The Inflation Reduction Act of 2022 (IRA), signed on August 16, 2022, reallocates federal funds to prioritize carbon emission cuts, reduce healthcare costs, bolster the Internal Revenue Service, and enhance taxpayer compliance.
*Note: Before we dive into the details, it’s important to clarify that this IRA is unrelated to Individual Retirement Accounts, to avoid confusion.
Energy efficiency is more than a buzzword. It’s a strategy to lower our environmental footprint, promote sustainability, and decrease the cost of our utility bills. For those reasons and more, federal and state governments incentivize energy efficiency investments through tax credits and deductions. In this article, we’ll unpack what these incentives entail, and how they can help you save money while contributing to a greener future.
Understanding Federal Tax Credits & Incentives
Tax laws do more than fund government operations; they shape societal behavior. They encourage and reward actions that benefit society, such as investing in energy-efficient technologies. Here are the primary mechanisms the government uses to incentivize such investments:
- Tax Credits: When you install energy-efficient appliances or systems in your home or business, you can often claim a tax credit, which is a dollar-for-dollar reduction in your tax liability. This direct cut in your overall tax bill makes energy-efficient investments more financially attractive.
- Tax Deductions: By investing in energy efficiency improvements, you can lower your taxable income. For instance, if you spend on energy efficiency upgrades for a rental property, you may deduct those costs from your taxable income.
Credits Versus Deductions: Maximizing Your Benefits
When leveraging energy efficiency incentives, understanding the difference between tax credits and deductions is crucial. A tax credit directly reduces your tax liability, while a tax deduction decreases your taxable income, lowering the amount of your income subject to tax. The actual tax savings from deductions depend on your marginal tax rate.
State Tax Incentives: An Added Advantage
Besides federal incentives, state-level incentives also play a significant role in promoting energy efficiency. These can take various forms, including tax credits, rebates, grants, or low-interest loans. Notably, these state incentives can be combined with federal tax credits, leading to substantial savings for those who opt for energy-efficient solutions.
While the specifics of state incentives are beyond the scope of this article, we are prepared to respond to any questions you may have relating to state incentives.
The Energy Efficient Home Improvement Credit
The Energy Efficient Home Improvement Credit is one of the main incentives available. This credit can be claimed for qualifying expenditures in an existing home, including additions. It’s important to note, however, that this doesn’t apply to new construction. The credit can be claimed for the year of installation, with availability ranging from 2006 to 2032. This credit applies to residential energy efficiency improvements, residential energy property expenditures, and, for property placed in service after 2022, the cost of home energy audits.
The energy efficient home improvement credit has evolved over the years. The Nonbusiness Energy Property Tax Credit (Section 25C) was in effect until the end of 2022 and offered individuals tax breaks for energy-efficient home improvements. Through this scheme, homeowners could claim 10% of qualified expenses, excluding labor, with an aggregate cap of $500 across all tax years. If you invested in particular energy-efficient equipment before 2023, you could qualify for varying credits: up to $50 for advanced air fans, $150 for certain furnaces and boilers, and $300 for select heat pumps, air conditioners, water heaters, and biomass stoves. All improvements needed to adhere to the standards set by the 2009 International Energy Conservation Code, encompassing materials that reduce home heat loss or gain, specific exterior doors, windows, skylights, and some roof types.
From 2023 to 2032, the energy-efficient home improvement credit underwent a significant update. The revamped credit now covers 30% of the cost of an eligible item or improvement, with individual caps per item. The most striking upgrade being that taxpayers can claim up to $1,200 in credits annually, a four-fold increase from the former $500 cap. This ‘new & improved’ version offers far more enticing benefits compared to its predecessor.
For building envelope improvements, existing homeowners can receive a tax credit worth 30% of the cost of upgrading the efficiency of the building’s envelope. The eligible improvements include exterior windows and skylights, exterior doors, and insulation materials. Note that installation (labor) costs are not included.
Under this arrangement, taxpayers who purchase qualified residential energy-efficient property that meets or exceeds the highest efficiency tier established by the Consortium for Energy Efficiency can get a credit equal to 30% of the cost of the equipment. This includes an electric or natural gas heat pump, central air conditioner, certain types of water heaters and boilers, panelboard or sub-panelboard replacements, and biomass stoves, all with a maximum credit cap.
To claim these benefits, you will need to fill out IRS Form 5695. In any case, considering the potential savings, these credits are a valuable incentive for homeowners to improve their energy efficiency and contribute to a more sustainable future.
The Residential Clean Energy Credit
To begin, let’s clarify the distinction: The Energy Efficient Home Improvement Credit, as mentioned earlier, promotes energy-saving renovations in existing homes, while the Residential Clean Energy Property Credit highlights the adoption of clean energy solutions in residences, including:
- Qualified solar electric property
- Solar water heating property
- Small wind energy property
- Geothermal heat pump property
- Fuel cell property (subject to limitations)
- Qualified battery technology expenditures (beginning in 2023)
The credit can also be applied to labor costs associated with the installation of these systems, making it even more valuable for homeowners. Furthermore, it applies not only to existing homes but also to new constructions.
The Inflation Reduction Act of 2022 extended this credit, which was originally designated for property placed in service in 2022. However, significant changes were made for the tax year 2023 and beyond. The credit rates, based on the year of installation, are as follows:
- 30% of the cost for property installed in 2017, 2019, and 2022 through 2032.
