The combined impacts of the Emergency Economic. Shining Light on a Solar Energy Investment. personal financial planning

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1 F I N A N C E personal financial planning Shining Light on a Solar Energy Investment By Michael J.R. Hoffman and Karen McKenzie The combined impacts of the Emergency Economic Stabilization Act of 2008 (EESA) and American Recovery and Reinvestment Act of 2009 (ARRA) provide homeowners with unprecedented opportunities to invest in U.S. energy independence and efficiency. One such opportunity is an investment in a solar energy system with significant financial help from federal and state government. As the government programs become more widely known, CPAs likely will receive an increasing number of inquiries relating to such investments. This article identifies relevant issues CPAs will want to address when discussing a potential solar energy system investment with clients, as well as key information sources from which CPAs may access current, location-specific guidance on available programs and policies. In addition to a discussion of federal incentives, this article provides an introduction to state-level incentives, with emphasis on those available in the state of New York. These incentives are illustrated via a payback analysis of a hypothetical investment in a residential solar electric system in New York. The paybacks for an equivalent system installed in the nearby states of New Jersey, Pennsylvania, and Connecticut are also addressed for comparison purposes. 2

2 Federal Incentives: Section 25D New in IRC Section 25D(a)(1), Credit for Residential Energy Efficient Property, allows a credit equal to 30% of expenditures made on qualified residential solar electric property. The federal credit is not limited to one s principal residence. Section 25D(d)(2), which relates to solar electric property, only requires that the dwelling unit be used as a residence by the taxpayer. Prior to 2009, the credit was capped at $2,000, which very much limited the incentive value of this credit. However, EESA eliminated the cap on the credit for solar electric property, effective after December 31, For example, on a $32,000 system, a credit of $9,600 was allowed in 2009, whereas the credit would have been capped at $2,000 in This change alone significantly decreases the cost of a residential solar electric system. EESA also extended the life of the section 25D credit through Also new, the amount that is eligible for the credit is not reduced by state subsidized financing. Section 25D(e)(9), which previously required that the base for the federal credit be reduced to reflect state subsidized financing, was stricken by the 2009 law (section 1103[b][2][B] of ARRA). Although definitive guidance has yet to be provided, presumably, this language means that the credit is computed on the full cost of the system, without reduction for state or local rebates or incentives. As with other capital improvements, the tax basis of the residence is increased to reflect the addition of a solar electric system. However, section 25D(f) requires the amount of this basis increase be net of the federal credit. Interaction with the Alternative Minimum Tax (AMT). Like most credits, the section 25D credit is nonrefundable. This means that, before considering prepayments of taxes (e.g., employee withholding), the credit is limited to one s tax liability. Two points merit mention in regard to this limit. First, if the credit is limited, any excess can be carried forward to the next year (section 25D[c][2]). Second, regarding the AMT, section 26(a)(1) limits nonrefundable credits to the excess of the regular income tax over the tentative minimum tax. Under this provision, if a taxpayer is subject to the AMT, nonrefundable credits cannot be claimed. However, Congress s annual patch of the AMT has removed this limit through Thus, the credit is allowed to reduce the AMT, as well as the regular tax (section 26[a][2]). If history is any indication, this patch will be repeated in the future as well. The credit and, if applicable, the tax liability limit and resulting carryover are reported on Form 5695, Residential Energy Credits. Is Interest Deductible? If the funds invested in a solar electric system will be borrowed, remember that personal interest is deductible only if it is qualified residence interest under section 163(h)(3). There are two types of home mortgages on which the interest is deductible: up to $1 million of acquisition debt and up to $100,000 of home equity debt. When the proceeds of a home mortgage are used for a capital improvement, such a loan is classified as acquisition debt (section 163[h][3][B]). This classification is important, as interest on acquisition debt is deductible in determining both the regular tax and the AMT, while interest on home equity debt is not deductible for AMT purposes (section 56[e][1]). Income Tax Withholding Issues In a rational and predictable world, one would set the withholding exemptions on Form W-4 such that there would be neither a large refund nor tax due. Of course, if circumstances change, withholding exemptions may need to be adjusted. Making a substantial investment in a residential solar electric system and qualifying for a large credit under section 25D would be such a change in circumstance. Unless the decision to invest in