Written by Dave McGuire, Shareholder, McGuire Sponsel

The Energy Policy Act of 2005 established certain incentives for building energy efficient buildings. These included the 45L tax credit for the construction of energy efficient single-family homes, and the 179D deduction for the construction of other energy efficient properties. Since 2005, very little has changed with these provisions other than extensions to allow businesses to continue to benefit from these tax provisions. In 2022, the Inflation Reduction Act (IRA) drastically changed not only the amount of these benefits, but also some of the underlying calculations associated with the incentives.

To understand the changes to 179D, let’s first start with the rules prior to the IRA. Prior to the IRA companies building energy efficient buildings were allowed a deduction of up to $1.80/sf (adjusted for inflation). To take this deduction, the building was compared to the ASHRAE 90.1-2007 standard, if the building reduced the energy consumption by 50 percent as compared to the standard a company was allowed a full deduction. Additionally partial deductions of $0.60/sf were allowed for reductions in energy consumption across the building envelope, lighting system, or mechanical systems. Finally in the case of government owned buildings that qualified, the government agency could transfer the deduction to the designer “primarily responsible for the energy efficient design.” This means architects and engineers designing government buildings were also eligible for this deduction.

The IRA changed this deduction in three ways. First it changes the calculation. Instead of partial deductions for each building system the deduction is changed to a calculation based on reducing the energy consumption of the building by at least 25 percent. The new law also increases the ability to transfer the deduction. Now in addition to government buildings having the ability to transfer the deduction to the designer, the ability has also been provided to tax-exempt organizations. This means private colleges, churches, and other tax-exempt entities can transfer the deduction to the person responsible for the energy efficient design. Finally, the amount of the deduction is changed from $1.80/sf to a sliding scale from $0.50/sf to $1.00/sf.
Many people may understand the change to the amount of the deduction above and be confused as many of the bill’s proponents have touted that it increases the amount of the deduction. That is because the bill introduces a concept where deductions and credits are increased if the company involved pays “prevailing wages”. Under this rule, if a company pays the prevailing wages detailed on the sam.gov website, they can multiply their deduction by 500 percent. This means that if prevailing wage requirements are met the deduction amount goes up to $2.50 to $5.00/sf. However, for many businesses the prevailing wage requirements may be hard to meet as it applies to all contractors working on the property, this would include painters, landscapers, and other unskilled trades.

The other real estate related tax incentive included in this bill is an extension and change to the 45L tax credit. The 45L tax credit had expired at the end of 2021, but this law extends the existing tax credit through 2022 and modifies it for years 2023 through 2032. The existing law, in place through the end of 2022, allows for a $2,000 per unit tax credit for the construction of low-rise residential construction. This includes new homes, apartments, and even assisted living facilities if they are three stories or less above grade. To take this credit, the home had to be 50 percent more efficient than the International Energy Conservation Code (IECC).

Starting in 2023, the 45L credit changes drastically. First, instead of being tied to the IECC code, the credit is now tied to Energy Star. Second the credit amount is now adjusted as follows:

  • Single Family Homes Meeting Energy Star Single Family Home Standard – $2,500
  • Single Family Homes Certified as Zero Energy Ready – $5,000
  • Multifamily Homes meeting Energy Star Multifamily New Construction – $500*
  • Multifamily Homes meeting Energy Star Zero Energy Ready Multifamily – $1000*

*Multifamily homes receive a 500% increase if prevailing wage requirements are met

The new requirement to tie the credit to energy star raises many questions. First it relates to the three-story requirement. Under the old rules, homes were limited at three stories or less above grade, this was based on the standards under the IECC code. Energy Star does not have the same three-story limitation; however, they do split multifamily into multifamily high rise, midrise, and low rise. The IRS has still not confirmed if the three-story limitation still applies.

The bigger issue with energy star is that it cannot be done after the fact based on the current standards. Under the old rules most developers would complete a project, then ask a 45L certification company to confirm the benefit. However, energy star requires that the contractor be working within the energy star requirements from the beginning. This may exclude developers from taking the deduction until they work to become energy star certified. Finally, the limitation of $500 for multifamily when prevailing wages are not met, may limit the applicability to many companies, as the cost to certify and claim the credit may outstrip the benefit.
As evidenced above the changes to 179D and 45L are significant and confusing. It is critical that taxpayers talk to professionals who are versed in these changes to ensure that they have access to the deductions and credits moving forward.