Tax credits are a powerful tool that can help reduce the amount of taxes you owe. In this article, we’ll explain what tax credits are, identify a few ways they can be used to reduce your taxes and explore why the government offers them.
What Are Tax Credits?
A tax credit is a dollar-for-dollar reduction in the amount of federal taxes you owe. For example, if you owe $1,000 in taxes and you have a $500 tax credit, your tax liability would be reduced to $500.
Tax credits are a significant tax saving opportunity for realized income and salary that you could take advantage of. They directly reduce the amount of taxes you owe and in some sense are similar to coupons you can use to reduce your tax bill.
What Are The Different Types Of Tax Credits?
There are many different tax credits available for a variety of situations. Some examples include the Earned Income Tax Credit (EITC), which is designed to help low- and moderate-income taxpayers, and the Child Tax Credit, which can help parents reduce their tax liability for each child under the age of 17. In addition, the government offers tax credits to incentivize certain behaviors or investments. For example, the Energy Efficiency Tax Credit allows taxpayers to claim a credit for making energy-efficient improvements to their homes. The Electric Vehicle Tax Credit can help offset the cost of purchasing an electric vehicle. There are also many tax credits opportunities offered to encourage more investment in renewable energy sources such as solar and wind among other opportunities.
Why Does The Government Offer Tax Credits?
The main reason why the government offers tax credits is to provide relief for taxpayers who are struggling to make ends meet and to incentivize certain behaviors or investments that the government views as beneficial to society. Tax credits for lower-income families, for example, help to reduce poverty and provide support for basic needs, while tax credits for solar projects can help reduce dependence on fossil fuels and combat climate change.
Having said that, anyone can take advantage of tax credits and other benefits when buying solar projects.
How Do Tax Credits Work In Practice?
Andres is a married small business owner living in California with $1,250,000 of income. He expects to pay $593,026 in taxes this year, including $457,353 in federal taxes and $135,673 in state taxes. As a result, he and his wife can expect to keep $666,974 after taxes. Andres and his wife would like to reduce that tax bill so they can save more and retire early.
Andres spent $400,000 in solar projects. In addition to tax credits, they generate depreciation and an income stream.
In return for his solar project purchase, Andres will end up saving up to $663,200 in federal taxes and California state taxes (including tax credits and depreciation). To understand how that is possible, we’ll concentrate on one of the concepts that arises with every tax-advantaged investment: tax credits.
Tax Credits From Solar Projects
In Andres’s case, he and his wife will earn a credit of $320,000 in the first year. Critically, this doesn’t mean that Andres’s income is reduced by $320,000. Instead, the credit applies directly to his taxes owed, reducing his overall tax liability by $320,000.
Because the credit is applied after depreciation, Andres could write-off up to 75% of his remaining tax liability using up his tax credits in a single year and can still take advantage of the excess. That’s not the case in this example, but even if it did happen, Andres could apply his remaining tax credits to previous tax bills between 2020-2022 or carry it forward to future years.You can read more about the qualifications and limitations on income tax write-offs here
Depreciation Tax Savings
Depreciation is the amount of value that an asset loses over time. In the context of tax-advantaged investments, each year’s depreciation is an amount that the investor can write off of their taxable income. We will not focus on depreciation in this example (you can read more about it here) but all in all, Andres can use depreciation to reduce his tax bill by up to an extra of $343,200.
Tax credits are a valuable tool that can help reduce your federal tax liability. Please do your own research and, where necessary, get help from a tax professional to identify credits for which you are eligible, and then make sure to claim them on your return. With the right information and preparation, you can make the most of the tax credits available to you in 2023 and save money on your taxes. If you have any accounting questions, we have put together an overview of the most common technical doubts accountants have for us and you can read them here.
How can you go about buying qualified projects? It’s relatively simple: Valur has partnered with nationally recognized accounting and investment firms to facilitate the purchase of solar projects. We will help you identify the opportunity and choose between different solar projects, visualize the potential benefits, and calculate how much you need to invest to capture the right sized tax credits. From there, we and our partners will help you seamlessly finalize your investment and keep track of the relevant data for ongoing tax purposes.
To learn more you can schedule a call with us here.
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