"Golf is a lot like taxes. You drive hard to get to the green and then wind up in the hole.” Anonymous
While everybody’s income profile is different, there are advantages in the IRS code for every taxpayer — if you can find your way through the complex tax landscape. Failing to properly manage your tax burden is like failing to patch a leak in your retirement bucket. Stop draining your income by using solar to reduce taxes.
To get every advantage to which you’re entitled in a solar project, partner with a solar financing company that can dive deep into the tax code on your behalf. At SDC Energy, we take complex commercial solar financing and make it both simple – and lucrative.
With the tax season behind us, we were able to sit down with our trusted CPA partner, Leo Smith at Miller Accountancy, to discuss how IRS rules affect solar financing. The following summarizes his answer to some of your top questions.
How does an individual apply the ITC?
The federal income tax credit (ITC) applies dollar-for-dollar against income tax; it cannot, however, offset certain taxes, such as self-employment taxes including social security or Medicare.
Because the 30 percent ITC is a non-refundable credit, it cannot exceed the taxes owed, but it can be carried forward every year for 17 years until completely used.
So far it’s pretty simple. Read on for a deeper understanding of the other, more complex, solar accounting rules.
How do investors qualify for depreciation on an individual tax return?
Taxpayers can invest in depreciable assets such as solar systems that are used in a trade or business, or to produce income. “Trade or business” has different connotations in various sections of the IRS code.
For example, while investing in real estate is not considered an actual trade or business, it is considered a trade or business for the purposes of depreciation because real estate generates an income.
Individuals can own assets directly or indirectly through a Limited Liability Company (LLC) or partnership to limit liability exposure. If the investor creates a single-member LLC, then income, expenses and depreciation flow-through are reported on the individual’s form 1040, not on the LLC’s.
How do you make passive activity rules your PAL?
The IRS created “passive activity loss” (PAL) rules to limit how much taxpayers can use passive revenue streams to reduce active taxable income. PAL rules limit deductions from active income (such as salary and portfolio gains) that were generated through passive income losses from trades or businesses in which the taxpayer does not “materially participate,” such as rental properties or royalties.
Three criteria must be met for the PAL rule to apply: (1) the taxpayer must be a person or entity covered by the rule, (2) the activity generating the losses or credits must be a trade or business, and (3) the taxpayer fails to meet minimum active participation requirements.
So who is subject to the rule? Individuals, estates, trusts, partnerships, “S” corporations and closely held “C” corporations. Widely held “C” corporations are not covered under PAL and can freely take the ITC.
Because investors do not actively participate in development of the solar project, circumventing PAL rules that limit their tax benefits is a tricky business. There are, however, ways to bypass PAL rules:
-Be the sole owner and operator of the solar asset (no co-mingling in a fund)
-“Materially participate” in the trade or business by satisfying any one of seven IRS tests that measure active time spent on the business:
Participate in the activity for more than 500 hours
Make participation constitute most of the taxpayer’s activity for the tax year
Participate in the activity for more than 100 hours and participate at least as much as any other individual (most SDC Energy clients opt for this rule)
Participate in all significant participation activities for more than 500 hours
Participate in the activity for any five of the 10 preceding tax years
Make the activity a personal service in which you participate for any three preceding tax years
Participate in the activity on a regular, continuous, and substantial basis during the year
If you have a lot of rental properties and other passive revenue streams to offset, being subject to passive activity loss rules likely is not a big concern. If a solar investment represents your primary passive income, however, selecting an experienced solar financing company like SDC Energy can help you avoid PAL rules and maximize tax advantages.
Of course, you can always take up some light reading with the IRS handbook on PAL rules and become an expert yourself.
How do you depreciate solar?
Generally, solar is taken over a five-year modified accelerated cost recovery system (MACRS). It can also be declared as section 179 property, which is a one-time, first year write-off as well.
The investor can select a 50 percent bonus depreciation, which writes off half the value up front in the first year. The 50 percent bonus depreciation is valid through the end of 2017 under the current tax code, then drops to 40 percent in 2018 and 30 percent in 2019.
Because the ITC already reduces the cost of the solar asset by 30 percent, the cost basis for the depreciation must be reduced by half of the credit claimed, or 15 percent. For example, on a $100,000 solar system that is claiming a $30,000 credit, the depreciation is taken on $85,000 (85 percent).
How do you select the best depreciation choice?
Selecting an accelerated, one-time first year write-off makes sense if the investor’s income sources qualify and their tax profile is expected to be substantially higher in year one than in subsequent years. Usually this option will create a loss to offset taxes in that year.
Alternatively, choosing a 50 percent bonus depreciation in the first year followed by the five-year MACRS schedule allows the investor to take depreciation more slowly. This will help shelter income flow from the solar investment in subsequent years.
Investors with solar assets classified as active businesses must consider both self-employment taxes and taxes on income from solar fees.
Here is a scenario to walk through depreciation:
Solar investment = $115,000 / Depreciable asset = $100,000
Year 1: 50% bonus ($50,000) + 20% of remaining 50% ($50,000), which is $10,000 for a total of $60,000
Year 2: 32% of remaining $50,000 = or $16,000
Year 3: 19% of remaining $50,000 = or $9,500
Year 4: 11.5% of remaining $50,000 = or $5,750
Year 5: 11.5% of remaining $50,000 = or $5,750
Year 6: 5.76% of remaining $50,000 = or $2,880
Because the MACRS depreciation is based on a half-year convention — meaning that it assumes the property is purchased mid-year– the schedule allows some depreciation in year six.
And if that wasn’t enough — if the asset was bought during the last quarter of the year — then the investor is subject to a mid-quarter convention, in which case the depreciation schedule is as follows: Year 1 = 50% bonus + 5%,Year 2 = 38%, Year 3 = 23%, Year 4 = 14%, Year 5 = 11%, Year 6 = 10%.
Still in a daze from “intaxication”?
SDC Energy can help. We have deep experience financing a multitude of projects with a skilled team to help you get the most out of your solar investments. Contact us for a consultation and start saving on your taxes today.
DISCLAIMER: the above tax information is based on interpretation and experiences. Individual application of the tax benefits of solar may be different. Consult with a CPA to determine your tax situation.