Solar has become one of the hottest tax advantaged investments over the past year due to the tax incentives created in the Inflation Reduction Act. One year after the bill has passed, Goldman Sachs estimates the cost of renewable energy tax benefits will 3x the 2022 government estimated cost, increasing the cost from $369 billion to $1.2 trillion. Now as individuals and their accountants look to take advantage of the opportunity large financial firms and corporations have been diving into they have a number of questions. While we can’t answer every question, we have put together an overview of the most common technical accounting questions accountants have for us!

Is this a syndication investment or can you structure this as a syndicate?

No. All of our solar projects are structured with a single owner — your LLC. If this were a syndication, every investor would need to spend more than 500 hours to become active in the business or have passive business income they were looking to offset. Since it’s not structured as a syndication it means you can qualify for material participation with a lower threshold of 100 hours.

What are the requirements for material particpation?

The active participation rules are based on the types of activities you spend your time and the number of individuals in the business and their participation versus a project structure. And this is where how many hours you spend and the types of activities will determine this.

Material Participation Tests

For any tax year, a taxpayer, or their spouse, qualifies as materially participating in a venture if they satisfy any one of the IRS’s seven material participation tests. For reference, here are those tests, with the most commonly and most easily satisfied tests in bold:

• Test one: Participation for more than 500 hours.
• Test two: Activity that constituted all participation substantially.
• Test three: Involvement for more than 100 hours and no less than the participation of any other individual.
• Test four: Which is a significant participation activity, combined with all significant participation activities, for more than 500 hours. A significant participation activity is a business in which the taxpayer participates, without qualifying for any of the other six tests, for more than 100 hours.
• Test five: Participation during any five of the preceding ten taxable years.
• Test six: Which is a personal service activity for any three prior taxable years. Personal service activities are activities in which capital is not a material income-producing factor, such as health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
• Test seven: Partaking for more than 100 hours and based on all the facts and circumstances, on a regular, continuous, and substantial basis.

Source: https://www.irs.gov/pub/irs-pdf/p925.pdf

Why do you have to be active (or materially participate) in the solar business?

It is a general feature of the US’s system of taxes, credits, and deductions that the character of your credits and deductions must match the character of the income they are being used to offset. So, for example, depreciation from a passive real estate investment — one where you buy a property and rent it out without being actively involved — can only be used to reduce your passive rental income. Losses from an active real estate investment, by contrast, can be used to reduce your earned income (W-2, for example).

So, too, with solar. To offset active income like W-2 earnings, profits from a business you run, or most capital gains, you will have to be active in the solar business. (Note that this is not true for investment in oil and gas wells due to a unique law benefiting the space, so that can be a viable alternative if you are unable to qualify as an active participant in solar. Note also that those with passive income can use the benefits of solar without qualifying as an active or material participant in the solar space.)

So what do you need to do to qualify as an active or material participant in solar? You will need to set up an LLC through which you will make your purchase, and you will also need to materially participate in your solar business. In this context, “material participation” means participating in solar business for more than 100 hours during the tax year in activities that are considered regular, continuous, and substantial and participating at least as much as any other individual involved in the business. Why, then, do we call this a “grey area”? This comes down to the lack of clarity from regulators: The IRS and tax court have so far chosen not to define what activities constitute material participation in the solar space. As a result, there isn’t complete certainty as to what specific activities will satisfy the 100 hour requirement outside of the general guidelines of spending time on regular, continuous, and substantial activities that will benefit your solar business. (This is a very simplified explanation. For more details on material participation and common questions we hear from CPAs, check out this article.)

What activities count towards material participation?

For people considering a solar purchase, the actionable question here is what activities count toward those 100+ hours of active, material participation in the event they were audited – an audit typically happens to taxpayers in this income bracket 0.5%-1.5% of the time. In general, participation in an activity that generates income is identified as active if it is regular, continuous, and substantial. Another way to think about this is that the activities should be the kind of thing a business owner would spend their time on while building and running the business. While unlike most businesses, your solar project will have one customer (the buyer of the electricity) and will run mostly autonomously — and, therefore, you will have very little overhead — we’ve seen people pass audit use activities including solar project site visits, project research and negotiations, financial modeling, and attendance at industry conferences, among other things.

