It’s that time of the year. Leaves are falling, snow is on the mountain tops, and tax filling extension season (10/15) has passed just as investors and taxpayers have healed from last year’s tax bill. As planning begins for tax mitigation for the upcoming 2022 filing, investors may have more options than the general practice of tax loss harvesting before the end of the year (maximum net capital loss in any tax year is $3,000 – $1,500 for married filing separately).
On the bright side, 2022 has seen several initiatives underpinned by global megatrends in infrastructure and climate change mitigation, unearthing investment, and tax strategies to help with both current and future tax and investment planning. The most prolific of which is the tax benefits of investing in the solar sector.
Solar, at present, is a mature technology and the highest growth form of renewable energy globally. Over the last 10 years, solar costs have come down dramatically, and the technology is now cost-competitive with fossil fuel generation technologies. According to the International Energy Agency (IEA), the world must reach an annual solar generation level of approximately 7,400 Terawatts (TWh) by 2030 to align with the Net Zero Scenario. This will require an average annual generation growth of about 25% during 2022 – 2030, and unprecedented private investment to achieve.
The need for growth in solar generation is further cemented by the growth in electric vehicles. According to Elements, in 2011 around 55,000 electric vehicles (EVs) were sold around the world. Ten years later in 2021, that figure had grown close to 7 million vehicles. The U.S. is now expected to account for 17% of the 56 million electric vehicles (EVs) sold by 2040, posing another catalyst for increased solar generation.
To be fully sustainable, electric vehicles must be charged with renewable electricity, not fossil fuel-generated electricity. Solar, at present, is the only cost-competitive technology that can achieve this on a timeline compliant with global climate targets.
Nicholaus Rohleder, Co-Founder of Climate Commodities and Adjunct Professor at Columbia University, added, “The backbone of grid and vehicle electrification hinges on the rapid acceleration of solar on a global basis. Unbeknownst to many, the sustainability of many industrial processes, grid applications, and vehicle applications begins with an input of renewable power. The majority of this needed renewable power must come from solar to meet stated climate targets given the current state of generation economics and technology readiness.”
The current administration recognizes the importance of a strong domestic solar sector and has been busy implementing tax benefits for investing in renewable energy in the United States. This began earlier this year with the rollout of initiatives in the Bipartisan Infrastructure Plan which contained provisions providing benefits for investing in solar in the United States and was further cemented by the passage of the historic Inflation Reduction Act.
On August 16th, 2022, the Inflation Reduction Act (IRA) became law, the largest climate policy ever enacted in the United States. The IRA will provide a total of $738 billion, of which $391 billion is earmarked for spending on energy and climate change. The general focus of these initiatives is to create jobs, address global climate challenges, accelerate growth in clean energy to 2035, and to bring manufacturing back to United States shores. Within the 730 pages of the IRA were Renewable Energy Tax Credits taking the form Investment Tax Credits (ITCs) for the solar space.
ITCs have been in existence since 1962 and are a way to stimulate individual and business investment through federal tax incentives. However, unlike other tax-related investment incentives, ITCs are not tax deductions; they are far more valuable. ITCs reduce what you owe on your federal taxes dollar for dollar.
For qualifying solar projects completed between January 1st, 2022, and the end of 2032, these ITCs can provide a 30% Federal Tax Credit (if they meet appropriate labor requirements), and an additional 10% for projects located in low-income communities (or 20% if the project is included in certain low-income housing). Another 10% can be achieved by utilizing domestically manufactured hardware, and a further 10% if the facility is located in what is deemed a former “fossil fuel community” or Energy Community.
In total, solar ITCs can reach up to 70%. Functionally, solar ITCs are claimed in the year that the project is “placed in service.” Unused tax credits related to the solar project may be carried back three years and forward 22 years for projects placed in service in 2023 or later. Projects placed in service before 2023 can carry the tax credits back one year and forward 20 years.
It is important to dig a little deeper and bifurcate between an individual investing in solar panels for their home versus a “Solar Investor”, who is an investor interested in the investment aspects of a commercial solar project.
For the solar investor, ITCs, along with bonus depreciation from making an investment in a solar facility, can offset passive or active income, depending upon the investor’s situation. In general, these benefits are always eligible to be deemed Passive Activity Losses (PALs). However, if it is an investment where the investor has “Material Participation” (see Publication 925), the credits or deduction can be used to offset Active Income (commonly wages, salaries, tips, commissions or business where you materially participate).
The solar investor generally has two different investment structures available to achieve the optimal tax benefit. However, going into this, it is imperative that the solar investor knows what type of income he or she is looking to offset with the structure of the solar investment the investor is making or participating in. The following provides a detailed framework for the solar investor:
Important General Notes:
- Investment holding period should be considered so an investor is not subject to any depreciation recapture.
- Passive activity (losses/deductions) only apply to passive income generators (PIGs).
- Active credits may only be applied to active income, not dually applied.
Passive Income Offset Criteria
(No Material Participation – Solar Fund Investment):
- This structure is most appropriate for solar investors who are high passive income generators (PIGS) not materially participating in the solar business.
Example Solar Investor Candidate:
An individual with substantial rental property income where they have minimal offsetting expenses or deductions, such as depreciation. This is commonly the case where an investment real estate property has been owned for a long time or has used up its depreciation offsets. See Schedule E (Form 1040, personal return) or Form 8825 (for 1065 Partnership).
- Limited Partnership (LP) income where the LPs do not materially participate in partnership activities is also potentially eligible as it could be classified as passive income.
- Income from equipment leasing can classify as passive income in certain cases.
Passive Income Offset Criteria
(Material Participation – Solar Project Investment
- A solar investor who materially participates in the solar investment with high active income, such as W2 or 1099.
- Material Participation in the activity and a Qualifying Real Estate Professional (See Publication 925 qualifications). A taxpayer’s rental real estate activity is not a passive activity if the taxpayer materially participates in the activity and performs qualifying services in the real estate industry.
- Royalties derived in the ordinary course of business.
- A closely held C Corporation, which is typically a family business. This is defined as a corporation in which 5 or fewer shareholders own more than 50% of the outstanding stock – IRC Section 469(e)(2).
In addition to the aforementioned, it is important to mention one further unique exception: Passive activity deductions are deductible against nonpassive income when a taxpayer disposes of the passive activity. Passive gains and losses are reported on IRS Form 8582.
So why would I make an investment in solar?
- Reduce or potentially eliminate federal income tax through ITCs and bonus depreciation with dollars owed to Uncle Sam
- Potential state tax benefits
- Potential tax-efficient income
- Appreciation potential
- Diversify portfolio with an uncorrelated asset class
- “Do well by doing good” – direct investments to align with interests in environmental impact and sustainability
- Invest in America’s future
Please consult your tax professional to discuss your personal tax situation. Many of these types of investments may have both minimums as well as Accredited Investor requirements to participate. We are happy to discuss your investment needs and see if this type of investment would be appropriate for you. Find us at www.assetstrategy.com.
By Kent A. Fitzpatrick, AIFA, GFS
Kent is a Contributing Editor for MoneyLetter, the Managing Director of Asset Strategy, and an Accredited Investment Fiduciary Analyst