Our tax code provides many potential tax benefits for investments in renewable energy systems, whether you are investing for the first time or expanding an existing system. If you can overcome the many hurdles imposed by our tax laws and utilize the tax benefits, the rates of return on the investments are usually impressive, good for the planet and your bottom line.
This article identifies the key tax issues that should be addressed before you commit to the investment. However, beware the tax laws can get complicated quickly, with many minefields to navigate. This is a high-level summary only, intended to help start the discussion with your tax advisor to make sure all the bases are covered.
The tax laws are constantly changing. Often a particular tax provision will expire, only to be reinstated retroactively. In my 30-plus years of practice, I’ve watched the renewable energy tax laws ebb and flow with the changing political and ideological winds in Washington. There have always been significant tax benefits available for the fossil fuel industries, but recently the tide has been shifting toward renewables. The Treasury Grant “§1603” program in the late 2000’s, which provided cash instead of tax credits, generated significant interest in these investments. We assisted many farms in my home state of Vermont to qualify for and obtain the grants for “cow power” methane digesters. After the §1603 program expired, the interest shifted primarily to solar energy, although we have also worked with clients investing in hydro, wind and biomass projects.
The tax laws differ for each type of renewable energy, and it would be impossible to summarize those differences in a short article, so the comments below focus on solar electrical production, although the concepts and issues are relevant for other types of renewable energy investments as well.
Federal Tax Credits: The U.S. income tax laws provide a significant tax credit for a certain percentage of qualifying costs – 30% in 2019, phasing down to 26% in 2020, 22% in 2021, and in 2022 and beyond the credit drops to 10% for businesses and 0% for residential. The tax laws also impose limitations on how much of the Federal income tax liability can be offset by tax credits, so you must take those limitations into consideration in your planning.
Business vs. Residential: Solar energy assets used for either business or residential purposes have the same Federal 30% (2019) tax credit, however the credits are allowed under different Code sections with different sets of rules, so be careful to follow the correct Code section and its related regulations and rulings. Some of the key differences are (1) only business assets can be depreciated, (2) carryovers and carrybacks of excess (unused) tax credits, (3) state income tax results, and (4) tax bases.
Qualifying Costs: The costs qualifying for the tax credit are generally those costs incurred for equipment that uses solar energy to generate electricity, as well as any equipment that is integral to that process, and components that are functionally interdependent. Certain assets do not qualify, such as land, inventory, buildings, transmission equipment, and non-integral equipment. It is not always clear whether certain costs are qualifying or non-qualifying, so it is critical that you explore these nuances.
State Taxes: Every state has its own set of tax laws, so you have to consider 50 different sets of rules. Often state income tax laws follow the Federal rules closely, which can make the analysis less complicated. Each state offers unique incentives for renewable energy, and the tax benefits can take many forms, such as deductions, credits, grants and exemptions. Vermont has a generous state-level income tax credit, equal to 24% of the Federal business tax credit allowed, as well as property tax exemptions.
Placed-in Service: The tax credits, as well as depreciation expense for business assets, are allowed and reported in the year the asset is “placed in service”, which is the tax code terminology for the moment when the asset is ready and able to perform its intended function. For solar arrays, this is generally the time when the array is “energized” (producing electricity), or when the local utility tests and approves the array for electricity transmission into the grid. The placed-in-service issue can be particularly important in determining the proper year for reporting the tax benefits for assets constructed close to the end of the year.
Passive Activities: The tax code imposes many limitations on the ability of taxpayers to deduct business losses and credits. Taxpayers usually don’t have problems with the basis and at-risk limitations in a typical solar investment, but the passive activity limitations are more difficult to overcome and tend to be where we do most of our tax planning with clients investing in renewable energy projects. The passive activity rules are too complicated to attempt to summarize here, so make sure you consider those issues with your tax advisor.
Financial Analysis: The potential investor will want to determine if the investment makes sense economically, usually in the form of cash flow analysis that calculates the internal rate of return (IRR). The IRR on solar investments is generally high, particularly if the tax benefits are available, and are less speculative than most other investments, because the electrical production and tax benefits are fairly predictable and stable.
I hope you found this overview of the key tax issues to consider when analyzing an investment in renewable energy helpful. Renewable energy tax planning tends to be a specialty niche area for CPAs, and not all are familiar with the nuances, so please consult with a qualified tax advisor before investing.
Chaz Blackmore is a partner at Bilodeau Wells & Co. in Essex Junction, Vermont. He is a CPA in practice for over 30 years, including stints with Ernst & Young in Boston and Fortune-500 high-tech companies in California. He lives with his wife, two children, and way too many pets, in Charlotte, Vermont.