the system is made late in the year, a large refund can be avoided by revising one s W-4, and thereby the section 25D credit can be recovered by means of reduced withholding throughout the remainder of the year. State Incentives While federal incentives are quite generous, especially when compared to pre levels, incentives offered by state and sometimes local governments can be equally attractive in some cases, larger in magnitude than federal incentives. Current information on specific state policies and available programs is easily accessed on the U.S. Department of Energy funded Database of State Incentives for Renewables and Efficiency (DSIRE at ). The rapidly growing interest in solar technology is evidenced by the addition of a solar-specific area of the DSIRE site: Given the surge in interest in going solar and the rapid evolution of solar policy at all levels of government, the Solar Policy Guide was created to provide context for the array of solar programs featured on the DSIRE website. Serving as a resource for policy makers and other interested stakeholders, it highlights key policies necessary to facilitate mainstream solar adoption. (www. dsireusa.org/solar/solarpolicyguide) The database is updated quarterly and provides direct links to current activities and programs by state. At the state level, homeowners should be made aware of rebate programs; property, personal (income), and sales tax exemptions; and the availability of netmetering service from the utility. Before considering rebate programs and tax incentives, net-metering availability should be confirmed. Net-metering simply means that the electric utility meter captures the amount of electricity both generated and used by the household. The homeowner is billed for the excess of electricity consumed over that which is produced. Availability of net-metering service is a crucial factor in analyzing an investment in a solar energy system. Without it, systems would need batteries for storage of excess electricity to be used whenever the household is consuming more than the system is able to generate (e.g., nighttime energy demands). Batteries add significant cost and space demands to a system, making it less practical for most residential interests. According to DSIRE, 42 states and the District of Columbia have set netmetering policy. State Rebates Currently, 29 states have solar rebate programs listed in DSIRE. Although the design and duration of these programs vary, most are based on a dollar amount per watt, with an established maximum rebate. Several states are taking advantage of ARRA grant money for state rebate funding. According to the Government Accountability Office (GAO), ARRA funding for state and local energy and envi- 3

3 ronmental projects will increase from 1% of state and local recovery act funding in 2009 to 17% in 2012 ( Some existing state incentive programs previously funded via the state s general fund have been put on hold due to dire budget conditions in the struggling economy, so investigating applicable programs and status is time well spent. In the state of New York, four rebate programs exist: the PV (Photovoltaic) Incentive Program from the New York State Energy Research and Development Authority (NYSERDA); the Town of Southampton s Photovoltaic Rebate Program; and utility rebate programs on Long Island and in metropolitan New York. According to the NYSERDA website, residential customers may save 40% to70% of the installed system cost by combining that agency s incentives with other New York energy-smart programs ( Solar.aspx). Property Tax Although property tax is the primary revenue source for local governments, states may dictate the handling of property value assessments. Currently, 34 states have created property tax exemptions regarding solar energy systems, declaring that the improvement should not add taxable value to property. Thus, unlike other major home improvements, increased property tax is not a factor in the solar system cost analysis for residents of those states. Residents of the remaining states should be made aware of the property tax impact specific to their area. In the case of New York, local governments are given an opt-out option. Although few local governments have exercised this option, one s local situation should be determined before committing to a residential solar electric investment. The value of the solar electric system that is exempted from state property taxes is not reduced by state or federal incentives or credits (New York Consolidated Laws, Article 4, Title 2, section 487-a). Somewhat related to the issue of assessment value is resale value. When considering major home improvements, homeowners are often interested in the improvement s impact on resale value. The most commonly referenced impact of a solar system on home value is that a dollar saved in annual energy cost produces over $20 in increased home value (Rick Nevin and Gregory Watson, Evidence of Rational EXHIBIT 1 Payback Period, 5,040-watt Residential PV System Installed in Binghamton, N.Y. System Cost Installed Cost $32,000 Less Federal Income Tax Credit (Section 25D) (9,600) Less State Rebate (8,750) Less State Income Tax Credit $(3,413) Net of Additional Federal Income Tax 956 (2,457) Actual Cost, Net of State and Federal Incentives $11,193 Assumptions Regarding System Payback Under Varied Electric Electric Electric