What is basis risk in tax credit transactions?

Whether purchasing transferable credits or deploying capital through tax equity structures — managing basis risk is critical for buyers and investors in the clean energy tax credit market. In the context of investment tax credits (ITCs), basis risk refers to the possibility that the Internal Revenue Service (IRS) may challenge or reduce the eligible basis used to calculate a credit, resulting in a partial disallowance of the claimed credit.

This installment of Crux’s series on underwriting risks will discuss basis risk: what it is, how it arises across different transaction structures, and how buyers and investors apply standardized risk mitigation processes so that they can transact with confidence.

What is eligible basis and basis risk?

The eligible basis, sometimes called the eligible cost basis, is the total capitalized expenditure directly related to the acquisition, construction, and installation of a qualifying renewable energy property. ITCs are calculated as a percentage of the eligible basis of a qualifying clean energy project. The higher the eligible basis, the larger the credit.

The base ITC is tied to 30% of the eligible basis of a facility (assuming prevailing wage and apprenticeship (PWA) requirements are met). For example, if a project's eligible basis were $1,000,000, its base credit is $300,000. That percentage can increase substantially — up to 70% in some cases — if the property qualifies for certain domestic content, low-income community, and energy community requirements, also known as “adders”.

Basis risk refers to the possibility that the IRS disputes the eligible basis used to calculate a credit, resulting in a partial disallowance of the credit. If, after the ITC has been sold, the IRS determines that a project’s eligible basis was overstated, it can claw back part of the credit from the transferee taxpayer, in this case, a buyer or investor. The IRS may also assess penalties for overstating the project’s eligible basis.

In some circumstances, a reduction of a project’s eligible basis can also create excessive credit transfer risk, where the buyer has purchased more credits than the project actually earned.

How does basis risk arise?

The nature of basis risk depends on the transaction’s structure. While basis risk is present in both tax equity partnerships and direct credit transfers, it manifests differently in each — and the magnitude of exposure can vary.

In tax equity partnerships, developers typically sell project assets into a partnership for a negotiated price — the fair market value (FMV) — which typically exceeds the costs incurred during development and construction. The purchase of the project for the FMV represents a new capitalized expenditure for the project at a higher price, which means the eligible basis of that project rises to match that new FMV. This difference between the development costs and the FMV is known as the “step-up” in a project’s eligible basis.

A step-up can meaningfully increase the value of the ITC generated because it increases the eligible basis of the credit, which in turn increases the value of the ITC. However, basis step-up introduces new risk: if the IRS determines that the appraised value was inflated or unsupported, it may reduce the eligible basis and disallow a portion of the credit.

In direct transfer transactions under Section 6418, basis risk dynamics differ slightly. Because there is no sale of the project to support a step-up to FMV, the ITC basis is tied more closely to the project’s actual cost basis. However, basis risk does not disappear — buyers still need to verify that stated costs are accurate, that eligible property has been properly categorized, and that the cost segregation-analysis supporting the credit does not include ineligible costs. For example, if a developer inadvertently — or incorrectly — includes costs for non-qualifying property or shared infrastructure in the eligible basis calculation, the credit amount will be overstated from the outset. If the IRS determines that the project overstated its cost basis, it may reduce the eligible basis and claw back the excess portion of the credit from the buyer.

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How do investors and tax credit buyers analyze and mitigate basis risk?

Under IRS rules, the transferee (i.e., the buyer) is the taxpayer utilizing the credits, meaning any recalculation of the credit's basis would affect their tax liability. Regardless of structure, the investor or buyer bears the consequences of a basis adjustment. In a direct transfer, the buyer is the taxpayer utilizing the credits, meaning any IRS recalculation of the credit's basis affects their tax liability directly. In tax equity, the investor's allocated share of tax benefits — including the ITC — is subject to reduction if the partnership's eligible basis is challenged. In both cases, the investor remains responsible for the difference between claimed and actual credit values, even when the discrepancy stems from the seller's or developer's representations.

However, the market has developed several mechanisms to manage this risk effectively and ensure that buyers are made whole in the event of a reduction in a project’s eligible basis.

