Maximize the Section 48 investment tax credit by beginning construction in 2024

Since enactment of the Inflation Reduction Act (IRA) in 2022, many taxpayers have pursued investments in projects qualifying for the expanded clean energy tax credits. Importantly, there is limited time left for construction to begin on certain types of projects, with a looming deadline of Dec. 31, 2024. Full construction may extend for years into the future, but completion of qualifying actions in 2024 is critical for projects involving biogas, combined heat and power, fiber-optic lighting, and electrochromic glass.

The creation of shifting investment tax credit rules in the Inflation Reduction Act

The IRA included a sweeping set of tax credits and incentives supporting the green energy ecosystem. Those programs generally took effect at the beginning of 2023 and most carry forward well into the future. In fact, several tax credits are scheduled to remain available into the early 2030s. Crucially, the IRA also created new monetization options for credits, which greatly expanded the pool of eligible entities and organizations. This meant that for the first time, governments, tax-exempt entities, and tribal governments became eligible to directly obtain cash benefits from income tax credits in the absence of federal tax liabilities.

While the IRA broadly expanded the availability of tax credits, policy choices favored some technologies over others. Importantly, this included an expansion of the Section 48 energy credit (or the ITC) for a limited period of time. The key date for this purpose is Dec. 31, 2024. Projects for which construction begins by that date will follow the rules of Section 48, as amended by the IRA. Those beginning construction after that date will be subject to the new rules of Section 48E. These two sets of rules are similar for many types of renewable energy equipment, but there are key differences.

Why does this matter? Technologies that will be impacted by the Inflation Reduction Act investment tax credit rules

One key difference between the ITC rules is that Section 48E only applies to property involved with the production of electricity or the storage of electrical or thermal energy. Another difference is the insertion of a requirement into Section 48E that the qualified facility must have a greenhouse gas (GHG) emissions rating of zero. Taken together, those changes are expected to impact the eligibility of key forms of equipment, including the following:

• Qualified biogas property. The IRA expanded Section 48 to include biogas property for the first time for a limited period. The term qualified biogas property means “property comprising a system” that converts “biomass” into a gas that: (1) either (a) consists of not less than 52% methane by volume, or (b) is concentrated by the system into a gas that consists of not less than 52% methane; and (2) captures that gas for sale or productive use and not for disposal by way of combustion. Biogas property by statute also includes property that cleans or conditions gas. Upgrading equipment may also be included in the ITC provided that “functional interdependence” is established under a threshold outlined in regulations.

Biogas is a popular form of renewable energy since it can be derived from readily available sources of organic matter, such as wastewater, landfills, breweries, distilleries, and livestock farms. However, the end product is renewable natural gas instead of electrical energy, so such property isn’t expected to qualify under Section 48E.

• Electrochromic glass or fiber-optic distributed sunlight. These technologies heat or cool and illuminate buildings. While they are energy-efficient, they don’t themselves generate electricity, a core Section 48E requirement, and won’t continue to qualify for the credit after 2024. Electrochromic glass uses electricity to change its appearance from transparent to opaque, or vice versa. This “smart” glass technology reduces energy needs by, for example, allowing less sunlight to enter buildings on hot days. Fiber-optic lighting is technology that takes sunlight and transfers it inside to help illuminate the interiors of buildings.
• Combined heat and power system property. Property comprising a combined heat and power (CHP) system has qualified under Section 48 for some time. A CHP system means property that uses the same energy source to co-generate: (1) electrical power and/or mechanical shaft power; and (2) steam or other forms of useful thermal energy, including energy with heating and cooling applications. Minimum 20% thresholds apply to both of the energy generation requirements. Thus, at least 20% of the system’s overall energy production must come from electrical or mechanical power, and at least another 20% must come in the form of thermal energy that’s not used to produce electrical or mechanical power. On top of this, the system’s overall energy efficiency must exceed 60%.

