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(Revised July 18, 2022)
Solar and other renewable energy projects eligible for the investment tax credit (ITC) rarely suffer causalities; however, cautious taxpayers often seek to understand and be prepared for the ITC consequences of a potential project casualty.
The ITC concern is the application of the "recapture" rules in section 50(a)(1) of the Internal Revenue Code as the result of a casualty. Recapture means that the taxpayer has to increase its federal income tax liability in the year of the recapture event by the amount of the recaptured ITC. Recapture occurs if a project or a portion thereof is sold, or otherwise disposed of, or removed from service (i.e., permanently ceases operating) in its first five years of operations. If recapture occurs, some or all of the ITC has to be recaptured, based on the recapture schedule that declines by 20 percent a year.[1]
The cost of recapture depends upon what portion of the project has been removed from service and what the taxpayer does about it:
First, the IRS has an administrative practice that if the project is partially damaged and the necessary repairs are made for it to be returned to service that no recapture is triggered.[2] There is no guidance as to how long the taxpayer has to repair the property; however, following Hurricane Katrina in 2005, the National Trust for Historic Preservation requested that the "period will be at least three years, or long as circumstances warrant."[3] There was no public response from Treasury to this request. Also, note that the amount spent on the repairs would not be ITC eligible as the amounts are being spent to avoid recapture and bring the project back to its original state.
Second, there is an analysis that if more than 20 percent of the project remains operational, that the project is not subject to recapture. This is because the project should continue to qualify as originally placed in service and recapture should not occur.[4] Under this analysis, there would be no obligation to replace the portion removed from service. Although logical, the IRS may view this analysis with some skepticism.
Third, there is a regulation with a complicated history that appears to provides a taxpayer six months to replace property subject to a casualty and avoid recapture (the "Six Month Regulation").[5] For instance, under the Six Month Regulation, a project that suffered a casualty in New Jersey could be replaced by a project in New Mexico and recapture avoided, if the New Mexico project is placed in service within six months after the casualty in New Jersey.
Treasury announced in Revenue Ruling 88-96 that the Six Month Regulation was not applicable to property acquired after December 31, 1985.[6] However, Administrative Procedure Act principles provide that a revenue ruling, which is not subject to the notice and comment process, cannot repeal a regulation that is subject to the notice and comment process. Thus, the 1988 revenue ruling is arguably invalid. Further, it is not clear why the regulation should not continue to apply to solar and other energy equipment that qualifies for the ITC, as opposed to equipment generally for which the Tax Reform Act of 1986 repealed the ITC for.
If a taxpayer decides to proceed under the Six Month Regulation, the ITC on the replacement property would reduce the recapture. However, the ITC on the replacement property will likely be calculated based on the vintage of the "safe harbor equipment"[7] included as the replacement property and the placed in service date of the replacement property (i.e., somewhere between 10 and 26 percent depending upon the facts and circumstances[8]).
The taxpayer may seek indemnification under its property and casualty insurance policy. The questions are whether the insurance (i) includes coverage for lost tax benefits and (ii) is sized to compensate the taxpayer for the physical damage as well as the potential ITC recapture cost. Some property and casualty insurers will agree to include coverage for specified lost tax benefits, such as ITC recapture, or alternatively there is a specialty tax insurance market that is versed in these issues.
If there is an insurance recovery, the project owner will likely want to take advantage of section 1033 election. Section 1033 provides that if property suffers a casualty and the insurance proceeds are spent on similar property, then the taxpayer may elect to not recognize any gain. [9]
Section 1033 refers to such a scenario as an "involuntary conversion." A classic example of an involuntary conversion is if a railcar with a zero tax basis suffers a casualty that is covered by insurance that pays the owner $100,000 and the owner of the railcar spends the insurance payment on another railcar. The owner of the railcar does not have to treat the damaged railcar as sold for US$100,000. Rather, the $100,000 insurance payment is received tax free and the owner retains a zero tax basis in the new railcar (which would be increased to the extent the owner comes out of pocket to buy the replacement property, e.g., if the railcar costs US$125,000 (i.e., US$25,000 more than insurance proceeds), the owner would take a US$25,000 basis in the new railcar). Section 1033 gives taxpayers two years from the end of the year in which the casualty occurs to spend the insurance proceeds on similar property.[10]
Section 1033 operates in the same manner for solar projects that suffer casualties and the proceeds are spent repairing the project or buying another solar project. However, section 1033 is limited to the deferral of gain and, unfortunately, does not address ITC recapture. Further, if the project is owned by a partnership, then the partnership must purchase the replacement property to qualify for section 1033.
Section 1033 requires the taxpayer on its tax return disclose the details of the involuntary conversion, which include what replacement property was acquired, the date it was acquired and the cost of it.[11]
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[1] I.R.C. § 50(a)(1)(B): "(i) One full year after placed in service 100 percent
(ii) One full year after the close of the period described in clause (i) 80 percent
(iii) One full year after the close of the period described in clause (ii) 60 percent
(iv) One full year after the close of the period described in clause (iii) 40 percent
(v) One full year after the close of the period described in clause (iv) 20 percent"
[2] See IRS, Market Segment Specialization Program Guideline, Rehabilitation Tax Credit (Jul. 2012) ("Partially damaged property would not trigger recapture if the owner makes the necessary repairs and places the property back in service."). This guideline relates to historic buildings; however, since the tax credit for historic buildings and for solar (and other energy property) are both investment tax credits subject to recapture under section 50(a), the same principle should apply to solar.
[3] Letter from Richard Moe, President of the National Trust for Historic Preservation, to Eric Solomon, Acting Deputy Assistant Secretary for Tax Policy and Donald Korb, Chief Counsel, IRS (Sept. 14, 2005).
[4] Rev. Rul. 94-31; PLR 200442014 (applying Rev. Rul. 94-31 to the potential replacement of a part of a synthetic fuel facility). This private letter ruling addressed whether the synthetic fuel facility had a new placed in service date, rather than recapture.
[5] See Treas. Reg. § 1.47-3(h)(1). Previously, there was not a time limit to acquire the replacement property for property destroyed by casualty, but the six month rule applies to disposition after April 18, 1969. See Treas. Reg. § 1.47-3(c). Also, the six month rule also applies to avoid recapture from dispositions generally (i.e., whether a sale or a casualty). See Treas. Reg. § 1.47-3(h)(1).
[6] Rev. Rul. 88-96, 1988-2 C.B. 27 ("If a taxpayer disposes of … property that qualified for investment credit and replaces that property within six months with property similar or related in service or use to the property disposed of, [the Six Month Regulation] does not prevent recapture of investment credit").
[7] See Notice 2018-59 (establishing rules for determining when construction begins, including a safe harbor based on five percent of spending of the "total cost" of the project).
[8] See I.R.C. §§ 48(a)(2)(A), -(a)(6) (referencing "construction of which begins" for determining the ITC percentage available).
