Incentives for solar power generation systems

With a host of tax and incentive programs, there are many reasons for taxpayers to install solar power generation systems. The tax benefits can include income tax credits, breaks on local real estate taxes, and enhanced depreciation of solar assets. However, the advantages extend beyond income tax incentives, as many states, power companies, and municipalities offer additional incentives, such as partial reimbursements or purchases of excess power generation.

These benefits vary depending on whether the system is for personal use or business purposes. Adding complexity, the nature of solar power generation systems often results in blurred lines between personal and business use and sometimes raises questions involving poorly defined areas of tax law. Determining the nature of these systems is the first step in properly reporting them.

Personal-use solar power systems

At one end of the spectrum are personal-use solar power systems. These systems are usually comparatively small, owned by an individual, and have no profit potential. They’re either not connected to the power grid, or the arrangement with the power company doesn’t facilitate the sale of excess power. A lack of capacity to produce excess power has the same result. A system incapable of generating excess power is effectively no different from a situation without an agreement to purchase it. Further, there should be no external programs compensating the owner for power generation, as such programs can create income from otherwise personal property.

Personal-use solar power systems are eligible for a federal income tax credit under Sec. 25D. This credit is available only for the taxpayer’s personal residence and equals up to 30% of the costs of qualified property installed. The cost of the system, net of the credit, forms the basis in personal property. If the system is permanently affixed to real estate, it becomes part of the real estate. This can include both freestanding (ground) mounted systems and those affixed to a structure (usually a roof) if not installed in a manner to be easily removed.

To claim the Sec. 25D credit, file Form 5695, Residential Energy Credits. For more information, see Jemiolo and Farnsel, “New and Enhanced Energy Tax Credits for Individuals,” 238-5 Journal of Accountancy 34 (November 2024).

There may also be state income credits. For example, in Massachusetts there is a solar energy credit of 15% or $1,000 (whichever is less) under 830 Mass. Code Regs. §62.6.1. Likewise, there may be local programs that pay for a portion of the system cost. Local PILOT, payment in lieu of taxes, programs that reduce real estate taxes will usually fall into the category of cost reimbursements. Any of these additional incentives further reduce the basis of a solar power system.

Is it a trade or business?

If the property does generate income, the next step is determining if it constitutes a nonbusiness activity or rises to the level of a trade or business. The classification of the activity guides the tax treatment.

While the term “trade or business” is regularly used in the Internal Revenue Code and Treasury Regulations, it isn’t defined anywhere. For a definition, court cases need to be considered. In Groetzinger, 480 U.S. 23 (1987), the Supreme Court stated that, to be a trade or business, the activity must have a profit motive and be regularly engaged in. While both factors are matters of fact and circumstance, a profit motive should be the easier one to identify for a solar power generation system.

Profit motive: Will the local power grid buy back excess power? If the system produces much less than the taxpayer’s personal residence consumes, is it set up in a way that it can be argued to be an activity on its own? For example, is it ground-mounted, on a potentially subdividable part of the real estate, zoned for this use, separately metered, and/or owned by a separate legal entity from the taxpayer? Alternatively, is the system enrolled in a program that pays for it to generate power where payments aren’t considered reimbursements of the purchase price? Depending on the answers to these questions, the activity could indicate a profit motive if revenue is being generated.

Regularly engaged in: This will be the problematic prong of the trade-or-business definition. The nature of solar power generation systems creates the difficulty here. While construction involves significant effort, maintenance is generally low and administrative duties are limited. Most of the court cases that address trade-or-business status are focused on whether the activity is merely a hobby under Sec. 183, not if it constitutes a nonbusiness activity. As such, regular engagement, or lack thereof, can be more easily pointed to in these examples. The only Treasury guidance on trade or business versus nonbusiness for the issue of whether an activity is regularly engaged in is the safe harbor for rental real estate under Sec. 199A found in Rev. Proc. 2019-38. As borrowed guidance from a revenue procedure relating to another portion of the Code, this is hardly definitive. Further, the 250-hour threshold for all activity under Rev. Proc. 2019-38 would likely be difficult for all but the largest solar power generation activities to meet.

Part of an existing business? Alternatively, the solar power generation system might already be part of an existing trade or business, not a separate activity itself. Any business that reduces its utility costs through a solar power generation system would include the solar power generation as part of the primary activity. For example, a landlord whose leases include utilities would include the solar power generation as part of the real estate activity.

Alternately, the grouping rules under Regs. Sec. 1.469-4 might be able to reclassify an otherwise passive activity as part of an active trade or business. This regulation specifies “geographical location” as one of the facts and circumstances for grouping activities. However, Regs. Sec. 1.469-4(b) indicates the grouped activities must “[i]nvolve the conduct of a trade or business (within the meaning of section 162),” making it unclear if the solar power generation activity must meet the regularly engaged threshold before being grouped or only that the grouping as a whole must constitute a trade or business.