A quick detour from the rules: Tracking these hours and activities can be a headache, but Valur streamlines your documentation process, enabling you to save relevant documents and log your participation hours directly on our platform. Read more about those tools here.

So this all seems relatively clear: If you want to use solar to reduce taxes on active earned income, then you have to qualify as an active, material participant in the project, which requires 100 hours of participation, among other requirements. Why, then, do we call this a “grey area”? This comes down to the lack of clarity from regulators: The IRS and tax court have so far chosen not to define what activities constitute material participation in the solar space. As a result, there isn’t complete certainty as to what specific activities will satisfy the 100 hour requirement outside of the general guidelines of spending time on regular, continuous, and substantial activities that will benefit your solar business. You and your accountant will ultimately have to decide which activities you are comfortable counting and, more broadly, whether solar is the right fit for your situation.

Where are the tax credits (and their limitations) described in the Internal Revenue Code?

The Investment Tax Credits (ITCs) for renewable energy, which are outlined in §48, are general business credits, governed by §38 of the Internal Revenue Code. General business credits are a type of tax credit. These credits can be applied to offset a an individual or company’s tax liability, and any unused credits can be carried forward to future years. However, there are limitations on the amount of credit that can be claimed in any given year, with a cap of 75% of the taxpayer’s total federal tax liability after depreciation and deductions are applied. For example, if you have a federal tax liability of $100,000 and are eligible for $80,000 in ITCs, you can only claim up to $75,000 in credits for this year, with the remaining $5,000 carried forward to future years or applied back to the past 3 years.

The specific tax credit levels and their requirements for renewable energy projects are identified in Internal Revenue Code § 48E. The key language is in 48E, which sets the base rate for qualifying projects under 1 mW (which all Valur projects are) at 30% and identifies add-on credits for which projects can be eligible. Many of the projects we have on the market right now qualify for an additional 10% “domestic content” credit, and we expect additional kickers to apply on projects that come online next year.

Why is most of the federal depreciation applied in year 1?

Most of the federal depreciation for solar assets is applied in year 1 because of bonus depreciation. Bonus depreciation is a tax incentive that allows businesses to immediately deduct a percentage of the cost of eligible assets in the year they are placed in service, rather than having to depreciate the cost over several years. In 2023, the bonus depreciation rate for solar assets is 80%, which means that up to 80% of the project value can be deducted from your income in that first year.

The rest of the depreciation is applied according to the The Modified Accelerated Cost Recovery System (MACRS) depreciation schedule. MACRS is a tax depreciation system used in the United States for assets placed in service after 1986. It allows businesses to recover the cost of an asset over a specified period of time through annual deductions. The MACRS depreciation schedule, copied below, outlines the non-bonus depreciation deductions for different types of assets over their respective recovery periods.

Where is the depreciation described in Code?

One of the main benefits of solar investing is the significant bonus depreciation available in the first five years. That bonus depreciation schedule is captured in IRC § 168(e)(3)(b), on page 724 of the linked PDF.

What are the depreciation limitations?

For earned income i.e. non-business income, the depreciation losses are limited to $289,000/person/year. This is based on the excess business loss rules from the the Tax Cuts & Jobs Act, which in 2018 set the excess business losses as your business income for the year as $250,000 plus inflation which in 2023 is $289,000 per individual (or $578,000 per couple/year).

Let’s walk through this with an example:

For 2023, Kyle, a single taxpayer, has $1 million of gross income and $1.4 million of deductions from a retail business that is an active business activity. His excess business loss is $111,000, ($1,400,000 – ($1,000,000 + $289,000)), which would carry over to 2024.

Source: https://www.law.cornell.edu/uscode/text/26/461

When does someone have to invest to benefit from the tax credits?