CHP systems are commonly used to generate electrical power and support heating and cooling systems for buildings, campuses, or other facilities. CHP systems can also be quite large and require extended timelines to source equipment and construct such facilities. As such, there will likely be many projects that are in development during the transition from 2024 to 2025. While CHP systems have enjoyed a straightforward path to qualification under Section 48, the situation is much more complex under Section 48E. Namely, CHP systems that will qualify under Section 48E must satisfy the zero GHG emissions rating. Proposed regulations published in June 2024 established a complex methodology for this test applicable to combustion and gasification (C&G) facilities, such as CHPs. Unfortunately, it’s likely that most new CHP systems will no longer qualify under the new ITC rules. Careful examination of the forthcoming final Section 48E regulations will, however, be important to identify any remaining tax credit options.

• Qualified fuel cell or microturbine property. Similar to CHPs, these technologies are power plants that generate electricity. They also face the same hurdle as CHPs given the need to satisfy the zero GHG emissions test under Section 48E. However, this is an evolving story, which depends in large part on the finalization of Section 48E regulations. The proposed regulations view fuel cell facilities as C&G facilities where electricity from the grid powers an electrolyzer or methane is used as fuel. Conversely, a fuel cell facility powered exclusively by power from a co-located new solar array or wind farm would have a simpler path to qualification as a non-C&G facility. Until final regulations are published (expected in late 2024), qualified fuel cells and microturbine property will face uncertainty about future qualification. As such, accelerating construction to qualify under Section 48 is expected to be the most favorable option.

The definitions of these types of property include both efficiency metrics and electrical capacity requirements. For qualified fuel cell property, plants must have a nameplate capacity of at least 0.5 kilowatts using an electrochemical or electromechanical process, and must have an electricity-only generation efficiency of above 30%. For microturbine plants, the nameplate capacity must be less than 2,000 kilowatts, and the property must have an electricity-only generation efficiency of at least 26%.

Additional technologies will phase out under Section 48 but are likely to qualify under the new rules of Section 48E. Those include core technologies such and wind and solar equipment. In addition, items such as certain energy storage technologies, fuel cells, and waste energy recovery property will likely qualify into the future. Finally, it’s notable that certain geothermal energy storage or energy sink equipment will continue to qualify under Section 48 through 2034.

What does it mean to begin construction by the end of the year?

Fortunately, the rules surrounding the term “beginning of construction” for purposes of the ITC aren’t new. Initially published in 2013, Notice 2013-29 first introduced the “beginning of construction” concept. Notices dating from 2013 to 2022 modified the concept’s meaning. After the IRA was enacted in 2022, the Treasury Department published Notice 2022-61, which applies those established standards from prior notices to facilities for which construction began on or after Jan. 29, 2023.

According to Notice 2022-61 and older notices, there are two ways in which a taxpayer can demonstrate that construction has begun for the purposes of Section 48: the Physical Work Test, and the Five Percent Safe Harbor.

The Physical Work Test

Under the Physical Work Test, construction of qualified energy property begins when “physical work of a significant nature begins.” This test considers the nature of the work performed and is unrelated to a project’s costs. Specifically, a taxpayer applying the Physical Work Test considers all relevant facts and circumstances in determining whether physical work “of a significant nature has begun.”

One important clarification is that “physical work” need not be performed by the taxpayer directly. It can be performed by other entities when done so under a binding written contract that’s entered into prior to the manufacture, construction, or production of the energy property or its components. This aspect meaningfully expands opportunities to satisfy the Physical Work Test since the actions of multiple parties at multiple locations (both on-site and off-site) may be included.

Qualifying activities for the Physical Work Test:

IRS guidance related to this test has included several examples. While those don’t all involve projects that aren’t expected to qualify under Section 48E, they do provide illustrative examples, including:

• Solar property: installation of racks or other structures.
• Geothermal property: installation of piping, turbines, generators, and the like.
• Qualified fuel cell property: installation of components of a fuel stack assembly (electrodes, membranes, gasketing).
• Combined heat and power property: installation of heat engines, generators, electrical interconnections.

Similarly, off-site work may include the manufacture of:

• Components
• Mounting equipment
• Support structures (rails, racks, inverters, transformers)
• Other power conditioning equipment

Physical work of a significant nature generally requires the physical construction of assets (and components thereof) that are necessary to the operation of the energy property. In addition, only physical work of a significant nature on tangible property used as an “integral” part of the activity performed by energy property is considered for purposes of determining if beginning of construction has occurred.

