As solar energy becomes an increasingly popular tax-advantaged option, it’s crucial for potential investors to understand the various constraints and requirements associated with these tax write-offs.
Quick takeaways:
- The tax benefits associated with buying solar energy projects are subject to various constraints and requirements based on the type of income a person has. Different rules apply to business income and personal income and active v. passive income.
- Business income, generated by companies like S Corps, LLCs, or C Corps, has no limit on the tax credits and depreciation that can be used to offset their income and tax liability.
- Personal income, such as salaries, capital gains, dividends, and rental income, may have limitations on depreciation deductions. The maximum annual depreciation deduction allowed against active personal income is $313,000 per person or $626,000 for a married couple filing jointly. However, investment tax credits are not subject to these limits and can be used to eliminate 75% of the tax owed after depreciation deductions. Unused credits can be carried over to future years. Passive personal income is not subject to depreciation limitations.
What Type Of Income Do You Have?
The tax code is full of income-based rules. Most basically, of course, your tax depends on how much income you have. But many credits and deductions carry income limitations as well. Charitable deductions are limited to a certain percent of adjusted gross income. The child and dependent tax credit begins to phase out at $400,000 of income for a married couple. And so on.
Solar tax benefits are no exception, and the rules are a bit more complex. Where your income comes from matters; is it business profits, wages, or from some other source? Is it active or passive income? These question have technical answers, and those answers will govern how large your tax credits and depreciation deductions will be, whether you need to satisfy “active participation” rules and, indeed, whether you are eligible for the program at all.
Let’s begin with the simplest of these distinctions: Business versus personal income.
The Business Income/personal Income Distinction
Business income refers generally to the money a company earns from its operations. In a legal and practical sense, this is income generated by an S Corp., LLC, or C Corp. In the context of solar tax write-offs, business income tends to take one of two forms: (1) Profits earned by the business itself, which the business can write down with direct solar investment; and (2) profits drawn out of a business by its owner, which that beneficiary can write down with his or her own investment.
Personal income, meanwhile, is the total income received by an individual or household from all non-business sources. This can include salaries, capital gains from the sale of assets, dividends, interest on savings, and rental income, among (many) other things.
How does this distinction affect the returns from tax-advantaged solar investing?
Capped And Uncapped Write Offs
Business income. Critically, there is no limit on the tax credits and depreciation you can earn from solar project and use against business income. In other words, the credits and depreciation we have described in these pages can be applied against any amount of business income, whether $10,000 per year, $10 million per year, or more. As a result, the only question for those with significant business income — whether individuals or the businesses themselves — will be how much of their tax bill they want to write off and, therefore, how large of a solar project purchase makes sense.
Active personal income. Active personal income, by contrast — that is, income you earn for performing work, like salary, wages, and RSUs — is subject to a tight cap on depreciation. Specifically, the maximum annual depreciation deduction allowed against active personal income is $313,000 per person or $626,000 for a married couple filing jointly.
Two important silver linings:
- Although you cannot use more depreciation than that in a given year, any depreciation above those amounts — for example, if you make a solar project purchase large enough to generate, say, $1 million of depreciation — will carry over to future tax returns.
- These limits do not apply to Investment Tax Credits, which are, for many, the main draw of solar investing. That is, you will be allowed to use the full tax credits on the project you invest in, up to the separate, typically higher limit described in the next section.
Tax Credit Limitations
This one is simple. Individuals who buy solar projects to write of personal income or profits pulled out of a business may use Investment Tax Credits to eliminate 75% of the tax they would otherwise owe after taking the applicable depreciation deductions.
Take a family that earns $1 million this year and would owe $500,000 of tax without any planning. Now imagine that family purchase a solar project that will generate a $200,000 depreciation deduction and a $400,000 Investment Tax Credit this year. The family would first be allowed to take the full depreciation deduction, which would leave their income at $800,000 and would reduce their tax bill to $400,000. Next, they would apply their tax credits. They would be allowed to use $300,000 of credits to reduce their $400,000 tax bill by 75% and, crucially, they would be able to carry over the remaining $100,000 of unused credits to next year (and up to 20 years if necessary).
The Active Income/passive Income Distinction
Separate and distinct from the income limitations described above is a critical distinction in the world of tax-advantaged investing: Active versus passive income. Put succinctly, an investor may use Investment Tax Credits and depreciation from passive solar purchases to write off passive income, and they may use the benefits of active solar purchases to write off active income.
What types of income require active solar investments?
Active personal income. Earned income, such as salary, RSUs, income from the exercise of incentive stock options, and side hustle earnings are considered active income and require active solar purchases to generate tax write offs.
Passive personal income. Passive personal income, like Limited Partner investments and earnings from an S Corp. that you aren’t involved in, does not require active investment. That is, you may claim the full credits and depreciation even without actively participating in the solar business.
Active, personal business income. Earnings from running or participating in a business — say, the profits you earn from your e-commerce store, or earnings from a personal-services LLC — are considered active income. Accordingly, this income may be offset only by active solar purchases.
Direct business income. A C Corp. can write off income with depreciation and Investment Tax Credits without becoming active in solar business. The corporation simply invests in an eligible project or buys transferrable credits and claims the benefits.
What is required for a solar project purchase to be considered “active”?
If, following the rubric described above, you must qualify as an active participant in the solar business to apply the tax savings to your income, then you will need to satisfy the “material participation”.
requirements outlined in the Internal Revenue Code. For most investors, this means that you will need to dedicate at least 100 hours to the solar business in the first year of your purchase and any later year when you would like to take a depreciation deduction.
Qualifying activities. Activities that count toward this requirement include visits to the site’s of your project’s, attending relevant conferences and educational seminars, and your research and due diligence before making an investment, among other activities.
Multiple projects. The hours requirement is a requirement that you spend that much time on solar projects generally. No matter how many projects you invest in, the hours requirement stays the same.
Conclusion
Understanding the constraints associated with solar projects is essential for making informed decisions and maximizing the potential benefits. With a firm grasp of active investor requirements, annual depreciation and tax credit limits, and tax limitations, you can better navigate the world of commercial solar investments and choose the right options for your financial goals.
If you have any accounting questions, we have put together an overview of the most common technical doubts accountants have for us and you can read them here.
About Valur
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