Clean energy tax-credit recapture: How it works

Recapture is the mandatory repayment of previously claimed tax credits to the Internal Revenue Service for disqualified credit amounts.

Tax credits allow the taxpayer who earns them to subtract the credited amount from their tax liability. Under IRS regulations, some federal tax credits, including the Section 48  and Section 48E clean energy investment tax credit (ITC), are subject to recapture under Section 50 of the Code. This means the taxpayer must repay all or some part of the credit they’ve claimed if certain events occur. 

(Apart from Section 50 recapture, the IRS may separately find that the eligible basis of the credit was incorrect and disallow part of the amount claimed, as noted below.)

Investment tax credits (ITC) and recapture

The U.S. Internal Revenue Code offers several clean energy tax credits for businesses. One of the most commonly claimed credits is the investment tax credit (ITC) under Section 48 and Section 48E of the IRC.

The ITC offers an up-front tax credit to cover a certain percentage of the qualified investment costs for building a clean energy asset. The ITC’s up-front credit is intended to incentivize developers and property owners to build clean energy projects that they wouldn’t otherwise build without the additional financing. But the ITC comes with an important requirement that the clean energy asset remain under continuous ownership and in continuous use for its intended purpose for at least five years after its placement into service. This five-year period is sometimes referred to as the compliance period or, more frequently, the recapture period.

If an asset’s ownership or use changes, tax-credit recapture can occur, whereby credits previously claimed must be repaid to the IRS. Recapture is meant to ensure the tax credit actually supports the desired outcome of the tax policy, which is the production of clean energy.

What is recapture?

A recapture is another word for mandatory repayment of claimed tax credits. Code Section 50(a)(1)(A) states that an investment credit property that is “disposed of or otherwise ceases to be investment credit property” during the recapture period is subject to recapture. When a recapture occurs, repayment of recaptured tax credits claimed on the investment must be made. 

Recapture period vesting

The amount of any claimed tax credit that is recaptured depends on the year of the recapture period in which the recapture event occurred. Recapture exposure decreases (“vests”) 20% per year over the five-year compliance period. 

In the first year of service, 100% of the claimed ITCs are subject to recapture. Each subsequent year, the amount of ITCs generated by the project that is subject to recapture declines by 20%, as follows:

This means that if a project placed in service on 1/1/2025 ceases to operate on 1/2/2026, 20% of the tax credits claimed on the project have already vested. The taxpayer would therefore experience an 80% recapture, requiring 80% of the claimed credits to be repaid to the IRS.

What can cause ITC recapture?

Section 50 states that a recapture has occurred if the investment credit property is “disposed of or otherwise ceases to be investment credit property” during the five years following placement into service. 

This can occur in a variety of ways, including:

• Change in ownership (also called “disposition” of the property): Any change in ownership of the clean energy asset within the five-year recapture period is considered a recapture event under current regulations. This is true even if the clean energy asset continues to produce clean energy under the new ownership. 
  
  Changes in ownership might occur through:
  • Sale of the asset
  • Surrender of the asset in bankruptcy or fraud proceedings
  • Foreclosure on the asset by a lender due to default on debt collateralized by the asset
    

• Change in use: If an asset that claimed the ITC changes its use such that it would no longer qualify for an ITC (e.g., the project is relocated outside the United States, or is leased to a tax-exempt entity), such a change would trigger recapture.
  
  
• Cease in operations: Similarly, if the asset is destroyed or damaged to the point where it no longer functions properly (a “total loss” for insurance purposes), it no longer qualifies as a clean energy asset and is subject to recapture.
  
  
  • In some cases, an asset experiences partial but not total damage due to a casualty event (such as a natural disaster or fire) or equipment failure. In such cases, recapture of the damaged portion will occur only if no continuous effort is made to rebuild/repair the system.
    
    
• Purposeful non-compliance with prevailing wage and apprenticeship requirements: Projects larger than 1 MW that do not meet the “Begun Construction” requirements set forth in the final Treasury guidance may only qualify for a 30% ITC (rather than the current base ITC of 6%) if prevailing wage and apprenticeship (PW&A) requirements are met. Recapture of the 5x multiplier may occur if a project owner or their contractors fail to comply with PW&A requirements. 

