With tax season just concluded, many financial advisors and their clients are turning their attention to strategies that can help make their portfolios more tax-efficient for next year.

A lean tax bill can be an elusive goal. In decades past, tax-exempt muni bonds offered a reliable place to park investment dollars in the long-term and whittle down the tax burden. As we’ve all witnessed, however, new issues on the muni market have become constrained in recent years as highly leveraged cities, counties and states tighten their issuance of new debt.

While real estate has traditionally been viewed as the next best investment asset for favorable tax treatment, a new tax-efficient option has emerged in the form of renewable energy projects. Beyond the environmental benefits of such investments, many of them can also provide significant tax benefits.

For advisors who want to deploy solutions in the renewable energy sector for clients, there are two challenges: first, explaining the potential tax advantages; and second, identifying options for accessing them that fit their clients’ needs.

Tax Advantages Of Investing In Renewable Energy Projects

Federal tax law has long allowed for the depreciation of certain renewable energy assets in as little as five years. (Depreciation, of course, is a non-cash expense that drives down taxable income.) This includes solar technology, fuel cells, biomass, geothermal and wind. To be clear, five-year depreciation on most types of renewable energy is nothing new—it’s been around in some form since 1986 as a way to reduce barriers to green investment.

What is new, however, is the potential 100 percent bonus depreciation in year one for certain renewable investments established in the Tax Cuts and Jobs Act of 2017. The law allows for full depreciation on a qualified renewable energy asset acquired and placed into service between Sept. 27, 2017 and Jan. 1, 2023.

Provided that the property is organized as a pass-through entity such as a limited partnership, this means the entire value of the asset can be passed through to investors as a non-cash loss in the first year of operation and immediately serve as a tax shield on other income. Compare that to commercial real estate, which can be depreciated gradually over either 27.5 or 39 years.

There’s another potential tax advantage of the faster depreciation of a renewable asset: when an asset with high depreciation expense makes distributions to investors, often it can pay out cash in excess of its net income. The part of the distribution over and above net income can be designated for tax accounting purposes as a return of capital.

Typically, returns of capital are not taxable as ordinary income. Rather, they lower investors’ cost basis in the asset, so when it comes time for the investor to exit, the gain is taxed at the (much more favorable) long-term capital gains rate rather than ordinary income tax rates.

Investors in eligible renewable energy projects, therefore, could enjoy two tax benefits: their tax bill could be deferred until the time of sale, with a potentially lower amount of tax than if the distribution had been taxed as ordinary income.

Accessing These Options For Clients

The traditional route for retail clients to invest directly in energy projects has been through master limited partnerships (MLPs), which offer professional diligence, selection and management of energy projects, along with pass-through structures that enable investors to utilize depreciation as a tax shield on other income. The problem, however, is that MLPs are not available in the renewable energy sector—placing the specific tax benefits of investing in green energy projects out of reach.

(MLPs often involve other headaches, as well, including the complexity of dealing with K-1s for tax reporting, and state-by-state tax filings depending on where the underlying assets are held.)

Fortunately, innovative new instruments have emerged in recent years that bring the primary advantages of MLPs—including professional project selection and management, pass-through structures and stable monthly distributions—to the renewable energy sector, while doing away with much of MLPs’ complexity.

These vehicles, sometimes called Yieldcos, are offered by a new breed of publicly listed, project-focused investment firm. In addition to the benefits above, many of these firms focus on purchasing existing green energy projects that already have contracts in place with municipalities and other “off-takers” of electricity, so they feature risk profiles that may be more suitable for retail investors.

Compared to real estate, which can utilize depreciation but at a much slower rate, renewable energy projects offer potentially much more favorable tax advantages for clients. The front end-loaded depreciation allows for a significantly greater portion of distributions to count as a return of capital when compared to REITs.

Combined with the opportunity to reduce carbon emissions at the same time, investments in renewable energy projects may be the ideal solution for clients who seek to lighten their tax load while contributing to the growth of green jobs and renewable energy capacity.

David Sher is co-CEO and director of business development for Greenbacker Capital, an investment firm focused on the sustainable infrastructure sector.