Utility Rates Utility Rates Annual Rate Increase Initial Utility Rates 0% 2% 5% 10% 10% Above State Average 13 years 11 years 10 years 8 years State Average 14 years 12 years 11 years 9 years 10% Below State Average 17 years 14 years 12 years 9 years Market Valuations for Home Energy Efficiency, The Appraisal Journal, October 1998, Community_Development/doc_files/apj109 8.pdf). Of course, sale of the home is required to take advantage of the increased resale value. This discussion ignores this sales option and focuses on benefits associated with owning a home equipped with a solar electric system. Sales Tax DSIRE currently identifies 21 states, including New York, that offer sales tax exemptions on solar electric systems. This is a fairly significant dollar savings within these states and a definite cost consideration in the system payback analysis for residents of states without such an exemption. In this section, a hypothetical investment in residential solar electric property in New York will be analyzed. The results of this analysis will be presented as a payback period. As used herein, the term payback period will reflect the time-value of money, rather than a simple payback in nominal dollars. Description of Payback Analysis The first step in the analysis is to determine the cost of the residential solar electric system after considering all federal and state incentives. The cost of a 5,040-watt PV system installed in the quad-state area was determined to be $32,000 (based on correspondence with Ross Solar Group of Danbury, Connecticut). As discussed above, the federal income tax credit is 30% of the installed cost. Thus, a $32,000 system would qualify for a $9,600 federal tax credit. The state of New York offers two incentives that directly affect the final cost of a solar electric system: 1) a rebate based on system capacity (in watts) and 2) a credit against the state income tax. As of January 11, 2010, the state rebate rate was $1.75 per watt of capacity, with a 5,000-watt capacity cap, or $8,750, for this scenario ( org/publications/summaryofrevisions pdf). The state income tax credit is 25% of the installed cost of the system, net of state and federal incentives, which for our scenario results in a state income tax credit of $3,413 (i.e., 25% x [$32,000 $9,600 4

4 (federal credit) $8,750 (state rebate)]). Of course, state income taxes are deductible for federal income tax purposes. The $3,413 state tax credit reduces the corresponding itemized deduction on the homeowner s federal income tax return, thus increasing one s federal taxable income. Assuming a 28% federal income tax bracket, this increased taxable income will result in a $956 increase in federal income taxes (i.e., 28% of $3,413 additional taxable income). Thus, after considering the increase in federal income taxes, the net benefit of the state income tax credit is $2,457 ($3,413 $956). When all incentives, both state and federal, are considered, the final cost of a $32,000 residential solar electric system with a 5,040-watt capacity installed in New York would be $11,193. The second step in the payback analysis is to determine how long it takes to recover this investment, with the time-value of money taken into consideration. As discussed previously, the principal source of financial return on a solar electric system is the electric utility costs that are avoided. For estimating the savings from reduced electric consumption, the authors used the PV Watts website (pvwatts.org). This site uses long-term weather conditions to estimate how much electricity will be produced by a solar electric system for several representative cities in each state. Using the average cost of electricity for the state of New York (source: ne.gov/statshtml/115.htm), the PV Watts site estimates on a monthly basis the cost savings from avoided electric bills. To be conservative in the analysis, the authors reduced these savings by an amount that approximates the additional homeowner s insurance premium attributable to a $32,000 home improvement ($130 annual premium, allocated equally to each month). To assess how sensitive the payback is to variations in electric utility rates, we also ran our analysis using rates that were 10% above and 10% below the state average. In addition, we considered several possible rate increases in our analysis. To the extent electric utility rates increase in the future, the payback on a solar electric system will be improved. Finally, to determine the payback period, a discount rate must be selected that reflects the longterm time-value of money. The IRS publishes several rates to be used for the purpose of determining the value of various financial instruments. These applicable federal rates (AFRs) are published monthly, with the AFRs for April 2010 being published in Revenue Ruling For our analysis, we used the AFR that, among other applications, is used for the valuation of annuities (Table 5, Revenue Ruling , IRB , 4/5/10). This AFR seems appropriate to our analysis, because what we sought to determine is the present value of an annuity consisting of avoided electric costs that extends for a relatively long period of time. For April 2010, this AFR was 3.2%. The Case for Solar in Binghamton, New York With these components in mind, the payback analysis for a hypothetical 5,040-watt residential solar electric system installed in