Exceptions to recapture

There are some exceptions to a recapture event occurring as a result of certain dispositions, which include the following:

• Transfer (change) of ownership due to the death of the taxpayer
• Change in ownership due to transfer between spouses or incident to divorce under section 1041. However, a later disposition by the transferee would be subject to recapture to the same extent as if the transferor had disposed of the property at that later date.
• A transaction to which Code Section 381(a) applies (certain acquisitions of the assets of one corporation by another corporation).
• Change in the form of conducting trade or business (e.g. a corporation that elects to be an S corporation or a corporation whose S election is revoked or terminated)
  

For more on disposition, visit this IRS webpage.

Avoiding recapture events

To minimize the risk of recapture, taxpayers should:

• maintain ownership of the asset for at least five years
• obtain forbearance from project lenders during compliance period
• maintain sufficient property and casualty insurance
• ensure the asset remains functioning as expected for five years through proper design, equipment selection, commissioning and performance testing
• conduct regular preventative maintenance and make all necessary corrective repairs
• ensure compliance with labor requirements during both the construction phase and the first five years of operations
• carefully document and report the operational status of the clean energy asset.

Recapture and ITC transfers

Under the Inflation Reduction Act, ITCs are among a number of tax credits that were made transferable, which means that the taxpayer who earned the credit can sell the credits to another taxpayer. 

Under current IRS rules, transferable tax credits can only be sold and transferred one time, and it is the buyer of the tax credit, not the seller, who experiences and must report recapture on their tax return. The IRS therefore requires buyers to conduct due diligence on projects, and requires sellers to provide “minimum documentation” for projects so that buyers can understand the risk of recapture for ITCs they wish to purchase. The costs of conducting diligence are typically paid by the seller. 

Additional considerations: Credit disallowance 

Separately from a Section 50 recapture, the IRS may also determine through audit that the eligible basis used to determine the amount of credits earned was incorrect. In these cases, the IRS would recapture only the portion of credits corresponding to the reduction in eligible basis. Fees and penalties would likely also be assessed in the case of an IRS audit finding resulting in recapture.

To avoid disallowance, sellers should maintain proper documentation of project costs to confirm eligible basis. Likewise, buyers should incorporate disallowance risk into their due diligence by requiring a cost segregation report by an independent third party. 

Due diligence: Understanding IRS recapture risks

In its rulemaking, the IRS also contemplated that the buyer would price recapture risk into their tax-credit purchases, and that tax credits would therefore trade at a discount to face value. 

While this is true, many buyers are reluctant to purchase tax credits from a seller without robust diligence that demonstrates the seller has taken reasonable steps to mitigate recapture.

Standard diligence includes an assessment of the sellers’ finances, which protects against voluntary disposal of the asset, and qualification of project documentation, such as leases, contracts for maintenance, property insurance, and more.

How Evergrow manages IRS recapture diligence

Unlike trading with a broker or on an online marketplace for tax credits, Evergrow only transacts on credits that have passed our rigorous diligence process. 

Evergrow diligence includes:

• documentation of project ownership by the tax-credit seller
• documentation of tax-credit registration with the IRS
• review of project specifications, to ensure ITC eligibility 
• comprehensive assessment of seller finances, to mitigate against voluntary disposals of the clean energy asset 
• collection of documents that support the project’s ability to continue operating for five years, such as site control, utility approvals, independent engineer review, revenue source (e.g., power purchase agreement), property and casualty insurance, operations and maintenance,, and other mitigants
• ongoing monitoring of project performance, to mitigate against change in use

In addition to these materials, Evergrow also commissions an independent cost segregation for each project, to mitigate against disallowance risk.

Because Evergrow requires diligence for all transactions, diligence costs are reflected in our pricing, which is net of diligence fees for cost segregation and independent engineering review. 

What to do in cases of recapture

If a taxpayer determines a recapture has occurred with respect to an asset for which they have claimed credits, they are obligated to self-report recaptured amounts on their next tax return. In cases where an IRS audit finding concludes recapture has occurred, the taxpayer must report recaptured amounts on their next tax return along with any fees and penalties owed. All recaptured amounts are reported on IRS Form 4255.

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