Commercial Solar Energy Credits: A Tax Primer

Co-authored by Stanley Rose

Introduction

A powerful tax credit designed to encourage construction of energy-producing solar equipment was set to expire next year, before Congress late last year extended its benefits for three more years. In addition to the energy cost saving itself, the favorable tax treatment makes this credit an attractive one for both residential and commercial entities, including banks.

Section 48 of the Internal Revenue Code awards different variants of its “Energy Credit,” including some involving wind power and waste recovery. The focus of this article is the tax credit applicable to solar energy property. Please refer to our related article for a discussion on the GAAP accounting considerations for this type of investment.

Qualifying property

The types of property that qualify for the credit include equipment that uses solar energy to generate electricity, to heat or cool a structure (except swimming pools), or less commonly, illuminate the inside of a building using fiber optic light. Common expenditures include costs of photovoltaic panels, transformers, mounting equipment, certain energy storage devices (batteries), related installation services, and sales taxes.

Computing the credit

The credit is equal to a percentage of the cost of qualifying property. Generally if construction of the property commenced in 2020 through 2022, and it is placed in service no later than 2026, the credit is 26% of the cost. For projects begun in 2023 and in service by 2026, the credit is 22%. It then decreases to 10% for later years. The code’s provision of both starting and ending dates is deliberate, and detailed rules accompany the definitions of both. Generally, at least 5% of the cost of the actual solar equipment must be incurred before a project is deemed to have commenced, and a property must be in use (generating electricity) for it to be deemed placed in service.

Using the credit

The credit can reduce your tax liability dollar for dollar, with any excess surviving for use against the following year’s liability, for up to 20 years. It also can be carried back one year, reducing the prior year’s tax liability, via use of an amended tax return.

The benefit of the credit can be relinquished under “recapture” rules if a property that generated the credit is disposed of within 5 years of the date placed in service. The recapture is accomplished by increasing taxable income by the full amount of the credit, if triggered in year 1; by 80% if triggered in year 2, and so forth.

Depreciating the balance of the cost

A tax credit reduces your tax dollar for dollar, and is more powerful than a deduction, which merely reduces the amount of your income subject to tax. Solar credit property, however, allows you to do both.

Most readers are familiar with depreciation, whereby the costs of equipment or buildings are recovered over prescribed tax lives as deductions in computing taxable income. If a solar credit is utilized, the taxpayer can still depreciate the cost of that property, but not the full amount. Logically, one might think the depreciable basis is computed by reducing the total cost by the amount of the credit. However, the tax rules only force a reduction equal to ½ of the credit amount (thereby allowing some level of double-dipping, where the same portion of cost generates two simultaneous benefits). The depreciable cost of most solar equipment also qualifies for so-called “bonus depreciation.” Bonus depreciation allows 100% of the depreciable basis to be deducted in the year the property is placed in service, rather than spread over the depreciable life. (This 100% first-year write off drops to 80% in 2023 and 60% in 2024, but regardless of that percentage, the remaining cost can still be deducted over the balance of the tax life.)

As is the case with any depreciable asset, if the solar property is later sold, the proceeds are compared to the adjusted basis (reduced by half of the credit and any depreciation allowed) and this will result in a corresponding increase in taxable gain upon disposition.

Example of tax savings (from credit and depreciation)

Here is a very basic example of the credit and depreciation in action, based on qualifying costs of $100,000 for a corporate taxpayer in the 21% federal tax bracket:

Credit:

Tax Savings

Qualifying costs

100,000

Applicable credit %

26%

Credit amount

26,000

26,000

Basis reduction %

50%

Basis reduction amount

13,000

Depreciation:
Qualifying costs

100,000

Basis reduction

(13,000)

Depreciable basis

87,000

Federal tax rate

21%

Tax reduction

18,270

18,270

Overall federal tax savings

44,270

Federal tax savings, as a % of cost

44.3%

Alternate structures

As we can see from this example (which doesn’t even include state taxes), due to the generous credit percentage and the ability to “double dip” by depreciating a portion of the already-credited amount, the solar credit punches above its weight – exactly as Congress intended. This savings will diminish, though, when the credit percentage begins to decrease.

Many entities do not invest directly in solar property; they instead invest in LLCs that do so – often with multiple owners. However, the tax impact is comparable to what the investor would experience if owning the property outright. The calculations shown above take place within the LLC, and the investor’s share of those adjustments pass through to the LLC investor via a Schedule K-1. The potential for increased gain due to basis adjustments is preserved as well, just as described above. For a direct owner, the basis in solar equipment is adjusted; and for the LLC owner, the basis in that LLC investment is adjusted in a similar manner. The 5-year holding period (to avoid recapture) continues to apply.

The tax basis reduction equal to half of the credit amount can create a permanent book/tax difference for the investor. A sister article, published with this one, addresses the GAAP accounting considerations for this type of investment.

Conclusion

The solar energy credit is a potent one whose expiration date has been extended by Congress to encourage and reward the construction of energy-producing solar equipment. Its benefits begin to decrease shortly, though, and interested investors should become familiar with it without further delay.

For more information or a discussion on how this may impact you, please contact your BNN advisor at 800.244.7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.