Binghamton, New York, is presented in Exhibit 1. Binghamton was selected because it is the closest city to New York in the PV Watts database, which was used for estimating the cost savings from reduced electric bills. Payback periods are rounded to the nearest full year. With no moving parts, the life of the roof on which the PV panels are installed is probably a more important factor in the useful life of a system than is the life of the panels. Accordingly, it is not unreasonable to expect a residential solar electric system to have a useful life of 25 years or more. The payback analysis presented in Exhibit 1 discloses that, in all cases, an investment in solar electric property will pay for itself well within the 25-year expected life of the system. For example, with electric utility rates reflecting the state average and increasing a modest 2% per year, it would take about 12 years to recover the investment in residential solar property. The authors omitted any immediate positive impact on a home s market value, for two reasons. First, home valuation is a very subjective exercise. Any assumptions regarding value increases would be difficult to defend. Further, the realization of any value increases requires the sale of the home, which effectively transfers future benefits of electric cost savings to the buyer. Accordingly, the increased selling price realized on the sale of a home with a solar electric system merely replaces the cost savings already included in our analysis. Rather than enhancing the return on investment, the increased selling price compensates the seller for giving up the future benefits associated with the solar electric system. The Case for Solar in Adjacent States As emphasized earlier in this article, incentives for investment in renewable energy property vary between states and, sometimes, within a state. Not surprisingly, the payback periods calculated for an equivalent solar electric system in three adjacent states differ from the New York case. Exhibit 2 presents the payback for each of the four states analyzed. For brevity, this table presents the analysis under just one electric rate assumption that electric utility rates will increase at a 2% annual rate. Financially, a solar electric investment in Newark, New Jersey, is substantially more attractive than in any of the other states analyzed. This advantage can be attributed to the active marketplace for solar renewable energy certificates (SREC) in New Jersey. The PV Watts website indicates that our New Jersey system should produce about 6,800 watts of electricity each year. Each 1,000 watts of electricity produced earns the homeowner one SREC. To be conservative, we included in our analysis the revenue from six SRECs each year, net of a 28% federal income tax on the revenue. Without this added revenue flow, the payback period for a New Jersey solar investment would be longer than in New York. For a system installed in Allentown, Pennsylvania, the payback period is two to four years shorter than in New York, depending on the rate structure assumed. Although not as financially attractive as New Jersey, Pennsylvania also offers homeowners the opportunity to generate added revenue from the sale of renewable energy certificates (REC). Connecticut s comparatively small state rebate results in a payback period that is substantially longer than the other states; however, as described below, the state has other ways to encourage homeowners to consider solar electric systems. Innovative Marketing of Solar Connecticut and New Jersey both have developed programs that should make the installation of solar electric systems attractive to homeowners. Although no longer accepting applications because 5

5 current funding has been fully committed, Connecticut s Solar Lease Program can serve as an example for other states interested in jump-starting their solar energy programs. Connecticut describes its program as making residential solar investments very attractive and bringing an investment in solar electric within reach of most middle-income residents (www. ctsolarlease.com). Based on our calculations, this lease program can result in the system being essentially free. The 5-kilowatt example presented for the Connecticut program assumes a system cost of $43,000. According to Ross Solar, the installed cost of a 5-kilowatt system is now about $32,000. With the lease payments adjusted to reflect reduced system costs, the present value of the lease payments is $13,643. If electric rates increase at 2% each year, the present value of avoided electric bills over the same 20-year term is $18,861 a positive net present value (NPV) for the lease option. The state of New Jersey has asked its public utilities to develop programs that will encourage the development of renewable energy sources. One program, offered by Public Service Enterprise Group (PSEG), will finance up to 60% of the cost of a solar electric system (10-year term, 6.5% APR) ( solar/residential/index.jsp). The homeowner assigns the SRECs generated by the system to PSEG. A minimum price is guaranteed for the SRECs, and the revenue from the SRECs is used to service the loan. If the SREC price moves higher than the guaranteed floor, the loan is paid down more quickly. If the solar electric system does not perform as well as expected and fewer SRECs are generated, the homeowner must make up any