For many years now, real estate owners have used cost segregation to accelerate depreciation by reclassifying building components into shorter-lived asset categories (e.g., decorative lighting, flooring, landscaping versus standard 39-year building life).
Under the Inflation Reduction Act (IRA), cost segregation has become critical for renewable energy projects seeking to maximize the Sections 48 and 48E investment tax credit (ITC).
An ITC-focused cost segregation study still classifies assets for depreciation, but its primary purpose is to determine which costs qualify as “energy property” under tax law. In other words, it identifies assets that qualify for an immediate tax credit, which can yield substantial benefits in the year the project is placed in service.
Why cost segregation is critical in Sections 48/48E energy credit projects
Cost segregation distinguishes which parts of a project’s cost are treated as ITC-eligible energy property versus nonqualifying spend. In large renewable projects, many expenditures (soft costs, site work, supporting infrastructure) might not directly qualify.
A thorough cost segregation classifies each cost as either part of the energy property or not, based on tax definitions. This determines the “credit basis” — the sum of costs that count toward the ITC. The study also has the secondary benefit of assigning appropriate tax recovery periods (generally five years for most energy equipment; land improvements typically 15 years; buildings 39 years). It’s helpful to note that depreciation on property for which the ITC is claimed is reduced by 50% of the credit taken, but the accelerated recovery of the remaining basis still provides value.
Without an ITC cost segregation study, a taxpayer might treat a renewable energy project’s costs as one asset or simply follow book cost categories, which risks misallocating costs. Ineligible costs could be mistakenly included in an ITC claim — leading to IRS challenges later — while eligible costs could be overlooked, resulting in a smaller credit than entitled.
The IRS has clear rules on what counts as energy property. For example, only property that’s “used as an integral part of” the energy facility’s generation or storage function qualifies. Cost segregation applies tests like “functional interdependence” (components that must operate together) and integral function (necessary for energy production) to each cost item. For example, in a solar farm built on land, the panels, inverters, racking, wiring, transformers, etc., are integral to producing power and thus qualify. But costs like the earth work to prepare the site or the fencing around the site may not qualify, as they don’t directly generate power. Those should be carved out of the ITC basis.
Case study 1: Geothermal heating system and rooftop solar array
A major university constructed a midrise office building to support its business operations and sustainability goals. As part of the project, the institution installed a rooftop photovoltaic array and a geothermal heating system. The total project cost was approximately $60 million.
The cost segregation study revealed approximately $9.7 million was attributable to the geothermal system and $490,000 to the solar array. Because construction began prior to Jan. 29, 2023, the project qualified for the enhanced 30% ITC rate without meeting prevailing wage and apprenticeship requirements. This resulted in an ITC benefit of approximately $3 million, significantly reducing the university’s net project cost and improving its return on investment.
Case study 2: Biogas digester project
A municipal waste facility invested in an anaerobic digester and gas upgrade system to produce renewable natural gas. The total project cost was $46 million, including digester tanks, gas upgrading equipment, and a building housing the control room.
The cost segregation analysis identified $42 million of ITC-eligible costs (digester, pumps, related systems), while $4 million in general site work, site fencing, and gas flare equipment didn’t qualify. As a large biogas project with a capacity of more than 3.41 MMBtu/hr of electricity, this project complied with prevailing wage and apprenticeship rules and qualified for the 30% ITC rate. Additionally, the facility owner documented that more than 40% of manufacturing equipment costs were U.S.-sourced, earning an extra 10% domestic content bonus. The result: a 40% ITC on $42 million, equating to a $16.8 million credit.
What costs are eligible for Sections 48/48E credit?
An ITC cost segregation study reviews all project cost elements, including indirect costs, to maximize the credit-eligible basis within the bounds of the law. Some examples of costs that usually do or don’t qualify for a Section 48/48E credit claim include:
- Direct generation/storage equipment, such as solar modules, wind turbines, biogas digesters, fuel cells, battery units, inverters, mounting racks, trackers, and heat exchangers typically qualify for the credit.
- Balance of plant items, such as transformers, step-up converters, wiring, combiner boxes, monitoring systems, power control systems, etc. These are usually eligible if they’re necessary for the energy property’s function. (Even grid interconnection equipment is eligible up to a point — the IRA explicitly made “qualified interconnection property” for small projects part of an ITC basis.)
- Installation and permitting costs, including labor and construction costs directly related to installing the energy equipment (mounting, assembly, electrical hookup), and design/engineering fees, permitting, interconnection studies, etc. These costs are typically eligible on a pro rata basis. These often can be apportioned to the energy assets as part of their cost. A cost segregation study will allocate shared soft costs between ITC-eligible and noneligible portions based on reasonable methods (e.g., percentage of qualifying direct costs).
- Supporting structures are generally not eligible, unless they’re so integrated that they’d be replaced if the energy equipment was replaced. For instance, a purpose-built enclosure for digesters might qualify if it’s essential to the operation (e.g., a specially engineered enclosure for an anaerobic digester). But a standard warehouse or building where solar panels sit on the roof does not make the roof or building an energy property.
- Land and site improvements are almost always excluded. Land is never depreciable or eligible. Site prep like grading is generally not eligible for ITC, unless it’s necessary for the energy equipment’s function (e.g., a road in a biomass plant used exclusively to feed materials to the digester might qualify as integral). Cost segregation will identify such integral site improvements versus general infrastructure.
- Dual-use equipment that serves both the energy property and other uses requires a careful analysis. Sometimes only a fraction of its cost can be counted. (For example, an HVAC system that cools both a battery storage area and an office might be part eligible, part not.)
In short, an ITC cost segregation study provides a defensible breakdown, showing the IRS exactly which assets and costs a taxpayer is claiming the credit on — with reasoning rooted in tax regulations.
Early planning pays dividends in accurate, documented Section 48 credit claims
Completing a cost segregation study early in the project’s life cycle delivers benefits far beyond calculating the credit amount. It provides a strategic framework for decision-making that ensures compliance with Section 48 requirements and maximizes available incentives. By identifying ITC-eligible costs upfront, stakeholders can structure contracts, procurement, and documentation processes to align with IRS standards.
Early analysis is particularly critical for projects seeking to qualify for prevailing wage and apprenticeship requirements or domestic content bonuses. These compliance areas are complex and often require detailed tracking of labor classifications, wage rates, and sourcing documentation. Addressing these requirements after construction begins can be costly and inefficient. A proactive approach allows stakeholders to integrate compliance measures into project planning, reducing risk and avoiding last-minute adjustments.
Additionally, early cost segregation supports accurate budgeting and financial modeling. Taxpayers frequently assume that every dollar spent on a renewable energy upgrade translates into credit-eligible energy property. In reality, the credit base is a complex mix of qualifying and nonqualifying costs. By conducting a study at the outset, businesses can forecast the true credit potential, optimize financing strategies, and ensure that eligible costs are properly documented throughout the project.
Finally, a comprehensive review before filing the return provides a defensible position in the event of an IRS inquiry. Detailed cost allocation and support documentation demonstrate compliance and expedite resolution of any questions. In short, early planning isn’t just a best practice, it’s essential for maximizing the financial and compliance benefits of the Section 48 ITC.
To learn more about how cost segregation can support Section 48 investment tax credit claims, please contact your tax advisor.
