Tax Credit Transferability Through the Inflation Reduction Act

The Inflation Reduction Act (IRA) has transformed the landscape of federal clean energy tax credits by significantly expanding available credits and introducing a transferability system to monetize these credits. Traditionally, these credits required a tax equity investment, which committed investors to long-term projects through IRS-approved ownership structures.

New flexibility with credit transfers

The IRA introduced a transformative option allowing the purchase and sale of tax credits for cash, creating a new market for eligible taxpayers — including for-profit corporations, partnerships, individuals, and trusts — seeking tax savings without long-term renewable energy investments. While some developers and investors may still prefer tax equity investments for benefits such as depreciation deductions, the option to transfer credits can provide additional flexibility.

Understanding tax equity

The United States tax code, enhanced by the IRA, incentivizes investments in certain sectors, particularly renewable energy. Developers are often unable to fully utilize these tax advantages, which leads to the creation of a tax equity market. This market draws investment from corporations capable of funding these projects with available cash. Key roles and terms in a conventional tax equity framework include:

• The project developer, referred to as the project sponsor, cannot fully utilize tax credits and depreciation benefits due to limited tax liability.
• A corporate taxpayer, acting as an investor, provides cash to achieve a desired return on investment or internal rate of return through tax benefits allocation.

For investors, the initial outlay is the upfront investment in tax equity. The anticipated returns comprise three main components:

• A decrease in cash tax liability through acquiring tax credits and expedited tax depreciation benefits;
• Regular preferred cash distributions on a quarterly or annual basis; and
• A final cash buy-out at the conclusion of the deal.

In a standard partnership flip deal, the partnership distributes 99% of the income, losses, and tax credits to the investor until a predetermined yield is achieved, although cash distributions can follow a different allocation. Once the target yield is met, the share of benefits allocated to the investor diminishes, and the developer has the option to purchase the investor’s residual interest, an option that is frequently exercised.

Credit transfer provisions in the IRA

As this area of tax credit transferability continues to develop, the current market offers the advantage of acquiring credits at a discount, with a reduced investment time horizon and a more straightforward legal formation process, as compared to traditional tax equity dealings.

The cost of purchasing tax credits may differ or be influenced by factors such as the seller’s financial reliability, the project’s scope, the type of credit and its volume, and whether tax insurance is in place. Transactions must be conducted in cash between unrelated parties, and credits can be sold only once.

The transfer is formalized through a purchase and sale agreement, accompanied by a transfer election statement included in both the seller’s and buyer’s tax returns for the relevant tax year. Considering the potential risks associated with these transactions, either the buyer or seller has the option to secure insurance to safeguard against possible recapture events.

Market strategies for new investors

The market remains vibrant for both traditional tax equity investments and credit transfer transactions. Developers are likely to continue pursuing tax equity investments to benefit from tax depreciation advantages, which are not available in tax credit transfer scenarios. Tax equity investors are exploring strategies to engage in traditional tax equity frameworks while also considering separate transactions to transfer credits.

Thorough due diligence and tax insurance are essential for reducing risks. The simpler process of credit transferability is attracting new investors, and each developer and investor must assess their specific circumstances to determine the right strategy.

There have been recent discussions in Washington, DC, regarding potential changes to the IRA. Renewable energy investors should closely monitor these legislative developments and be prepared to adjust their strategies accordingly.

Regardless of the chosen approach, the key takeaway is that the transferability of tax credits is an innovation that opens the market to new investors in the tax credit investment space.

How CLA can help

Real estate businesses and investors can explore how the IRA's provisions align with their specific needs and goals. For example, consider how the flexibility in credit transfers can help manage tax liabilities more effectively and invest in sustainable projects that enhance property value.

CLA’s energy tax services team has helped hundreds of eligible taxpayers navigate and capture the advantages of the IRA, including the complexities of the transferability system. Contact us to learn the rules and discover how you or your business might benefit.