Nonbusiness activity: If the solar power generation activity fails to qualify as a trade or business but still shows a profit motive, it would be categorized as a nonbusiness activity. As a nonbusiness activity, the income is not subject to self-employment tax. Also, the present limitation on miscellaneous expenses through 2025, per Sec. 67(g), that would otherwise be allowed under Sec. 212(2) will bar the deduction of any related expenses such as repairs, maintenance, or administrative fees. However, the effects of Sec. 67(g) appear to be double-edged. Per Sec. 469(c)(6)(a), even though the enterprise is not a trade or business, it will be considered one for purposes of subjecting it to the passive-activity rules if Sec. 212 expenses can be deducted. As such, if the activity is passive, loss limitations under Sec. 469 would apply, and income would be subject to the net investment income tax under Sec. 1411. However, Sec. 67 pulls all but a few specifically named deductions into the category of miscellaneous itemized deductions, including those under Sec. 212, and the limitation under Sec. 67(g) should blunt the passive categorization of this income, since those expenses cannot currently be deducted.

Tax treatment

If the solar power activity qualifies as a trade or business on its own, is part of an existing one, or can be grouped to achieve the same result, it will be treated as any other business income. If the business activity is passive, it might be subject to the net investment income tax under Sec. 1411, and losses could be limited. If the activity is nonpassive, losses could be used to offset other income or create a net operating loss. Income could also be subject to self-employment tax at the individual level and could be eligible for the deduction under Sec. 199A.

Depreciation: Both trade or business property and income-generating property are eligible for depreciation under Sec. 167(a). Solar power generation systems, under the modified accelerated cost recovery system (MACRS), are classified as five-year property. Further, while the basis of property usually must be reduced by credits received, solar power generation systems are subject to a special rule, under Sec. 50(c)(3), where basis is adjusted by only half the value of the investment tax credit taken. However, the distinction between trade or business and nonbusiness does play a factor when considering accelerated depreciation options. Electing current expensing under Sec. 179 is only available for trade or business activities, but bonus depreciation under Sec. 168(k) does not have this restriction. Likewise, the broad scope of Sec. 67 appears to sweep the specifically allowed depreciation under Sec. 167(a) on property held to generate income into the limitation under Sec. 67(g) through 2025.

Tax credits: Regardless of their status as either a trade or business or a nonbusiness activity, solar power generation systems may be eligible for either an investment tax credit under Secs. 48 and 46 or a production tax credit under Sec. 45. The Sec. 48 credit requires the property to be depreciable, which includes both property used in a trade or business and property held to generate income under Sec. 167(a). The Sec. 45 credit requires the power to be sold to an unrelated person. Neither credit requires the activity to only be a trade or business. Unfortunately, the two credits are exclusive to each other. Both credits are part of the general business credit under Sec. 38, and both have restrictions, such as prevailing wage requirements, to qualify. However, as a specified credit, per Sec. 38(c)(4)(B), the Sec. 48 investment tax credit is not subject to the alternative minimum taxable income (AMTI) restrictions by which other portions of the general business credit, including the Sec. 45 production tax credit, are restricted under Sec. 38(c)(1). In most cases it is simply easier to take the investment tax credit upfront, but for larger systems, where power is sold back to the grid, the production tax credit may be more beneficial after taking administrative considerations into account.

Mixed personal and business usage

Additional complexity can arise when the correct classification is more than one category. For example, if a taxpayer owns a two-family home, half of which they rent out, utilities included, and half of which they occupy as their primary residence, there is both a personal residential portion and a portion associated with the rental activity. Here, some metrics should be used to reasonably allocate the solar power system between the residential portion, to claim the Sec. 25D credit, and the rental portion, to claim depreciation and, potentially, a general business credit. Alternately, a de minimis business-use rule exists under Sec. 25D(e)(7), where the entire solar power generation system can be treated as a nonbusiness activity for purposes of the credit if no more than 20% is used for business purposes. Unfortunately, in practice, most split-use cases will involve comparably small dollars and not be economical to properly report.

In split-use situations, most taxpayers use the Sec. 25D(e)(7) de minimis rule, relying on the nonbusiness definition. When these programs create revenue, if it’s in an activity that fails to rise to the level of a business, this Code provision allows the full value of the property to be used for the Sec. 25D credit. The resulting income is then reported as nonbusiness income.

The most important point

When dealing with solar power generation activities, it’s paramount to determine the nature of the activity itself. Whether the solar power system is personal property, constitutes a nonbusiness activity, rises to the level of a trade or business on its own, or is already part of another business activity will point the compass to how to treat the activity for tax purposes. This encompasses which tax credits are available, how or whether to depreciate the equipment, and how to report the income and/or expenses.

— Damien Falato, CPA, CGMA, MST, is managing director of UHY Advisors Inc. in Wayland, Mass. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.