Solar Investment Tax Credits Overview

Introduction

Solar Tax Credits have recently gained national attention due to the significant improvements made in the Inflation Reduction Act of 2022 (IRA). The IRA has made accessing the significant benefits that Solar Investment Tax Credits offer significantly more attractive. With business owners always looking for new ways to lower their taxable income, and with this recent focus on solar tax credits, we thought it would be helpful to provide a breakdown of what they are, how they work, and how you can take advantage of the credits. While you may think of solar tax credits as something only available to specific companies, the reality is that you may be able to benefit from them as well.

Prefer to Watch a Video? Check out our video below!

What Are Solar Tax Credits

There are two types of Solar Tax Credits – Investment Tax Credits and Production Tax Credits. The value of Investment Tax Credits is based upon the amount invested to place equipment in service, whereas Production Tax Credits are calculated based on power generated. For the purposes of the blog today, we will be discussing Solar Investment Tax Credits.

Solar Investment Tax Credits (or ITC) were created by the Energy Policy Act of 2005. The main purpose of this act was to incentivize solar production by offering tax credits to those investors and developers who invested and created solar energy projects. This act created a 30% ITC that applied to both residential and commercial property, but with various caps and rules to attain the credit. To be clear, this means that solar investors receive a tax benefit for directly investing in solar energy equipment such as solar panels, thus lowering the cost of each project. To get the credit, you must first invest, install, and operate the equipment.

However, the main problem with the Act was that the tax credits were temporary in nature. As a result, the credits were extended through a variety of Acts and before the IRA, the Solar Investment Tax Credit had been reduced to 22% and was scheduled to fall to 10% thereafter.

So, what did the IRA do to improve Solar Investment Tax Credits?

The Inflation Reduction Act of 2022 had three significant impacts on Solar Tax Credits:

1. It extended the window for the Solar Investment Tax Credits through 2032.
2. It renewed the base credit to 30%
3. Created bonus credits based on project characteristics up to an additional 40% in Solar Investment Tax Credits

The first two impacts on Solar Investment Tax Credits are straight forward. The tax credit was scheduled to phase out and had been steadily reducing each year. The IRA increased the base solar tax credit to 30% and then extended this credit for 10 full years.

The last step is a little more complicated and allows for increased solar tax credits if certain parameters are met by the project:

The bonuses available for the solar tax credits are as follows:

As you can see from the table above, there is a clear emphasis on a few key priorities:

1. Wages for workers
2. Domestic Content
3. Location of Projects, with a particular emphasis on low-income areas

If you follow the law’s incentives for solar tax credit investing, you could potentially receive up to 70% in solar investment tax credits! Whether or not your project meets all four bonuses, the solar investment tax credit completely changes the math of how a non-qualifying project compares to qualified project.

Tax planning is all about following the incentives. If something sounds too good to be true, then it very well may be. Typically, when there is a substantial tax benefit, the government is very clearly trying to get you to act in a particular manner. When making an investment where taxes are a major benefit, it’s important to ask, why are these benefits offered?

When you look at Solar Investment Tax Credits the answer is simple – the government wants to incentivize production of green energy and especially projects that are made with United States based components, well paid employees, and in underprivileged areas. If you can do that, you can achieve significant tax benefits.

How do I invest in Solar Investment Tax Credits?

There are two methods to investing in Solar Tax Credits – Direct Investment and Credit Transfers. Direct Investment was the only way to invest in Solar Tax Credits until the IRA allowed Solar Tax Credits to be bought and sold for the first time. The IRS is still clarifying their guidance on credit sales, so we will focus on direct investment now and update the blog later once guidance has been finalized.

Direct Investment

In a direct investment, you invest a certain amount into a solar producing business. In return, you receive solar tax credits and ownership of the project and its associated cash flows.

Typically, this takes the form of forming a business, partnering with a developer, and then creating clean electricity.

Most direct solar investments take three forms today:

1. Sale Leaseback – in this model, you purchase solar equipment, lease it back to the seller, and the seller/lessee begins generating clean energy. In this example, you typically earn solar tax credits and an annual payment for the lease of the equipment.
2. Partnership Flip - in a partnership flip, you invest in a project with a developer who needs capital funding and has no need for the tax credits. These partnerships are typically structured in such a way that the developer keeps most of the economic benefit, while you the investor keep most of the tax benefits. At the end of a set period, the developer typically buys out their investors at a set price or valuation.
3. Inverted Lease – the third and final method is the inverted lease. In an inverted lease, the investor does not purchase the equipment but instead is the lessee. The deal is structured in such a way that the investor receives the tax benefits of the project and pays the lessor for the equipment rental.  

This is a very brief overview of the three main methods of direct investment in solar tax credits. I don’t want to get bogged down with the details of each method, but we will do a more detailed analysis of the options on its own blog. In the interim, this blog has a good amount of detail on the structures. Each option has its pros and cons, but most importantly they each have detailed rules and regulations that must be followed.