shortfall in the loan service. Using a 6.5% APR, our analysis shows that a 10-year loan that financed 100% of the cost of a New Jersey solar electric system (5,040 watts), net of federal and state incentives, would require a monthly payment of about $165, well below the average monthly SREC revenue at the guaranteed floor and the homeowner still benefits from reduced electric bills from day one. The system is essentially free, and the homeowner receives all benefits, electric utility savings, and SREC revenue after the 10-year loan term is completed. Thus, in Connecticut and New Jersey, the state has encouraged the development of programs that allow homeowners to install solar electric systems at little or no cost. Indeed, when the savings that continue after the lease or loan term has been completed are considered, the investment in solar generates a positive rate of return not merely break-even. Before leaving the subject of creative financing programs, it should be observed that a homeowner does not need a formal, state-sponsored program to set up an arrangement like those in Connecticut or New Jersey. Private mortgage financing (e.g., a second mortgage) can be arranged for all or most of the out-of-pocket cost of a solar electric system, with electric utility savings (and revenue from sale of RECs in Pennsylvania and New Jersey) servicing the debt. For example, if a prime plus zero home equity loan can be obtained, the full out-of-pocket cost of the 5,040-watt system could be paid off using electric savings and REC revenue in as little as five years in New Jersey. The payoff period EXHIBIT 2 Payback Period for New York, Pennsylvania, Connecticut, and New Jersey Assumptions: 2% Annual Electric Rate Increase and 3.2% Discount Rate N.Y. Pa. Conn. N.J. Cost of Solar Electric System, Net of Federal and State Incentives $11,193 $13,580 $13,600 $14,588 Initial Utility Rates Are: 10% Above State Average 11 years 9 years 13 years 5 years At State Average 12 years 9 years 14 years 5 years 10% Below State Average 14 years 10 years 16 years 6 years would be six years in Pennsylvania, 12 years in New York, and 14 years in Connecticut all well within the expected life of the system. This analysis understates the advantages of solar inasmuch as it assumes a 28% federal income tax rate on REC revenue, while disregarding future electric rate increases and tax savings from interest deductions, both of which would shorten the payoff period. State Incentives Can Be a Moving Target What the authors hope to emphasize by the comparison of three states is that the case for solar will differ, perhaps substantially, between jurisdictions. A clear understanding of the incentives available in one s state of residence is an important first step in analyzing the case for solar at least from a financial perspective. Also, before committing to an investment in a solar electric system, one should double-check whether state funding of its solar rebate program has changed. New York State provides an excellent illustration of this issue. When this article was being written, the New York State rebate was funded at $3.00 for the first 4,000 watts of system capacity and $2.00 for the next 4,000 watts of capacity. Before this manuscript was submitted for publication, the New York rebate had been reduced to $2.50 and $1.50 for the first and second 4,000 watts of capacity, respectively. While this manuscript was under review, the New York rebate was reduced to $1.75 per watt, with a 5,000-watt capacity cap. Further, $12 million of funding for the period January through June 2010 was allocated at $2 million per month. No new applications would be accepted once the $2 million budget for a given month had been committed. Thus, over a period of slightly more than five months (August 9, 2009, to January 11, 2010), the state rebate for the 5,040-watt system we present in this article went from $14,080 to $11,560 (in August 2009) to $8,750 (in January 2010, assuming January s budget allocation had not been fully committed). Had the initial system cost remained at $40,000, the outof-pocket cost of the system (and the related payback period with a 2% annual rate increase and electric rates at the state average) would have increased from $11,414 (12 years) to $13,481 (15 years) to $15,785 (18 years). However, with the drop in 6

6 system cost over this period, the out-ofpocket cost and payback now stand at $11,193 and 12 years, respectively. Thus, even with decreasing state incentives, the real system cost and payback have remained stable. As to the other states we address herein, Pennsylvania s rebate rate fell from $2.25 per watt to $1.75 per watt. New Jersey is considering a reduction of its residential rebate rate to $1.35 per watt (from $1.55 or $1.75 with an energy audit). Connecticut s rebate rate has not been reduced, but its solar lease program has committed all of its current funding. Whether the incentive reductions are temporary adjustments resulting from challenged state budgets or more permanent changes in the incentive structure for alternative energy investments remains to be seen. Certainly, budget challenges at least partially explain the reduced rebate rates. However, while this article was being written, the cost of a 5-kilowatt solar system fell from $40,000 to $32,000. Arguably, with system costs falling, less of an incentive is warranted. The