179D and 45L technical update
Inflation Reduction Act offers tax savings opportunities for real estate clients
By Karen Koch, CPA, MT, Source Advisors and Brian Coddington and Imran Syed, PE, LEED AP, CEM
October 10, 2022
Recent passage of the Senate amendment of H.R. 5376, The Inflation Reduction Act, (IRA) bill contains many energy-related tax provisions that can benefit your clients who are building owners, developers and designers. The most important provisions are the significant changes to the New Energy Efficient Home Credit (Section 45L) and to the Energy Efficient Commercial Buildings Deduction (Section 179D). Let’s take them one at a time:
1. The New Energy Efficient Home Credit
The Internal Revenue Code (IRC) Section 45L New Energy Efficient Home Credit is for developers of energy efficient dwelling units, including single-family homes, multifamily buildings and even mobile homes. The credit was $2,000 per unit but expired at the end of 2021. The IRA extends the current Section 45L credit through Dec. 31, 2022, for dwelling units first leased or sold for use as a residence through Dec. 31, 2022. However, for units first leased or sold starting on Jan. 1, 2023, there are substantial changes to the credit rate and qualifications.
a. Single-family dwellings eligible for the Energy Star Residential New Construction Program or the Energy Star Manufactured New Homes Program that meet the energy savings targets qualify for either a $2,500 per unit credit or a $5,000 per unit credit.
- For units leased or sold before Jan. 1, 2025, the $2,500 credit is for dwelling units that meet the Energy Star Single Family New Homes National Program Requirements 3.1.
- For units leased or sold after Dec. 31, 2024, the $2,500 credit is for homes that meet the Energy Star Single Family New Homes National Program Requirements 3.2
- In both cases, the dwelling unit must also meet the most recent Energy Star Single Family New Homes Program Requirements for its geographic location that went into effect on the latter of Jan. 1, 2023, or Jan. 1 of two calendar years before the date of acquisition.
- The $2,500 credit also applies to a mobile home that meets the most recent Energy Star Manufactured Home National Program Requirements effective on the latter of Jan. 1, 2023, or Jan. 1 two years before the acquisition date.
- The $5,000 credit is for a unit that meets the Zero Energy Ready Home Program of the Department of Energy effective Jan. 1, 2023 (or the successor program).
b. Multifamily dwelling units that meet the requirements of the Energy Star Multifamily New Construction Program receive a credit of either $500 or $1,000.
- The $500 credit is for dwelling units that meet the most recent Energy Star Multifamily New Construction National Program Requirements in effect on the latter of Jan. 1, 2023, or Jan. 1 three years before the acquisition.
- The $1,000 credit is for dwelling units that meet the Zero Energy Ready Home Program of the Department of Energy in effect on Jan. 1, 2023 (or the successor program).
- The multifamily credits increase to $2,500 and $5,000, respectively, if contactors meet prevailing wage requirements. If the prevailing wage requirement is not met, the impacted workers can be paid the difference between the wage paid and the prevailing wage in wages plus interest — and the developer can pay a $5,000 per worker penalty to meet the requirements.
Tax planning notes:
- The new criteria for qualifying for the energy efficient home energy credits are complex. The plan to qualify starts in the early stages of the project during the planning and design phase. Now is the time to talk with your developer clients to understand the scope of the projects to be completed beginning in 2023. Due to compliance with other federal credits or to obtain local permits, the developer may already be required to pay prevailing wages. Now you and your client just need to make sure the unit meets the energy criteria to qualify for the $2,500 per unit tax credits. Then look at the additional construction costs to build a Zero Energy Ready Home. If the prevailing wages are met, and the home is Zero Ready, there is a good opportunity to qualify for the $5,000 per unit tax credit. This will certainly change the economics of the project. For instance, if the developer has 100 Zero Ready Units certified, the tax credits would amount to $500,000.
- Paying prevailing wages for 45L energy efficient homes is not required for developers of single-family dwellings.
- The legislation allows for Section 42 Low Income Housing Tax Credits (LIHTC) to retain the basis for calculating the LIHTC. Basis is only reduced for depreciation purposes.
- With the switch to Energy Star qualification criteria, this provision is not limited to low-rise residential buildings of three-stories or less.