One final note is that most solar equipment qualifies as a depreciable asset. However, the basis of the asset is reduced by ½ of the tax credit.

If you buy an asset for $500,000 and receive a 40% credit, you will have a basis of $400,000.

Credit Transfers – To Be Updated Later

The second, and until recently impossible, way to obtain solar tax credits is through purchasing the credits.

In a credit sale, you will typically see something like this:

You pay $0.95 for a $1 of credits. You then offset your federal taxes with that credit, resulting in a 5% discount.

The good part about these credits is that you don’t have to be involved in any business to get them. You simply pay the seller and receive your credits with some additional tax filing.

The IRS is still clarifying their guidance on Credit Transfers so we will hold off on discussing them at this time. Once the guidance is finalized, we will update this blog.

Case Study – Solar Investment Tax Credits

Now that we’ve discussed how Solar Tax Credits work, let’s see an example of how they would work in real life.

Joe and Mary:

1. $1,250,000 LLC Income Taxed as a Sole Proprietorship
2. Married Filing Joint
3. Want to Invest $500,000 in a solar project

Project Type: Solar Leaseback with a $25,000 lease payment

After careful review of the projects available, Joe and Mary decide to invest in a sale-leaseback as it makes the most sense for their financial situation and they believe they will be able to manage it most effectively.

As a result, they invest $500,000 in the project which will pay them $25,000 a year for 20 years. As a result, they receive tax credits, depreciation on the equipment, and rental payments for 20 years.

The solar project also uses a majority of components from the USA which allows the project to qualify for a 40% credit. They do not locate the project in a low-income neighborhood.

Here’s how this looks from a financial perspective:

‍

As you can see, investing in a solar project results in significant federal tax savings for Joe and Mary. This analysis excludes any state savings.

While tax savings are typically the item that grabs people’s attention, I think it’s equally as important to note that a significant amount of the lifetime project benefits come from the developer continuing to make their lease payments. While most investors will chase the tax benefits, it’s important to realize that finding a reputable partner to execute these transactions with is key for the long-term value of the investment.

Active vs. Passive Tax Savings

The next part of investing in a solar project is the nature of the tax credits received. You cannot simply invest in a project and expect the credits to offset your active income.

There are two main categories of income in the United States– Active Income and Passive Income.

• Active Income includes income like your W-2 and business income from your business that you work full time in.
• Passive Income includes income from real estate and businesses that you are invested in but are not actively involved in.

As you can imagine, most individual's incomes are active income. As a result, they would like their solar investment tax credits to be active as well. However, if they invest in a project only to be uninvolved on a regular basis, they will be disappointed.

If you invest in a solar project and are uninvolved, your tax credits and depreciation will be considered passive. If you have passive income, that’s great as you’ll offset that income. However, if you don’t have passive income, your tax credits and depreciation will be suspended and you will be unable to offset your active income.

So how do you determine if an activity is active or passive? There’s a multi-step test. An activity is considered active if you materially participate by meeting any of the following criteria:

1. You participated in the activity for more than 500 hours.
2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities under Recharacterization of Passive Income, later.
5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
6. The activity is a personal service activity in which you materially participated for any three (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

If you meet any of these criteria during the year, you maybe eligible to offset your other sources of active income. As you can see, this requires more than simply investing in the project. To make your solar investment tax credits active, you must put in the time and be materially involved to benefit from the project.

Furthermore, claiming projects as active when they are passive is an area that the IRS is fully aware of and likes to target. Making sure you are involved, recording your hours contemporaneously, and being on the same page with your tax counsel is important to making the most of your solar tax credit investment.

Summary

As you can see from the numbers above, there are significant benefits to playing along with the incentives offered by investing in solar projects. By aligning your own incentives with the Inflation Reduction Act, you can potentially generate hundreds of thousands in tax savings.

These projects are for two types of investors – those who have significant amounts of passive income and those who have very high incomes and additional time to spare to dedicate to a project.

Overall, Solar Tax Credit Investing is extremely appealing and will be around for at least another 10 years. If you believe you may benefit from offsetting your taxes, Solar Investment Tax Credits may be for you.

Ironclad Wealth Management specializes in working with business owners with 1-25 employees who are looking for integrated tax and financial planning. If you are interested in solar tax credits as part of a full financial plan, schedule a no-cost introductory call below!

MGO One Seven LLC ("MGO One Seven") is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). Registration with the SEC does not imply a certain level of skill or training. All titles listed for individuals associated with Ironclad Wealth Management represent the individual's role with Ironclad Wealth Management, and not their role with MGO One Seven. Services are provided under the name Ironclad Wealth Management, a DBA of MGO One Seven. Investment products are not FDIC insured, offer no bank guarantee, and may lose value. Please visit our website www.WeAreOneSeven.com for important disclosures.

Please note, the information provided in this presentation is for informational purposes only and investors should determine for themselves whether a particular service or product is suitable for their investment needs. Please refer to the disclosure and offering documents for further information concerning specific products or services.

Nothing provided in this presentation constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments. Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

‍