Passive Loss Rules and You

Paul Schwabe's picture

As my colleague Mike Mendelsohn has noted in several analyses, the relatively constrained tax equity market may limit the amount of investment flowing to renewable energy projects. [1] [2] To help bolster the supply of tax equity, high-net-worth individuals could moonlight as renewable energy investors much in same way a corporation would. However, unlike corporations, individual investors are subject to passive loss rules that will likely mitigate the value of federal incentives for renewable energy projects.

Passive loss rules can restrict renewable energy investment in two ways:

  1. The rules stipulate that individuals, as passive investors, can only apply the tax credits or depreciation to other forms of passive income. In the context of renewable energy projects, most individual investors who are not actively participating in the day-to-day operation and management decisions of the project would likely be considered as passive by the Internal Revenue Service. [3]

  2. Most individuals do not earn that much passive income. Qualifying passive income is generally limited to either (1) rental income or (2) income from a project in which the investor does not materially participate either in the management or normal business activity.[4]

In general, the two primary forms of income for most high-net-worth individuals in the United States—wages/salaries and dividends/capital gains—are not considered passive income.

The effect of these tax treatment considerations is that most passive individual investors in renewable energy projects can only apply the tax benefits of the production tax credit (PTC), or the investment tax credit (ITC) and net operating losses from accelerated depreciation, to the income generated from the project itself. In other words, an individual who is a silent investor in a project, could not apply their share of the project's tax benefits to other active income (e.g., salaries and wages) or income from their portfolio (e.g., stocks, bonds, gold bars, pork belly futures, etc.).[4] Tax benefits, which are earned but not utilized in a specific year, are applied to future taxable income returns, often referred to as "carry-forward."

The detrimental economic impact of carrying tax benefits forward to future tax returns instead of using them in the period in which they were earned is significant. Time-value-of-money factors reduce the value of tax benefits that are carried forward to future taxable years. Therefore, most investors prefer to use a tax credit as soon as it is available. The challenge is that future taxable returns can be very difficult for individuals to predict.

To demonstrate the economic impact of carrying forward tax benefits, I modeled the levelized cost of energy (LCOE) for a hypothetical 50-MW wind project where the investors can either use tax credits in the period in which they are earned or carry them forward to future years. I utilized NREL's Cost of Renewable Energy Spreadsheet Tool (CREST) to do the analysis, assuming a $1,700/kW investment with a 35% capacity factor, a 10% expected internal rate of return, and a 20-year project life. All other assumptions are held to CREST's default wind values.

As shown in Table 1, the LCOE increases from $65/MWh to $95/MWh when the tax benefits of the PTC and accelerated depreciation are carried forward instead of utilized the year they are earned. So, because most passive individual investors will likely have to carry these benefits forward, the resulting higher LCOE may eliminate the financial attractiveness of the wind project investment. This will make it harder to secure a utility power purchase agreement, and hence guarantee project revenues.

Table 1. LCOE For A Hypothetical Wind Project Under Two Tax Considerations

Wind Project Scenario

LCOE ($/MWh)

Tax Benefits Utilized As Generated


Tax Benefits Carried Forward


Looking ahead, there is likely to be an even larger strain on the traditional corporate sources of tax equity with the expiration of the §1603 Treasury Cash Grant at the end of 2011. Changes in passive-loss rules could allow individual investors to become a larger supplier of tax equity financing in the United States. However, changing the passive-loss rules would also most likely reduce the amount of tax revenue collected by the U.S. federal government.[5] More analysis is needed to determine whether or not the relative benefits gained are worth the challenges of considering changing the passive loss rules for individual investors.



[1] Mendelsohn 2011, "Will it Eat New York Too? Voracious Bonus Depreciation Eats Up Available Tax Appetite," Renewable Energy Project Finance

[2] Mendelsohn 2011, "A Chicken in Every Pot? Is there Enough Tax Equity to Sustain the Market," Renewable Energy Project Finance

[3] Bolinger 2010, "Revealing the Hidden Value that the Federal Investment Tax Credit and Treasury Cash Grant Provide to Community Wind Projects," Lawrence Berkeley National Laboratory

[4] Investopedia, "Passive Income," accessed December 2011

[5] Mendelsohn 2011, "Cover Your Eyes: RE Financing May Be In For A Scary Ride Once the Treasury Grant Terminates," Renewable Energy Project Finance