To be eligible for the program’s tax credits and depreciation, you have to buy the project and place your investment at risk before it is materially complete. “Material completion” in solar projects refers to the point at which the solar project is complete and operational. So, in other words, you have to sign the project paperwork and cut your check before the project has been brought online.

The requirement to invest in a solar project before it is materially complete to be eligible for tax credits is outlined in the Internal Revenue Code Section 48(a)(5), which states that the credit is only available for property that is “new” and is placed in service by the taxpayer during the taxable year. The term “placed in service” refers to the point at which the property is in a condition of readiness and availability for its specified use.

The IRS also provides additional guidance on this requirement through various publications, including Publication 946, which provides instructions for claiming depreciation on property, and Publication 541, which outlines the tax rules for partnerships.

When do the tax credits apply?

The Investment Tax Credits from solar projects apply during the taxable year when the solar project is placed in service by the taxpayer. The term “placed in service” refers to the point at which the property is in a condition of readiness and availability for its specified use not necessarily when it goes online as it may require approvals before being turned on.

Why won’t the IRS invalidate your tax credits?

There are cases where the IRS denies the tax credit and depreciation. What’s important to take into account is that those cases are referring to projects that were not intended to generate any electricity or revenue. All of the developers we work with have a track record of developing solar projects that are completed, generate electricity and revenue. As part of our process we do require that you talk to these developers as we think it’s important for you to meet them and get references.

How do these projects generate income?

All of our projects start generating income once they are turned on, they have cash flow and a profit motive.
They generate income by selling electricity generated by the solar panels to the offtakers (the business that will use the electricity). For all our projects, the offtakers are commercial entity’s where the solar panels are located or a utility provider.

You may wonder why are these businesses buying the solar electricity. It’s simple, cost. The solar electricity is significantly cheaper than the cost the business would pay their utility provider for electricity. This income is also important from a tax perspective as it means that the depreciation from the business doesn’t create hobby loss issues.

How to file for the tax benefits?

We’ve put together a simple and easy to follow visual guide here!

Step 1: Form 3468 – Investment Tax Credit (ITC)

The Investment Tax Credit (ITC) is a critical component of solar benefits. To claim it, report the credit on Part III – line 12c of Form 3468. The total credits from Part III are then added to line 14 and carried over to Form 3800

Step 2: Form 3800 – General Business Credit

On Form 3800, report your investment credits under the renewable energy category on Part III – line 4a. The total credit, including any carry forwards, is subject to limitations and reported on Part II – line 38

Step 3: Form 1040, Schedule 3 – Additional Credits and Payments

The credits allowed on Form 3800 are then reported on Form 1040, Schedule 3, Part I – line 6a. These nonrefundable credits are part of your total tax liability calculation

Step 4: Form 1040 – Income Tax Return

Finally, the nonrefundable credits are reported on line 20 of Form 1040. It’s important to note that these credits cannot offset other taxes such as self-employment tax or Medicare tax.

How We Can Help

So, how can you go about investing in qualified solar projects? It’s relatively simple: Valur has partnered with nationally recognized accounting and investment firms to facilitate these investments.  We will help you identify the opportunity and choose between different types, visualize the potential benefits, and calculate how much you need to invest to capture the right sized tax benefits. From there, we and our partners will help you seamlessly finalize your investment and keep track of the relevant data for ongoing tax purposes. 

About Valur

We’ve built a platform to give everyone access to the tax and wealth-building tools typically reserved for wealthy individuals with a team of accountants and lawyers. We make it simple and seamless for our customers to take advantage of these hard-to-access tax-advantaged structures. With Valur, you can build your wealth more efficiently at less than half the cost of competitors. 

From picking the best strategy to taking care of all the setup and ongoing overhead, we make things simple. The results are real: We have helped create more than $3 billion in additional wealth for our customers. If you would like to learn more, please feel free to explore our Learning Center. You can also see your potential tax savings with our online calculators or schedule a time to chat with us!