Investing In Alternative Energy? Consider The Passive Activity Loss Rule

The federal government provides several valuable incentives to promote alternative energy investments. Many of these incentives take the form of favorable federal income tax benefits.

For example, a solar energy project may entitle its investors to a 30 percent investment tax credit (ITC) and accelerated cost recovery deductions. Together, these benefits often eliminate the taxable income (and with it, the associated tax liability) of a solar installation during the early years of the project's life. To the extent these deductions and credits exceed the project's income or tax liability in the current tax year, an investor may be entitled to use those excess deductions and credits to offset income and tax liability from other sources. Simply put, making the alternative energy investment can reduce the investor's overall tax liability.

Unfortunately, federal incentives encouraging alternative energy investment do not apply uniformly to all taxpayers. For example, because alternative energy investments typically are structured through limited liability companies or limited partnerships in which the investor does not actively participate in project development or management, one particularly challenging obstacle a taxpayer must consider is a limitation commonly known as the "passive activity loss" (PAL) rule.

Components of the Passive Activity Loss (PAL) Rule

The Internal Revenue Code limits the ability of individuals and certain other taxpayers to deduct losses or use tax credits from "passive activities." For purposes of the rule, a passive activity is defined as any activity that involves the conduct of a "trade or business" in which the taxpayer does not "materially participate." To be subject to the PAL rule, (1) the taxpayer must be a person or entity covered by the rule, (2) the activity generating the losses or credits must constitute a trade or business, and (3) the taxpayer's active participation in the activity must fail to satisfy a minimum threshold.

If the PAL rule is triggered, then the taxpayer's losses and tax credits from the passive activity may be used to offset the taxpayer's income and tax liability from other passive activities, but may not be used to offset active or "portfolio" income (including dividends and gains from stock investments). Unused losses and credits are carried forward to the next year. When the taxpayer ultimately sells its passive investment, any unused losses that remain with respect to that...