2. Energy Efficient Commercial Buildings deduction
Unlike the Section 45L credit for residential structures, the Section 179D Energy Efficient Commercial Buildings deduction is a
permanent part of the IRC that currently provides up to a $1.88 per square foot deduction for building owners or designers of government buildings that install energy efficient commercial property. The Inflation Reduction Act makes permanent, substantial changes to the deduction starting in 2023.
Although this provision was made permanent several years ago, the IRA has significantly changed the criteria for qualifying for the provision as well as the deduction amounts. Here are some of the most important changes:
Changes to energy savings and standards
- The energy savings target is reduced to 25% from 50% and the amount of the deduction is reduced to $0.50 per square foot from $1.88 per square foot. For each percentage point increase in energy savings, the deduction goes up by $0.02 to a maximum of $1.00 per square foot for a reduction of 50%.
- The base deduction for 179D starts at 54 cents for 25% energy savings, increased by 2 cents per percentage point in increased savings, but not above $1.07. For taxpayers that meet the prevailing wage and apprenticeship requirements, it starts at $2.68 for 25% and increases 11 cents per percentage point, but not above $5.36.
- The energy standard is now the more recent of ASHRAE Standard 90.1-2007, the most recent ASHRAE 90.1 standard for which the Department of Energy has issued a final determination, and which has been affirmed by the Secretary, after consultation with the Secretary of Energy. This change will require building owners and developers in areas with long construction lead times to increase the energy savings relative to the current standard.
Labor requirements
- The prevailing wage requirements for contractors and subcontractors generally require adherence to Davis Bacon Act guidelines.
- Unlike the prevailing wage requirement, the apprenticeship requirement cannot be fixed after construction. The Act does allow good faith, failed efforts to meet the apprenticeship requirements.
- The IRS issued Notice 2022-61 to provide more specific guidance on the prevailing wage and apprenticeship requirements. This notice puts the responsibility for meeting the prevailing wage and apprenticeship requirements, if applicable, squarely on each taxpayer claiming these energy incentives. Under this guidance, if construction commences on or prior to Jan. 29, 2023, the prevailing wage and apprenticeship requirements will be treated as met for property placed in service afterwards. The notice also provides guidance on how to determine when construction commences.
Changes to the partial deductions
- The partial deduction, including the interim lighting rule, is eliminated.
- The act replaces the partial deduction with an Alternative Deduction for Energy Efficient Building Retrofit Property installed as part of a qualified retrofit plan.
- This alternative deduction is based on a reduction in energy use intensity certified a year after the property’s placed-in-service date.
- The deduction is limited to domestic buildings originally placed in service at least five years before the qualified retrofit plan’s establishment.
- A baseline energy use intensity must be established to show a reduction.
Other changes
- The allocation of the deduction by government agencies to designers has now been expanded to allow other tax-exempt entities to allocate the deduction to a designer.
- Currently, the available deduction must be reduced by all past Section 179D deductions. The act reduces this to a three-year lookback period for property owners and four years for building designers.
Tax planning notes:
- The prevailing wage requirement applies to laborers, mechanics and workers during the project. To meet the apprenticeship requirement, qualified apprentices would need to perform an applicable percentage of total labor hours of the construction project.
- The deduction allocation to the primary designer for government entities is now expanded to include tax-exempt entities, such as nonprofits and tribal entities. Primary designers, such as architects and engineers, can significantly impact their taxable income with the design of energy efficient buildings for government owned buildings to buildings owned by charities, churches, private schools and universities, tribal governments and others.
- Real Estate Investment Trusts can now use this deduction to calculate earnings and profits, with some limitations.
Be proactive
This new legislation has a direct impact on the construction industry. The tax incentives related to energy conservation with energy efficiency and to energy generated via alternative energy are significant. However, to qualify for these incentives the developer and accounting teams will need to connect with independent energy consultants to review the drawings and equipment specifications now for projects already started — but not completed — until 2023. An independent energy consultant is a professional who can review, validate and certify the project beginning with the design, throughout the construction and at completion.
If your clients or organization would like more guidance on how to claim the maximum benefits of these energy-related provisions, please don’t hesitate to
contact us.
Karen Koch, CPA, MT is a senior director at Source Advisors, Brian Coddington is a director of tax accounting methods & credits at Source Advisors and Imran Syed, PE, LEED, AP, CEM is a director at Source Advisors.
