Taking advantage of solar tax incentives and investing in short-term rental 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 — plus income.
• Investing in Short-Term Rental Real Estate Yields Smaller Tax Savings but Higher Returns: Short-term rentals can yield large depreciation deductions, but the tax benefits are generally smaller than the tax benefits that solar tax incentives generate. That said, the income generated by short-term rentals can be high, and the rules for using depreciation from short-term rentals to offset other types of income are less strict than the rules for other real estate investments.

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 Short-Term Rentals?

Short-term rentals are residential properties that are rented out for a short duration, often through platforms like Airbnb or VRBO. These rentals can generate income while offering substantial tax benefits, including deductions for depreciation, mortgage interest, and other expenses.

How are Short-Term Rentals Treated for Tax Purposes?

Income generated from short-term rentals is considered active income, which allows property owners to deduct ordinary expenses such as property management fees, maintenance costs, utilities, and mortgage interest. Additionally, property owners can depreciate a property over time, further reducing their taxable income. If the property owner actively participates in the rental activities, they may be able to offset other forms of active income with losses from the rental property.

Benefits of Short-Term Rentals:

1. Income Generation: Renting out a property for short durations can generate substantial income, often more than traditional long-term leases (but with higher volatility).
2. Lower Material Participation Standard: If the average length that your tenants stay in your property is less than seven days, you can meet the material participation standard by spending either 100 hours on the rental activity each year (and more than anyone else spends on the rental) or a total of 500 hours working on the rental business throughout the year. The typical real estate professional standard for material participation requires either 500 hours spent on the rental activity or a total of 750 hours spent on the business.
3. Tax Deductions: Property owners can deduct a wide range of expenses, including mortgage interest, property taxes, repairs, and depreciation.

Drawbacks of Short-Term Rentals:

1. Management Burden: Managing a short-term rental can be time-consuming, involving frequent tenant turnover, cleaning, and property maintenance.
2. Regulatory Risks: Many cities and municipalities have strict regulations regarding short-term rentals that are rapidly changing, which can impact the viability of these investments.
3. Income Volatility: Beyond regulatory risks, rapidly changing supply, demand, and platform take rates can dramatically change the income and value of these properties.

What is an Ideal Use Case?

Peter, a married New Yorker earning $1,200,000 per year, has historically invested only in stock indexes. Tired of paying $550,000 of tax on his salary each year, Peter purchases a $500,000 house and lists it on Airbnb. 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 51%, that will save him close to $153,000, effectively reducing his taxes this year from $550,000 to under $400,000 (not including the income he generates from the rental).

Why Choose One Strategy or the Other?

Taking advantage of solar tax incentives and investing in short-term rentals accomplish different things. Solar tax incentives are heavily tax advantaged but do not yield particularly large investment returns. Short-term rentals can yield larger investment returns, but the tax benefits are comparatively modest. When choosing between these two strategies, the key question is: What are you trying to accomplish? If your goal is simply to maximize tax savings, then solar tax incentives are probably a better fit. If your goal is to maximize total returns, it is a closer call.

Conclusion

Taking advantage of solar tax incentives and investing in short-term rentals 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

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!