Biden’s Inflation Reduction Act (IRA) in 2022 made a massive investment in climate, calling for $369 billion in tax incentives for investment in green energy, like solar projects. The tax benefits to come out of this make investing in solar projects the best tax saver for anyone with a high W-2 or business owner income. If eligible, it can offset hundreds of thousands of dollars in business profits or W-2 income, plus earn you a nice income stream on the side.
Let’s pretend that you’re a business owner. You have $2.2 million in income for the year, and are liable for about half of that ($1.1 million) in taxes.
- Federal taxes: $850,000
- State & local taxes: $250,000
Now, instead of writing a $1.1 million check to the IRS, you decide to use it to buy $1 million worth of solar projects. Instead of losing the million dollars, you instead will get $825,000 in tax savings along with an income stream of $50,000 per year over the next 20 years.
Here’s how it’s broken down.
Tax savings: $825,000
- 40% tax credit: $400,000 in year 1
- Federal and state depreciation: $275,000 in bonus depreciation that you can claim in year 1, and an additional $155,000 in depreciation that you can claim in years 2 to 5.
- Income: 5% of your investment ($50,000) per year for 20 years, which equates to $1 million of income over the next 20 years.
Rather than losing the entire $1 million to taxes, by investing it into a solar project you get a substantial tax credit + tax deduction + income stream. The only difference between the two outcomes is who you wrote the check to.
Benefits of investing in solar projects
When you invest in a commercial solar project, you get 3 big benefits:
- Federal tax credit of 40%.
- Depreciation on the project that can reduce income to offset federal and state taxes. And with bonus depreciation, you can claim 80% of it in the first year.
- Income from the solar project (around 5% of your investment value).
Benefit #1: Federal tax credits
Most commercial solar projects today have an immediate 40% tax credit (which may increase even higher next year), and you get it all in year 1. With a million dollar investment, that’s $400,000 in tax credits right off the bat. Since tax credits directly reduce your tax bill (not your taxable income), a $400,000 tax credit allows you to pay $400,000 less in taxes.
A tax credit is a dollar-for-dollar reduction in the amount of federal taxes you owe. This is far better than a tax deduction, which only reduces your total taxable income, saving you only a percentage of the expense you’re claiming.
Tax credits have many other benefits including:
- You can claim them for taxes already paid for the last 3 years.
- They can be carried over for 20 years if you don’t use them.
- You can also sell your tax credits: They trade for around 90 cents on the dollar.
Benefit #2: Depreciation
Depreciation is the amount of value that a physical asset loses over time. This provides you with a tax benefit because you can take a deduction on the amount of the depreciation, reducing your taxable income.
Commercial solar has an especially attractive depreciation.
For federal taxes, you can depreciate the entire value minus half the tax credit over 5 years. In our earlier example, you can depreciate 80% over 5 years. And via bonus depreciation, depreciate 80% of it in the first year.
Bonus depreciation allows you to front-load the depreciation and take more of it in year one. Without bonus depreciation, you’d depreciate the value evenly over 5 years. But bonus depreciation at 80% lets you claim 80% of the value in the first year, and the rest over subsequent years.
That would reduce your taxable income by $640,000, all in year 1.
For state taxes, you can depreciate the entire value over 5 years. Some states also allow bonus depreciation. In a high income tax state like New York, you could end up with over $100,000 in lifetime state tax savings on the $1 million project over 5 years.
Benefit #3: Income stream
Most commercial solar projects under the Inflation Reduction Act of 2022 include 20 year income streams. This is tied to the solar energy produced by the project and usually pays out around 5% of your investment.
So on your $1 million investment, it’d pay you another $50,000 per year for the lifetime of the project. Essentially, in addition to the tax savings, you’ll also earn $1 million in additional income off of your investment.
Type of income
The following types of income can be invested in solar projects. And different types of income can have additional eligibility requirements to receive the tax savings offered from investing in solar projects.
- C-corporation profits: Some of the biggest investors in solar projects are corporations like Google, Facebook, and Amazon.