Nonqualifying activities for the Physical Work Test:

“Physical work” for purposes of the safe harbor doesn’t include preliminary activities like:

• Planning
• Designing
• Obtaining permits
• Licensing
• Conducting studies
• Surveys and tests
• Clearing a project site

Any removal of existing structures and equipment will not be considered “physical work.” So, for example, removing energy-generating structures like wind turbines and solar panels won’t qualify taxpayers for this beginning of construction safe harbor. There is even more nuance here: while activities such as excavation to change the contour of the land don’t qualify, excavation to prepare the land for footings or foundations do qualify as the start of physical work on the property.

Physical work of a significant nature also doesn’t include work that’s performed by a taxpayer or on behalf of the taxpayer under a binding written contract if that property is normally held in inventory by a vendor. For example, if a taxpayer is purchasing equipment from another entity that was not made specifically to order for the taxpayer but was made by a vendor that regularly keeps such equipment in stock, the vendor’s work to manufacture such equipment will not be considered the start of construction under the Physical Work Test.

Observations: The Physical Work Test is an attractive option given its qualitative nature. The examples provided by the applicable notices are also helpful in that they seem to offer a nonexhaustive list of factors to consider. However, the use of specific examples in lieu of guiding principles may set the stage for future controversies. Those wishing to utilize the Physical Work Test are encouraged to include key terms in their contracts, obtain periodic reports from contractors, and document both on-site and off-site activities through photographs or other evidence.

The Five Percent Safe Harbor

The alternative to the Physical Work Test is the Five Percent Safe Harbor. To fit into this safe harbor, a taxpayer must: (1) pay or incur 5% or more of the total cost of the energy property; and (2) make continuous efforts to advance toward completion of the property. The first part of this safe harbor requires analysis and, in practical terms, documentation as to both the total cost of the property and the amount of costs incurred prior to the subject date. As with the Physical Work Test, the total cost of the property under the Five Percent Safe Harbor doesn’t include the cost of any property not integral to the energy property.

Many advisors recommend planning and modeling for a “buffer” amount beyond the minimum 5% requirement to guard against the possibility of unexpected rises in total project costs, which go into the denominator. All costs that can be included in the depreciable basis of the property can be considered if they are integral to the energy property. And so, some portion of costs for preliminary activities like planning, designing, obtaining permits, licensing, conducting studies, surveys, and tests may be includable in the 5% calculation.

Additionally, taxpayers that build property or have property built for them may utilize a “look‐through rule” to include costs of labor or materials incurred by a contractor for the 5% safe harbor.

The Look-Through Rule

This look-through rule’s application is determined under Section 461, which adds a level of complexity. Under the principles of Section 461, expenses are deemed incurred when they are paid for by taxpayers that use the cash method of accounting. On the other hand, under the accrual method of accounting, expenses are deemed incurred when: (1) all events have occurred that establish the facts of the liability; (2) the amount of the liability can be determined with reasonable accuracy; and (3) economic performance has occurred.

Consequently, a taxpayer may not only need to determine when costs are incurred internally but also externally by the taxpayer’s vendors. Close coordination may therefore be necessary with contractors and subcontractors alike in order to accurately predict what costs have been incurred for purposes of the Five Percent Safe Harbor. To accomplish this coordination, taxpayers will need to request documentation that details the activity of contractors and subcontractors to prove costs have been incurred by those parties. 

Observations: The Five Percent Safe Harbor has the positive attribute of relying on hard numbers that can be quantified through invoicing, payments, and other contractual documents. The look-through rule also provides flexibility by allowing for the inclusion of supply chain expenditures. But those attributes also provide downsides to the safe harbor. For example, the reliance on specific numbers poses challenges when cost overruns occur, or the depreciable basis of the qualifying property expands beyond original projections. Additionally, the use of the look-through rule may cause practical challenges as a taxpayer seeks detailed information from a contractor regarding the expenditures and labor incurred by such contractor.

