Taking advantage of solar tax incentives and investing in real estate 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 can 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. Solar projects also generate income.
• Investing in Real Estate Yields Smaller Tax Savings and Requires More Hours: Real estate investments can yield large deductions, but the upfront tax benefits are generally smaller than the tax benefits that solar tax incentives generate. Moreover, in order to offset non-real estate income with real estate depreciation, the investor must be a “real estate professional,” which requires the investor to devote several hundred hours each year to real estate.

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 Real Estate Investments?

This article uses “real estate investment” broadly to mean any investment involving the purchase, sale, management, or leasing of property for profit. Real estate investors can benefit from several tax-saving strategies, but depreciation (specifically accelerated depreciation) is the most important for people looking to reduce their ordinary income taxes. Critically, to offset ordinary income with real estate depreciation, you need to be a real estate professional, which means spending more than 500 or 750 hours in a year on your real estate business. For practical purposes, that means you can’t have another job. But if your spouse doesn’t have a full-time job (and wants to spend 750 hours per year on real estate), or you don’t have a full-time job (and want to spend 750 hours per year on real estate), it can work.

Benefits of Real Estate Investments:

1. Tax Deductions: Investors can deduct a range of expenses, including depreciation, which reduces taxable income.
2. Appreciation Potential: Real estate can appreciate over time, providing both rental income and capital gains.
3. Leverage: Real estate allows investors to use debt to finance purchases, amplifying potential returns and tax savings from depreciation.

Drawbacks of Real Estate Investments:

1. Illiquidity: Real estate investments can be difficult and time-consuming to sell.
2. Management Burden: Owning and managing real estate requires significant time, effort, and expertise.
3. Market Risk: Real estate markets can be volatile, and values may decrease due to economic downturns or other factors.
4. Material Participation Requirements: To use the depreciation to offset ordinary income, real estate has to be your (or your spouse’s) full-time job.

What is an Ideal Use Case?

Kevin, a married New Jersey resident who is a real estate developer, is earning $1,000,000 with a $420,000 annual tax bill. In the past, he has only invested in stock indexes. Tired of paying so much tax on his salary, Kevin buys a $500,000 duplex and rents it out. He deducts 60% of this amount as depreciation in the first year, reducing his taxable income by $300,000 that year. If his marginal tax rate is 50%, that will save him $150,000, effectively reducing his taxes in that year from $420,000 to about $270,000 (not including the income tax generated by the rental). Due to leverage, he may have only had to invest $100,000 in the property upfront, with the rest covered by loans. The loan interest will also be deductible, reducing his taxable income by another $20,000 or so. In future years, he’ll be able to deduct additional depreciation as well as interest on the loan. That said, taking on leverage is risky and means that Kevin will have to cover the interest and principal payments as they come due. Kevin or his spouse will also have to qualify as a real estate professional in order to use the depreciation to offset his ordinary income.

Why Choose One Strategy or the Other?

Taking advantage of solar tax incentives and investing in real estate accomplish different things. Solar tax incentives are heavily tax advantaged but do not yield particularly large investment returns. Real estate can yield larger investment returns, but the tax benefits are comparatively modest and the minimum time commitment for offsetting non-real estate ordinary income is quite high. When choosing between these two strategies, the key question is: What are you trying to accomplish? If your goal is simply to maximize immediate tax savings, then solar tax incentives are probably a better fit. If your goal is to maximize total returns, and you can afford to invest a very substantial amount of time into real estate investing, then real estate investing may make sense.

Conclusion

Taking advantage of solar tax incentives and investing in real estate 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.

About Valur

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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!