tax structures for C-PACE financings.
C-PACE Assessments and C-PACE Bonds
C-PACE assessments arise from PACE programs for commercial properties administered by local property taxing jurisdictions. “PACE” means “Property Assessed Clean Energy.” A C-PACE program provides funding for the installation of renewable energy, energy efficient, climate resiliency, water conservation, seismic retrofit, and similar improvements located on commercial properties, depending on the local jurisdiction and state-enabling legislation. In general, a commercial property owner that wants to participate in a C-PACE program enters into a contract with an entity established by or for the local government or agency in charge of administering the C-PACE program whereby the property owner agrees to a special assessment (the “C-PACE assessment”) being imposed on the owner’s real property. The C-PACE assessment constitutes a lien against the entire property, not just the specific improvement that is installed and funded pursuant to the contract. The C-PACE assessment remains with the property, regardless of any intervening sales, until it is fully paid (unless prepaid voluntarily by the property owner or removed through exercise of eminent domain powers).
In some jurisdictions, a governmental entity will pool one or more C-PACE assessments and issue securities backed by such C-PACE assessments, which are commonly referred to as “C-PACE bonds.” In such cases, it is typical for an indenture trustee to hold the C-PACE assessments and use collections on the C-PACE assessments to make payments on the issued securities. Thus, a holder of a C-PACE bond does not directly hold the C-PACE assessments themselves.
Tax Treatment of C-PACE Assessments and C-PACE Bonds
From a property owner’s perspective, the tax treatment of a C-PACE assessment resembles that of debt. Although payable in the form of property taxes via the property tax bill, the C-PACE assessment payments are not treated as such. The IRS regulations provide that payments of special assessments are not deductible as property taxes.2 Instead, they are treated analogously to the repayment of principal on a loan, which is not deductible. However, if the special assessment contains an interest component, the payment of that component may be deductible.
In the context of PACE programs for individuals with respect to residential properties (so-called “R-PACE”), the IRS had previously provided on its webpage that the interest portion of a special tax assessment under a R-PACE program may be deductible as interest for a homeowner.3 It stated:
There are popular loan programs that finance energy saving improvements through government-approved programs. You sign up for a home energy system loan and use the proceeds to make energy improvements to your home. In some programs, the loan is secured by a lien on your home and appears as a special assessment or special tax on your real estate property tax bill over the period of the loan. The payments on these loans may appear to be deductible real estate taxes; however, they're not deductible real estate taxes. Assessments or taxes associated with a specific improvement benefitting one home aren't deductible. However, the interest portion of your payment may be deductible as home mortgage interest.
By allowing a deduction for the interest component, this approach provides a strong inference that the special assessment is itself indebtedness.
The IRS statements above match the conclusion of a PLR issued by the IRS in 1978.4 It addresses a special property tax assessment that allowed each affected taxpayer to pay an up-front amount or, at the election of the taxpayer, to pay over time. In the latter case, the taxpayer would be obligated to pay a yearly amount that included a portion of the assessment, an interest charge and a handling charge. The facts state that the taxing jurisdiction confirmed that the assessment was secured by a lien against the real property. The 1978 PLR concludes that, although the special assessment itself could not be deducted as a tax under Section 164, the interest charge could be deducted under Section 163. The conclusion that there is interest under Section 163 must mean that there is indebtedness for tax purposes.
In contrast to the property owner’s treatment of a C-PACE assessment, there does not appear to be any guidance expressly addressing the tax treatment to a holder of a C-PACE assessment, aside from the newly issued PLR, which is limited in several respects. As a result, a number of questions remain regarding the tax treatment of C-PACE assessments to a holder.
C-PACE bonds have more certain tax treatment. Obligations of state or local governments (and “on behalf of issuers”5) have long been respected as debt even when the payment thereof is limited to payments made by private, non-governmental persons in a back-to-back arrangement (such as so-called “private activity bonds”).6 Accordingly, C-PACE bonds should be treated as debt, subject to all the federal income tax rules applicable to debt.