Special rules for continuous construction

Under both the Physical Work Test and the Five Percent Safe Harbor, a taxpayer must undertake continuous efforts toward completion of the project once construction has begun. In the case of the Physical Work Test, continuous construction is determined by considering all relevant facts and circumstances. Under the Five Percent Safe Harbor Test, continuous efforts to advance toward completion are also required. However, the notices provide facts and circumstances factors that may indicate continuous efforts, including:

• Paying or incurring additional amounts included in the total cost of the energy property.
• Entering into binding written contracts for the manufacture, construction, or production of components of property or for future work to construct the energy property.
• Obtaining necessary permits.
• Performing physical work of a significant nature.

While continuous construction is required, there are exceptions for taxpayers who are unable to continue construction of property due to disruptions beyond their control. These disruptions include conditions such as severe weather, licensing and permitting delays, financing delays of less than six months, delays in the manufacture of custom components, and other supply or labor shortages.

Continuity Safe Harbor

While the continuity requirements generally don’t present a significant hurdle to most taxpayers, the rules are designed to ensure that energy property is placed in service within a reasonable period after construction was deemed to begin. To that point, a continuity safe harbor exists that, if met, will deem a taxpayer to have satisfied the continuity requirements without further proof of continuous construction or continuous efforts toward completion. For purposes of Section 48, the Continuity Safe Harbor will be satisfied by taxpayers who place energy property in service by the end of a calendar year that’s no more than four calendar years after the calendar year during which construction of the energy property began.

For example, where construction begins during 2024, the property must be placed in service by Dec. 31, 2028 to meet the Continuity Safe Harbor. If energy property isn’t placed in service within four calendar years from the calendar year construction began, the continuity requirement will need to be satisfied by the subjective relevant facts and circumstances.

What to do now? Documenting the beginning of construction and more

Timing is crucial and running quickly for those that are pursuing energy projects that aren’t expected to qualify under Section 48E. Specifically, the following actions are recommended as we advance toward the end of 2024: 

• Confirm project eligibility. A key question is whether a project that’s expected to qualify for the ITC will qualify under Section 48, Section 48E, or both. It’s possible, for example, that a project could qualify under both versions of the credit. In that case, taxpayers may be faced with a choice of whether to accelerate construction or defer the project until 2025. However, for many other projects, the Section 48E rules either preclude eligibility or impose new requirements to be satisfied. Thus, a threshold matter involves confirmation of which, if any, version of the ITC may be generated by an intended project.
• Evaluate all options for documenting beginning of construction. When reviewing the tests, a bias toward either the Physical Work Test or Five Percent Safe Harbor will likely exist for any given project. Ideally, both tests would be satisfied since that would provide the greatest degree of certainty about a project’s eligibility. To that end, it’s recommended that at least some efforts be undertaken for both tests rather than merely relying on one test from the beginning.
• Undertake actions with documentation in mind; plan for future audits. It’s possible to assume overreliance on contractual terms and the ability to document things at a later date. Thus, it’s strongly recommended that taxpayers undertake proactive actions during 2024 to prepare contemporaneous documentation to support all contractual arrangements. That may take the form of site photographs to document on-site work or even off-site construction of equipment. Proactive engagement with vendors may also result in better documentation of the look-through rule under the Five Percent Safe Harbor. Transitioning into 2025, new qualifying actions will no longer be available, but continued development of a factual record based on 2024 actions is possible. To that end, the mere change in the calendar year shouldn’t be viewed as the end of documentation development.
• Maximizing the value of the credit. One feature of both Section 48 and Section 48E is that the value of the credit can vary dramatically from one project to another. That is because both versions of the credit “stack.” The current version of the credit has a baseline value of 6%, but if various additional requirements are met, then the credit’s value can jump to 30 or 40% (or more) of the project’s cost. Satisfaction of prevailing wage and apprenticeship hour (PWA) requirements are especially important in this respect. Taxpayers triggering the beginning of construction threshold described above may also trigger the ongoing PWA requirements. Understanding when such rules will apply, and what compliance and monitoring actions are required, is crucial to maximizing the future value of the ITC.