Taking advantage of solar tax incentives and entering into conservation easements are two popular strategies for offsetting ordinary income tax. How do you know which one is right for you? This article explains what these strategies are and when they make sense.

Key Highlights and Takeaways

• Two Ordinary Income Tax Strategies: Both strategies offset ordinary income tax at least to some extent.
• Solar Tax Incentives Yield Significant Tax Savings: The federal and state governments offer significant tax benefits to people who purchase solar projects. It’s possible to receive more than a dollar in a tax benefits for every dollar of solar assets you purchase — plus income.
• Conservation Easements are Risky but Can Yield Large Tax Savings: A conservation easement is a legal arrangement in which a landowner agrees to restrict the use of a piece of land. Conservation easements are a type of charitable gift and yield similar deductions. Donors often claim very aggressive valuations for the land over which the easement is being granted. The resulting tax savings can be quite large, but it is an aggressive tax strategy that involves significant legal risk to the donor.

What are Solar Tax Incentives?

Solar tax incentives are tax incentives that are designed to encourage renewable energy production. The current system was created by the Inflation Reduction Act, passed in 2022. There are two basic types of solar tax incentives: tax credits and depreciation.

How Do Solar Investment Tax Credits Work?

The federal government provides Solar Investment Tax Credits (ITCs) equal to 30-70% of the cost of installation for any eligible project. These tax credits are some of the most valuable tax benefits available in any context, because they directly reduce income tax liability, not just a taxpayer’s taxable income. So, for example, if you put $100 into a solar project that qualifies for a tax credit equal to 40% of the amount contributed, you’ll receive $40 back from the government ($100 x 0.40).

How Does Depreciation Work?

The federal government, and most states, also provide generous depreciation deductions. While not as valuable as tax credits, depreciation is still quite valuable. For example, assume your federal marginal income tax rate is 37%, your state marginal income tax rate is 10%, and you purchase $100 of eligible solar projects that qualify for 40% ITCs. You will be able to depreciate the full $100 for state tax purposes. You will be able to depreciate only $80 for federal purposes because your federal depreciation basis will be reduced by one-half of the $40 of ITCs. As a result, you will save ~$40 from depreciation: $10 of state tax ($100 x 0.10) and about $30 of federal tax ($80 x 0.37). That’s on top of any savings from the solar tax credits themselves. You can estimate your potential returns here!

Benefits of Solar Tax Incentives:

1. Substantial Tax Savings: Allocating money to solar energy projects reduces a taxpayer’s federal and state tax liability. The cumulative tax benefits can approach — and, in some cases, exceed — 100% of the amount contributed, meaning you can actually make a profit from the tax benefits alone.
2. Income: These projects sell electricity, typically generating 3-7% of a project’s value each year in revenue. The income from the projects is distributed to the owners.
3. Environmental Impact: Renewable energy, including solar energy, reduces carbon emissions. Many people put money into these projects in part for environmental reasons.

Drawbacks of Solar Tax Incentives:

1. Material Participation: To use solar tax credits and depreciation to offset your ordinary income, you need to materially participate in the renewable energy space. That’s why it’s necessary to set up a small solar business in order to qualify for the credits. This entails creating an LLC and spending 100+ hours per year running the business. The IRS hasn’t provided specifics on what activities count toward the hours requirement. What we do know is that a taxpayer must engage in regular, continuous, and substantial activities that will benefit his or her solar business. We also know what activities other solar business owners have spent time on and what has passed IRS audits.
2. Developer/Project Risk: The tax benefits hinge on the project being completed in the tax year you are looking to offset ordinary income and on the project generating energy for five years.

What are Conservation Easements?

A conservation easement is a legal agreement between a landowner and a qualified organization, such as a land trust or a government agency, that restricts the development of the land in perpetuity, protecting wildlife habitats or preserving historic sites even if the property is later sold or passed down to future generations. Conservation easements, in short, are a way for landowners to protect property from future development, no matter who ends up in control of the land in the future.

Conservation easements are also a tax tool. When you agree to restrict the use of your land for conservation reasons, the government considers that a type of charitable donation, and you get a charitable deduction based on the lost value of the land. In practice, taxpayers often claim a value that is a multiple of the value at which the land was purchased. This deduction can be used to offset ordinary income up to 30% of the donor’s adjusted gross income (AGI), with any excess carried forward for up to five years.

Because a number of players in the space are unscrupulous, the IRS has become concerned in recent years that the tax code’s conservation easement rules are being exploited. Certain types of conservation easements are now considered “listed transactions” that must be flagged for the IRS. Sen. Ron Wyden, chair of the Senate Finance Committee, has been consistently critical of conservation easements, which he describes as “a tax shelter gold mine.”

Benefits of Conservation Easements:

1. Tax Benefits: A donor can receive a charitable deduction for the value of the easement, which can significantly reduce the donor’s taxes. The resulting deduction may exceed the initial cost of the land.
2. Preservation of Land: The easement permanently protects the land from development, preserving its historical or environmental value.

Drawbacks of Conservation Easements:

1. Permanent Restrictions: Once granted, the easement permanently restricts development of the land.
2. Complex Valuation Process: Determining the value of a conservation easement can be complex and may require an expensive appraisal.
3. Legal Risk: The IRS has been scrutinizing conservation easements very closely, so there is substantial risk that an aggressive deduction will be disallowed.
   

What is an Ideal Use Case?

Gabriel, a single New Jersey resident, earns $1,200,000 per year. His annual tax bill is $550,000. Gabriel happens to be an avid conservationist with an appetite for risk. Tired of paying so much tax on his salary, Gabriel purchased a $100,000 property fours years ago and this year he put a conservation easement on the land to protect it from future development. The easement is valued at $350,000 and he is allowed to deduct this entire amount from his income, reducing his taxable income by $350,000 this year. If his marginal tax rate is 50%, that will save him close to $175,000, effectively reducing his taxes this year from $550,000 to under $375,000.

Why Choose One Strategy or the Other?

Both claiming solar tax incentives and entering into conservation easements can be attractive strategies. Solar tends to generate larger upfront tax benefits. Yet solar requires a taxpayer to “materially participate” in the solar energy space. Conservation easements are legally risky, and in general the larger the tax benefits from a conservation easement, the riskier the project. Conservation easements also don’t yield any income, unlike solar energy projects. Which strategy makes the most sense for any particular person will depend on how that person weighs the various pluses and minuses of each strategy.

Conclusion

Taking advantage of solar tax incentives and entering into conservation easements are both viable tax strategies, but they serve different objectives. Hopefully this article has given you a better idea of what each strategy entails, and whether one or the other might be a better fit.

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