Securitization of C-PACE Assets
As an initial matter, any securitization of C-PACE assets must address compliance with the taxable mortgage pool (“TMP”) rules. Both C-PACE assessments and C-PACE bonds appear to constitute “real estate mortgages” for purposes of the TMP rules.7 So, a securitization of C-PACE assets must be structured to avoid suffering entity-level taxation as a TMP.
The following structures could be used to securitize C-PACE assets to avoid entity level taxation as a TMP:
REMIC: Using a REMIC to securitize C-PACE assessments would require sufficient comfort with the analysis of the new PLR, given that no reliance can be placed on the conclusion of the PLR itself. A REMIC could not be used to securitize C-PACE bonds, however, because they are not “qualified mortgages” under the REMIC rules.8 Note that C-PACE bonds are not principally secured by interests in real property, but at most are secured by obligations that are themselves principally secured by interests in real property. That is, C-PACE bonds are problematic for purposes of the TMP rules but are not “qualified mortgages” for inclusion in a REMIC.
REIT: The PLR may offer some comfort for REITs with respect to C-PACE assessments. That is, the same reasoning for concluding that C-PACE assessments constitute “obligations . . . secured by an interest in real property” for purposes of the REMIC provisions may lead to a conclusion that C-PACE assessments constitute “obligations secured by mortgages on real property or on interests in real property” for purposes of the REIT provisions. At a minimum, a REIT should be able to hold a REMIC regular interest backed by C-PACE assessments as “real estate assets.”9 It is not clear whether or not C-PACE bonds would qualify as “real estate assets” for a REIT, although there are certainly policy arguments that favor such treatment.
Onshore CLO: The TMP regulations permit tranches that bear credit risk differently, but the tranches cannot otherwise have different maturity dates.10 A securitization could avoid being a TMP by paying principal to the debt classes on a pro rata basis unless and until a loss trigger event or other credit-based event occurs, and then paying principal sequentially until the trigger event is resolved. Each tranche would have the same maturity date absent losses but would bear credit risk differently. This structure is typically used in current securitizations of C-PACE assets.
Offshore CLO: A securitization issuer that is classified as a TMP can avoid entity-level taxation if the issuer is formed in a foreign jurisdiction that does not have entity-level taxation (e.g., the Cayman Islands or Bermuda) and is not engaged in a U.S. trade or business.11 For example, such an offshore entity might hold one or more REMIC regular interests issued by REMICs that hold C-PACE assessments and might also hold C-PACE bonds directly, in each case as an investor. Both the REMIC regular interests and the C-PACE bonds should be treated as debt qualifying for the portfolio interest exemption from U.S. withholding tax.12 Such an issuer, even if classified as a TMP, would avoid U.S. withholding tax and U.S. income tax on its assets. Further, it could issue securities typical of an offshore CLO. This structure may provide the most flexibility with respect to time and credit tranching, if a REMIC cannot be used because C-PACE bonds are included in the collateral.
Footnotes
1 Section 6110(k)(3) of the Code.
2 Treasury Regulations Sections 1.164-2(g) and 1.164-4.
3 Internal Revenue Service, Topic No. 503 Deductible Taxes, https://web.archive.org/web/20230413031630/https://www.irs.gov/taxtopics/tc503; cf. Internal Revenue Service, Topic No. 503 Deductible Taxes, https://www.irs.gov/taxtopics/tc503.
4 PLR 7912070 (Dec. 20, 1978).
5 Rev. Rul. 63-20, 1963-1 C.B. 24.
6 See Fairfax Cty. Econ. Dev. Auth. v. Commissioner, 77 T. C. 546 (1981), aff'd, 679 F.2d 261 (D.C. Cir. 1982) (per curiam).
7 See Treasury Regulations Section 301.7701(i)-1(d)(3)(ii).
8 See Treasury Regulations Section 1.860G-2(a)(6).
9 See Section 856(c)(5)(E) of the Code.
10 Treasury Regulations Section 301.7701(i)-1(e)(2).
11 See Sections 864(b)(2) and 882(a) of the Code.
12 See Sections 881(c) and 1442(a) of the Code.