- 26% of the cost for property installed in 2020, 2021, and 2033.
- 22% of the cost for property installed in 2034.
Please note, however, that the amount of any credit allowed must reduce the basis of your home. As of 2023, biomass furnaces no longer qualify for this credit, transitioning instead to the energy-efficient home improvement credit. From 2023 onwards, the credit applies to battery storage technology with a capacity of at least three kilowatt-hours.
Here are some steps to take to ensure that you can retain this credit:
- Retain all receipts and manufacturer’s certification statements as documentation for the credit.
- File Form 5695 with your Form 1040 to claim the credit. Refer to Part I of the form for detailed instructions.
Only improvements made to a home located in the United States during the year the credit is claimed can qualify.
For the purpose of the credit, costs are treated as being paid when the original installation of the item is completed. Similarly, costs associated with the construction of a new home are treated as being paid when your original use of the constructed home begins.
The credit amount for qualified fuel cell property costs is capped at $500 for each half-kilowatt of capacity.
The Tax Credit for a new Energy-Efficient Home
The federal government has extended several energy-efficiency tax credits through the end of 2032 to encourage the construction of new energy-efficient homes. These incentives have the potential to greatly offset the costs associated with sustainable construction. Here is a brief overview of these incentives:
Under Section 45L of the Internal Revenue Code, eligible contractors can receive a tax credit for each new energy-efficient home built and acquired for use as a residence within a given tax year.
Before 2023, home builders could qualify for a $2,000 tax credit if they built new energy-efficient homes that achieved 50 percent energy savings for heating and cooling compared to a comparable dwelling unit. The comparable unit had to conform to the 2006 International Energy Conservation Code (IECC) standards and have certain air conditioning and heat pump requirements. Additionally, 20 percent of the energy savings had to come from building envelope improvements.
The situation was slightly different for manufactured homes. Before 2023, contractors of these homes could apply for a $2,000 credit if they reduced energy consumption by 50 percent, or a $1,000 credit if they achieved a 30 percent reduction. Part of these savings had to come from improvements to the building envelope, or the structure had to meet the EPA Energy Star Labeled Homes program standards.
Eligible contractors could claim these credits using Form 8908 for each qualified energy-efficient home sold or leased during the year.
From 2023 through 2032, the credit amount increased to $2,500 for both home builders and contractors of manufactured homes, provided they met the requirements of the Energy Star Single Family New Homes National Program. Additionally, homes certified as “zero energy ready” under the U.S. Department of Energy’s Zero Energy Ready Home Program can receive a larger tax credit of $5,000.
Plug-in electric drive motor vehicle credit:
Internal Revenue Code Section 30D offers credit for qualified plug-in electric drive vehicles.
IRA extended this credit with additional requirements. The credit is available for qualified plug-in electric drive motor vehicles such as cars and light trucks. Before January 1, 2023, the credit was $2,500 plus $417 for each kWh of battery capacity over 4 kWh, making larger battery vehicles more beneficial. However, for vehicles purchased after December 31, 2022, the credit is up to $7,500 if specific sourcing requirements are met.
Qualifying vehicles must be new, have four or more wheels, a gross vehicle weight rating of less than 14,000 pounds, and propulsion derived from a battery with at least 4.0 kWh that can be recharged externally. It must be made by a manufacturer and acquired for use or lease by the taxpayer, not for resale. Additionally, there’s a tax credit available for qualifying used vehicles, with details provided below.
However, it’s essential to note that leasing an electric vehicle does not qualify an individual for tax credits. The leasing company may claim the tax credit and typically pass the savings onto the lessee as an attractive way to experience new technology.
After a manufacturer sells 200,000 qualified vehicles for use in the United States, the credit begins to phase out. During the phaseout period’s first two quarters, qualifying vehicles are eligible for 50% of the credit. This drops to 25% during the third and fourth quarters.
For vehicles placed in service after December 31, 2022, and before January 1, 2033, additional component sourcing requirements apply, along with final assembly taking place in North America. Vehicle’s battery components must be largely sourced from the United States or countries with a free trade agreement or recycled in North America.
The credit is not available for taxpayers with a modified adjusted gross income exceeding: $300,000 for a joint filing, $225,000 for a head of household, or $150,000 for a single filing.
The credit can be claimed using Form 8936 for both business/investment and personal use of the vehicle. You should keep the manufacturer’s certification that the vehicle meets IRS requirements. The basis of the qualified vehicle is reduced by the amount of the credit allowed.
Lastly, there’s also a credit for previously owned clean vehicles, which is the lesser of $4,000 or 30% of the sales price. Eligibility requirements include acquisition after December 31, 2022, being within the adjusted gross income limitations, and acquiring a vehicle in a qualified sale with a price not exceeding $25,000, among others.
While this article provides a broad overview of Energy Efficiency Federal Tax Credits and Incentives, it is important to note that the scope of this piece does not encompass all the energy tax credits available for taxpayers.
The tax credits discussed in this article include but are not limited to, incentives for energy-efficient home improvements, renewable energy installations, and eco-friendly vehicle purchases. These provisions are designed to reduce the financial burden for individuals and businesses committed to reducing their carbon footprint.
Understanding and navigating these credits and incentives can be complex. If you have any questions or require more detailed information on federal tax credits and incentives related to energy efficiency, please do not hesitate to reach out to us at HKP. We are equipped with the expertise to guide you through this labyrinth of tax incentives and help maximize your potential savings.