moral is to be aware of your state s current program status and pending changes; incentives may have been reduced by the time planning becomes a decision. Solar Incentives for Business Although the detailed discussion of incentives available to commercial interests for investments in solar electric systems is beyond the scope of this article, a brief review of such incentives is appropriate. In most cases, incentives available to commercial interests are very similar to those available to homeowners. At the federal level, the principal difference between incentives offered to homeowners and to commercial interests is found in the statutory authority and flexibility regarding the manner in which the incentive is applied for. State-level incentives may vary on the basis of per-watt incentive rate and permissible capacity. Federal Incentives for Business Both homeowners and business owners are eligible for a 30% credit against federal income tax liability. As discussed above, the statutory authority for the residential credit is section 25D, and Form 5695 is used to claim the credit. In contrast, the authority for the business version of this credit is section 48 the investment tax credit and Form 3468 is used to claim the credit. Under section 1603 of ARRA, business owners eligible for this credit under section 48 can instead apply to the Department of the Treasury for a grant. This grant, in lieu of the credit, is available for projects placed in service during 2009 and For solar electric property, the grant amount is also 30% of the cost of the system. The rationale for this grant, in lieu of a tax credit, is expressed in the Program Guidance provided by the Treasury Department as follows: It is expected that the Section 1603 program will temporarily fill the gap created by the diminished investor demand for tax credits. In this way, the near term goal of creating and retaining jobs is achieved, as well as the long-term benefit of expanding the use of clean and renewable energy and decreasing our dependency on non-renewable energy sources. ( guidance.pdf) What this means is that an income tax credit provides no immediate incentive to a business that has little or no taxable income, because the credit is nonrefundable. The grant option allows these businesses to get immediate benefit from an investment in a solar electric system. State Incentives for Business Three of the four states we consider in this article offer incentives to businesses to encourage investments in solar electric property. Each state s solar energy incentive program is briefly described below, with the primary focus on the per-watt rebate rate and system capacity caps. New York. The New York solar rebate program offers the same $1.75 per-watt rate to both businesses and homeowners. However, the capacity cap for a business is 50,000 watts (i.e., $87,500 maximum rebate). Exceptions to the capacity caps may be made on a case-by-case basis. The capacity cap for a residential system is 5,000 watts ( incentives/incentive.cfm?incentive_code= NY10F&re=1&ee=0). New Jersey. The New Jersey solar rebate rate for businesses is 90 cents per watt, compared to $1.55 per watt for residential solar electric systems. The capacity cap applicable to a business is 50,000 watts, compared to 10,000 watts for residential. A business can qualify for a slightly higher rebate rate ($1.00 versus 90 cents) if it participates in certain state programs, such as a Municipal Energy Audit. Businesses can also participate in the state s renewable energy credit marketplace( tive.cfm?incentive_code=nj04f&re= 1&ee=0). Connecticut. Connecticut s On-Site Renewable Distributed Generation Program has suspended the acceptance of applications for commercial solar electric systems. Until this suspension is lifted, the only incentives offered to businesses in Connecticut are those offered at the federal level ( incentive.cfm?incentive_code=ct10f&re =1&ee=0, default.aspx?tabid=95). Pennsylvania. In contrast to its residential solar rebate program that pays $1.75 per watt for up to a 10,000-watt system, the rebate program for businesses is a three-tier program. Solar electric systems in the 3,000- to 10,000-watt capacity range receive a rebate of 75 cents per watt. The rebate for the next 90,000 watts is 50 cents per watt, with 25 cents per watt paid for the next 100,000 watts. Thus, solar electric systems with a capacity between 3,000 and 200,000 watts are eligible for the Pennsylvania rebate ( org/incentives/incentive.cfm?incentive_ Code=PA37F&re=1&ee=0). Know All the Variables While federal incentives and policies apply consistently throughout the United States, state policies will vary. Perhaps the most important consideration that makes a residential solar investment feasible is the availability of net-metering. State incentives, including rebates and exemptions from sales and property tax, also must be understood. Advisors interested in addressing individuals solar system investment concerns should have an understanding of the variables to incorporate in their client-specific analyses, as well as some key resources for accessing current, location-specific laws, policies, and program availability. 7

7 Michael J.R. Hoffman, MBA, DBA, is a professor of taxation and Karen McKenzie, Phd, is a professor of accounting, both at Nova Southeastern University, Fort Lauderdale-Davie, Fla. 8