Expanding the ITC: The Inflation Reduction Act
The Inflation Reduction Act expanded the Section 48 Commercial Investment Tax Credit (ITC) for renewable energy and related technologies. Subject to prevailing wage or maximum size requirements, the ITC is valued at 30% of the project cost, using either a cost basis or fair market basis.
Calculating the ITC: A Practical Example
A $1,000,000 solar project would generate a $300,000 ITC value, using the cost basis method. In many circumstances, the taxpayer who owns the solar project can also claim an accelerated depreciation deduction, worth nearly as much as the ITC for 2023 and 2024 projects.
However, as discussed in this previous article, How to Better Understand and Benefit from Solar Tax Incentives – Part 3: Investing in Solar Tax Credits, before the Inflation Reduction Act, the ITC, is subject to the passive loss limitation and the general passive activity rules.
Navigating ITC Eligibility: A Four-Step Analysis
In general, the following four-step analysis is required for new Investment Tax Credit investors:
- Except for projects owned by tax-exempt entities like a city or a non-profit organization, the ITC is not refundable. Therefore, taxpayers must have a significant federal tax bill that the ITC can offset. An ITC investor must make a business decision if taking advantage of the ITC carry-forward rules, spreading the ITC value over multiple years.
- Is the taxpayer claiming the credit one of the two types that are exempt from the passive loss limitation?
- C-Corporations, and/or
- Commercial Real Estate Professionals.
- If not exempt, does the taxpayer have the passive income required that the ITC can offset?
- If not exempt, and the taxpayer does not have the required passive income, can they meet material participation tests to reclassify the loss as active rather than passive?
The passive loss test applies whether via a tax-equity partnership (often as an investor in a special purpose LLC) or via the transfer/purchase of the ITC as now authorized by the Inflation Reduction Act under Section 6418 of the tax code.
A “commercial real estate professional” must spend more than 750 hours a year in and receive 51% of your income from commercial real estate activities.”
Meeting Material Participation Tests
The material participation test requires that an activity must be regular, continuous, and substantial. Because the section 6418 ITC purchase must be to a taxpayer unrelated to the originating partnership, the material participation test is not possible, so can only be achieved via material engagement in a qualifying tax credit development activity.
Understanding the Seven Material Participation Factors
To meet the material participation test, you must squarely fit into at least 1 of the 7 material participation factors:
- Test 1: Participation for more than 500 hours;
- Test 2: Activity that comprises nearly all of the activity;
- Test 3: Involvement for more than 100 hours and at least as much as any other individual in the partnership;
- Test 4: A significant participation activity of at least 100 hours where the total time of all participants combined is less than 500 hours;
- Test 5: Participation in at least 5 of the last 10 tax years;
- Test 6: Activity is a personal service, non-capital activity for any three prior taxable years; and,
- Test 7: Participating for more than 100 hours and based on all facts and circumstances regularly, continuously, and substantially.
Cautionary Notes: Applying ITC to Prior Years
Meeting any material participation test factor requires robust recordkeeping and exposes taxpayers claiming credit to significant audit risk. For most potential ITC investors, Test 1 or Test 7 might be the most likely to be met, but ITC claimants must feel comfortable with taking the audit risk. Further, taxpayers should be cautious about attempting to apply the ITC to prior year taxes via the ITC 3-year-lookback if the material participation test is not met during a prior year.
Get Expert Guidance: Contact Jeremy Kalin
If you’re interested in pursuing a potential solar tax credit investment or adding a solar development to your commercial property, please contact Jeremy Kalin, who will be in touch with more information soon.