- Passive business income: LP investments (investors in venture funds, real estate, or private equity funds) or income from a business you do not actively run, such as income from an S corporation or LLC that you’re no longer actively involved in.
- Active business income: Business income from an S corporation or LLC.
- Earned income: W-2, 1099, RSUs, capital gains, and partnership income.
- Incentive Stock Options / AMT
Depreciation limitations on earned income
If you have earned income, depreciation is capped at $289,000 per year for singles and $578,000 for couples. However you can apply the excess amount in future tax years. Business owners have no limit to the amount of depreciation you can apply.
Limitations on active and business income
If you have c corporation or passive income, you can invest in solar projects and directly take the tax credits and depreciation.
On the other hand, if you have active business income or earned income, the IRS only allows you to write off your active income with other active income. And the only way to receive the tax credits and depreciation from solar investments made with active income is to satisfy the “material participation” requirement outlined in the Internal Revenue Code.
You only need to meet one of seven criteria, but the easiest one to meet is to spend at least 100 hours per year to your new solar business during the first year of any investment to receive the year 1 credits and depreciation, and every subsequent tax year for the first 5 years you would like to take a depreciation deduction.
A common structure for people with earned or active business income who want to make solar investments is to set up a new solar or renewable energy business under a single member LLC. And to meet the material participation requirement, you would simply need to spend 100 hours per year running your new business.
The 100 hours requirement is the same whether you’re invested in one solar project or multiple, and can be fulfilled by activities like visiting the sites of your investment, attending solar conferences and seminars, doing research on your investments, or even spending time to read articles and research reports, or watching educational videos on the business of solar power.
Does it have to be a single member LLC?
A common question around this is whether you can invest with friends and partners through a multi-member LLC. The answer is yes, but it significantly increases the material participation hours requirement from 100 hours to 500 hours, and each individual member must meet this requirement.
The more effective method is to set up a single member LLC and invest on your own, or with your spouse, to keep the participation hours requirement at 100 hours.
Do all of my hours need to be satisfied in person? Do I need to physically be at the solar investment location for 100 hours?
The hours requirements are not tied to how much time you directly spend with your investments. They’re met by you spending time on your solar or renewable energy business.
Not all of your hours must be satisfied with in-person visitations to your investment locations. You can do due diligence online or talk to investors or developers over the phone. However, having some in-person hours is something the government really wants to see. Rarely are you going to make an investment of hundreds of thousands or millions of dollars and not take the time to visit the location where it’s happening.
This sounds too good to be true
Many people who learn about tax savings from solar investments for the first time have a lot of questions like:
- Why does this exist?
- Are the returns going to be horrible since the tax incentives are so good?
- What’s the catch?
Fortunately, there is no “catch”. The government wants to essentially make the return from investing in renewable energy higher than oil and gas. And the tax incentives introduced through the Inflation Reduction Act (IRA) are a byproduct of the government trying to make it a no brainer to choose investing in renewable energy over oil and gas.
In terms of cash flow, there are better investments to be made than solar projects. However, it’s difficult to match the tax credits and depreciation from solar investments, in addition to the additional income received over a 20 year period.
Why isn’t everyone doing this?
Some of the constraints to solar investments are being able to have enough taxable income to invest, access to the projects, and the time required to meet the material participation requirement. That being said, there are actually more people doing this than you might think. Since the Inflation Reduction Act was introduced, more than 270 new clean energy projects have been announced, with private investment totalling $132 billion, and is expected to create over 86,000 new jobs.
When it was introduced, the government estimated that this was going to cost them $369 billion dollars over 12 years. Only a year later, Goldman Sachs estimated that it’s actually going to be $1.2 trillion, with another $3 trillion in investments made by businesses and individuals.
Why aren’t the developers taking advantage of all of these tax credits?
Another common question is: If the tax savings are so great, why aren’t the developers taking advantage of this themselves?
The answer is, they are and they’re maxed out on how much they can use. They have constraints on how much income they can make and how much they can write off, but they are fully utilizing these benefits. They’re taking advantage of this themselves and selling the excess.
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