Local government incentives available under Inflation Reduction Act
Federal energy policy is making many new incentives available for local governments to fund energy-related assets. The Inflation Reduction Act (IRA), enacted in 2022, established a set of energy-related asset categories that are now being directly subsidized by the federal government. Under the IRA, nearly any advanced or renewable energy asset constructed by a local government is eligible for some kind of federal cash subsidy.
Importantly, local governments are not taxpayers and normally do not benefit from tax credits, but the IRA authorizes direct pay tax credits as cash subsidies to local governments to fund energy-related assets. Now, counties, townships, municipalities and school districts can build long-term energy-producing assets like solar fields, install geothermal heating, or invest in clean fuel buses for their vehicle fleets, all with federal support. New local government buildings can be constructed more cheaply with IRA-authorized subsidies.
This article provides a summary overview of the key incentives available under the IRA for local governments investing in green, energy-related assets.
Green asset categories are targeted
The IRA opens up the playbook for investment by authorizing direct federal support for many green and renewable technologies. The investment tax credit is available for solar facilities, small wind projects, fuel cells, energy storage systems, microgrid controllers, electrochromic glass, certain geothermal facilities and qualified bio gas facilities. The production tax credit is available for solar and wind facilities, biomass facilities, geothermal facilities, hydropower, small irrigation and certain landfill and trash energy facilities. Other direct pay tax credits are available for qualified clean commercial vehicles and alternative fueling and charging stations in low-income or rural areas.
In addition to the green asset categories described above, certain tax benefits may be passed along to vendors that design energy-efficient buildings for tax-exempt local government users. Care should be taken when designing new government building projects, because many projects may have energy-related elements that are eligible for federal support.
Significant cash payments are available through tax credits
The IRA makes tax credit funds available for an unlimited number of energy-related projects nationwide. For the investment tax credit category, generally the base tax credit can be as low as 6% of the project’s costs and the maximum tax credit can be as high as 70%, depending on the specific asset, the location of the project and certain other compliance-related factors. The typical investment tax credit for a small solar asset under 1MW will be equal to 30% of the qualifying costs of the solar asset. For the production tax credit category, tax credit levels are based on the amount of green power produced by the asset. Tax credits are available to local government and non-profit owners in addition to private owners, manufacturers and utilities.
Tax filings are required to claim payment
To claim a direct pay tax credit under the IRA, a local government must pay the cost of the eligible asset, place that asset in service and then file a special tax return that claims a refund for the amount of the tax credit. The IRS will then issue a refund check for the amount of the tax credit.
Local government fiscal officers should be mindful that the tax credit process involves certain IRS filing requirements that may be unusual for fiscal officers. A special application process for direct pay tax credits was used for Build America Bonds, Qualified School Construction Bonds, Recovery Zone Facility and Economic Development Bonds that were authorized under the American Recovery and Reinvestment Act of 2009.
Tax-exempt governmental bond options are enhanced
Local government benefits have typically not been the focus of federal tax laws. Recognizing the opportunity to spur local investment in green assets, the IRA has enhanced local government opportunities to fund green assets with tax-exempt governmental bonds.
Previously, tax-exempt governmental bonds that funded green assets would not result in special federal tax benefits beyond the tax exemption itself. In addition, the private activity bond rules in effect before the IRA resulted in a 50% reduction in the tax credit when attempting to pair an investment tax credit or a production tax credit with tax-exempt bond financing. The IRA permits tax-exempt governmental bond financing of green assets and scales back the reduction in tax credit percentages from 50% to 15%. Now, any local government projects financed by tax-exempt governmental bonds will receive a much smaller 15% reduction in the amount of credit for which the project is otherwise eligible. For example, a 30% investment tax credit for a solar project funded entirely with tax-exempt governmental bonds will be reduced by 15% to become a 25.5% effective credit. In other words, if local government pays $100,000 for a solar installation with cash, then the effective subsidy is $30,000, but if local government pays $100,000 for a solar installation with tax-exempt bond proceeds, then the effective subsidy is reduced to $25,500.
Sequestration risk is limited
Prior federal laws and programs, including many ARRA bond programs, attempted to stimulate local government investment by using tax credit subsidies to offset debt service payments. Later, when times were tight and federal budgeting priorities shifted, the federal government unilaterally reduced the subsidy by sequestering a portion of the payments it promised to local government bond issuers. In many cases, local governments that relied on ongoing tax credit subsidies to support their debt service obligations felt a bit of “bait and switch” due to the IRS enforcing sequestration.
The IRA attempts to eliminate sequestration risk by causing the federal subsidy to become a one-time, up-front style payment instead of an ongoing series of payments over time. Once an eligible project is placed in service, the local government owner can apply for the direct pay tax credit and obtain the direct pay tax credit payment. There are some mechanisms in the IRA that offset or reduce the effectiveness of the tax credit as a penalty if the requested tax credit is too high or not applicable. While no one can predict how long the exact tax credit percentages in the current version of the IRA as enacted will remain in effect, it does appear that local governments can rely on the subsidy opportunities without extensive recapture or sequestration risk.
Compliance issues are present but not onerous
It should be noted that the IRA is federal legislation and it comes with some specific rules based in part on the assets being constructed and in part on the level of tax credit being requested. Some energy-related assets have specific construction and placed-in-service requirements that need to be followed. There are important domestic content rules in place to ensure that energy assets are sourced from American-made materials. In addition, all eligible assets can obtain some base level of tax credit, but some of the higher tax credit percentage levels may require additional federal prevailing wage compliance or may need to be located in targeted areas.
Energy assets are often long-term assets that reduce ongoing operating costs and can be worthwhile projects on their own. Under the new IRA law, the upfront cost of an energy asset can be partially offset with a cash payment from the federal government equal to 30% or more of the cost of the asset. In short, there’s pretty much no good reason why a local government investing in renewable energy assets, sustainability assets or clean vehicles should not consider applying for a federal tax credit to offset the costs of these assets. If a local government is including energy assets in a project, there are some compliance boxes to check off, but the amount of the federal tax credit payment can be significant.
Bricker’s Public Finance, Construction and Energy teams can advise directly on IRA qualification and compliance issues. Our teams are excited to leverage this new law and assist local governments seeking to invest in clean, renewable and sustainable energy assets.