Due diligence

Buyers, investors, and their advisors conduct thorough reviews of a project's cost documentation and supporting analyses before committing capital, as well as the seller’s background and creditworthiness. Investors and their advisors should carefully examine:

Cost-segregation analysis: A cost segregation report is an independent technical analysis that identifies and classifies project components eligible for the ITC. The report serves as the foundational basis for determining the quantum of ITC-eligible property and, by extension, the tax credit position being acquired or financed. Buyers and their counsel should assess whether the classifications applied in the cost segregation report are technically defensible and methodologically consistent with applicable IRS guidance. Key diligence considerations include the qualifications and independence of the preparer, the granularity and documentation supporting each classification, and whether asset categorizations align with IRS regulations and relevant case law. A poorly supported or aggressive cost segregation analysis represents a primary source of ITC basis risk and warrants heightened scrutiny.
EPC contracts: The eligible basis for ITC purposes must be grounded in actual, substantiated costs. Buyers should conduct a thorough review of all documentation evidencing construction costs, including Engineering, Procurement, and Construction (EPC) contracts, invoices, and change orders. This review ensures that the costs underpinning the claimed tax basis are accurate, reasonable, and properly supported. Many market participants engage independent engineers to evaluate EPC contracts and related invoices, confirming the reasonableness of costs and ensuring consistency with the classifications established by the cost segregation provider. Discrepancies between construction cost documentation and the cost segregation analysis — whether in scope, value, or timing — can undermine basis supportability and should be resolved prior to closing.
Third-party appraisal: In transactions involving a FMV step-up, a third-party appraisal is the primary mechanism for substantiating the elevated basis claimed for ITC purposes. Buyers and their advisors should critically evaluate the appraiser's qualifications, methodology, and underlying assumptions to assess whether the resulting FMV conclusion is defensible in an IRS audit context. As a general market benchmark, basis step-ups in excess of 20–25% above cost invite heightened scrutiny and may signal elevated basis risk. That said, step-ups above this threshold are not inherently problematic — projects with strong operating cash flows may support higher FMV conclusions when grounded in well-constructed discounted cash flow (DCF) models and appropriate discount rate assumptions. The critical diligence inquiry is not whether a step-up exceeds a particular threshold, but whether the appraiser has applied a balanced, well-supported methodology — including appropriate discount rates, consideration of multiple valuation approaches, and assumptions consistent with market practice. Appraisals that rely disproportionately on a single valuation method or employ aggressive assumptions without adequate support present greater audit risk and should be reviewed with particular care.

Crux's platform streamlines this process by automatically generating diligence checklists linked to documents in the data room and extracting key details from critical contracts like EPC agreements and PWA compliance documentation. This gives buyers and their counsel a clear view of available documentation, the ability to request additional materials directly within the platform, and a single source of truth that reduces manual back-and-forth — helping transactions that use the Crux platform close 14% faster on average.

Indemnification

Buyers typically negotiate indemnification provisions requiring the seller to make them whole if credits are disallowed. The structure and scope of the indemnities are negotiated deal terms, making seller creditworthiness a key part of underwriting. The vast majority of tax credit transfer agreements include "no-fault" indemnity provisions, meaning the buyer is entitled to be made whole for any reduction in credit value — even if the loss does not result from a breach of the seller's representations. In some cases, a parent guarantee may provide additional security, particularly when the seller is a project-level or passthrough entity or otherwise lacks sufficient creditworthiness.

Tax credit insurance

Many buyers and investors use tax credit insurance to protect against financial loss. If a covered loss occurs, the insurer agrees to compensate the buyer’s full financial loss up to the policy limit and subject to the terms of the policy. Among other risks, tax credit insurance can cover the risk that the IRS disallows some or all of the claimed credit due to a basis challenge, providing buyers with meaningful downside protection.

Basis risk is one of the most commonly insured risks for ITCs, as audit focus is often concentrated on project basis claims; agents frequently challenge appraisals and rely instead on comparable cost data. This makes large basis step-ups particularly sensitive, and insurance carriers often only provide policies if step-ups are 20–25% or less.

For more information, see Crux’s comprehensive Guide to the Tax Credit Insurance Market.

Pricing adjustments

Basis risk is reflected in how investors price transactions and the discount buyers apply to the face value of the credit. In direct transfers, deals with greater basis uncertainty (e.g., basis step-ups greater than 20-25%) may trade at wider discounts to the face value of the credit. In tax equity, basis risk may be priced into the investor’s required return or reflected in structural protections like higher indemnification thresholds or escrow requirements.

How does Crux help buyers and investors navigate basis risk?

An experienced advisor like Crux guides buyers and investors throughout each step of the deal process to help them understand what is standard for the market in terms of risk and pricing, ensure the diligence process runs smoothly, and connect them with trusted legal, accounting, and insurance providers when needed.

Crux's platform features a curated selection of pre-vetted credits from leading developers and manufacturers, giving buyers and investors access to quality deal flow from the outset. Our team of finance, tax, and development experts works alongside buyers and investors to evaluate basis-related documentation against proven market benchmarks, drawing on industry-specific workflows validated by 40+ top-tier legal and accounting firms and our $55 billion transaction dataset. Through established partnerships with leading legal and insurance advisors, we help buyers and investors efficiently structure protections and move transactions forward with confidence.

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