How the Federal Solar Tax Credit Works

How the Federal Solar Tax Credit Works

With solar prices falling and a key federal tax credit ramping down, commercial and industrial businesses are increasingly considering adding solar panels to their facilities.

One of the top incentives for building solar facilities — the federal investment tax credit, or ITC — can make solar panels an appealing option, but it’s important to understand how the program works, especially its eligibility deadlines.

Before getting into the details on the ITC, we should say the program could change soon. Congressional lawmakers are talking about extending the ITC in response to the COVID-19 pandemic. Renewable energy trade groups and others have been asking Congress to extend the ITC and to possibly give companies the option of getting direct payments instead of tax credits for their solar investments.

Solar provisions weren’t included in the $2.2 trillion coronavirus relief bill signed into law March 27. However, discussions are already underway on follow-up legislation, and the ITC measures may make it into that bill. We’ll be keeping a close eye on this.

How the ITC works

The ITC allows homeowners and businesses to reduce their federal income tax liability based on a percentage of their investments in solar property.

Eligible expenses that can be covered by the tax credit include solar photovoltaic panels, inverters, racking, balance-of-system equipment, step-up transformers, circuit breakers and surge arrestors. Energy storage can also be covered if the storage is charged by renewable energy at least 75% of the time.

Companies that start construction on solar facilities this year are eligible for a 26% federal tax credit on their investment. The tax credit falls to 22% for projects that start in 2021. To be eligible for the tax credit, the facilities must be operating by Dec. 31, 2023.

In 2022, the solar ITC for commercial facilities falls to 10% for projects that begin that year. The commercial tax credit stays at 10% after that while the residential credit expires.

When does construction begin?

The Internal Revenue Service (IRS) has issued guidance defining exactly what it means to “start construction” under the ITC.

There are two ways to establish the beginning of construction under the IRS guidance.

First, construction starts when physical work of a “significant nature” begins. There is no fixed minimum amount of work and no monetary or percentage threshold required to satisfy the physical work test. The IRS will consider both on-site and off-site work in deciding whether work has started on a project.

On-site work could include installing racks or other structures needed for solar panels, according to the IRS. Off-site work could include manufacturing key components, such as mounting equipment, inverters and transformers.

Physical work doesn’t include things like planning, designing or permitting activities.

Second, a taxpayer can establish the start of construction by spending at least 5 % of a project’s expected costs. The total cost of the project doesn’t include the cost of land or any property not integral to the project, according to the IRS’s “5% safe harbor” test.

Under both methods, the taxpayer must make “continuous efforts” to finish the project once construction starts. Activities showing continuous work include entering into project-related contracts, obtaining permits and performing significant physical work, according to the IRS.

There are excusable reasons for not being able to keep up continuous efforts on a project, according to the IRS. Those factors include delays due to natural disasters and severe weather. This could be relevant during the COVID-19 outbreak.

It’s also important to note that the ITC is only available for direct investments in a solar project, so companies that lease solar facilities can’t claim any credits.

The bottom line is that timing is important when it comes to securing the tax credit. Unlike many personal tax credits, the ITC requires advance planning.

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