Inflation Reduction Act: Impacting Real Estate Tax Returns
The Inflation Reduction Act of 2022 brought substantial changes to Section 179D Energy-Efficient Commercial Building Tax Deduction, a flagship federal tax incentive. Here’s what to know for this tax season.
By Benjamin Kluwgant | Digital Exclusive – 2024
As we enter the first tax season since the Inflation Reduction Act of 2022 (IRA) became law, there are several key changes certified public accountants (CPAs) should be aware of, including updates made to Section 179D Energy-Efficient Commercial Building Tax Deduction.
Originally introduced into law in 2005, Section 179D was designed to reward developers of contemporary and energy-efficient commercial or high-rise residential buildings. To qualify for the tax deduction, a series of steps need to be followed, including the development of an energy model using Department of Energy-approved software and a site inspection by a licensed, third-party professional engineer.
From a tax standpoint, taking the deduction for a building placed into service in a previous year requires a change of accounting method (through Form 3115), and the basis of the building is to be reduced by the deduction taken.
The Tax Side of 179D
As noted, Section 179D is a deduction, not a credit. For the actual tax benefit to be calculated, the deduction needs to be multiplied by the company’s tax rate.
If the company has a tax liability, it can use these deductions to reduce its assessable income and, ultimately, reduce its tax liability. Without a tax liability, it can be carried forward indefinitely.
Additionally, the basis of the building needs to be reduced by the deduction amount taken. This is important to note because if the company decides to sell the property shortly after taking the deduction, capital gains are likely to be higher due to the lower basis value. As years go by, this becomes less of an issue due to depreciation.
How 179D Worked Pre-IRA
Before the introduction of the IRA, energy efficiency was measured across three systems: lighting, building envelopes, and HVAC.
For eligible buildings, a tax deduction of up to $1.80 per square foot was available (adjusted for inflation, depending on the year). For developments that only demonstrated efficiency across one or two of the above-mentioned systems, a deduction of 60 cents per square foot was available per system (again, adjusted for inflation).
Additionally, real estate investment trusts (REITs) were unable to take advantage of the incentive.
How the IRA Changed 179D
The IRA overhauled the incentive by removing the concept of “partial qualification” and increasing the value of the deduction. Now, the deduction starts at $2.50 per square foot for a building that’s 25% more efficient than a 2007 reference building and increases 10 cents per square foot for every percentage of increased efficiency, capped at $5 per square foot (adjusted for inflation).
Under the new laws, REITs can benefit from the deduction, and developers are now required to meet apprenticeship and prevailing wage requirements to be eligible for the increased deduction.
According to IRS guidance, for buildings where construction began prior to Jan. 29, 2023, and placed in service after that date, the prevailing wage and apprenticeship requirements don’t need to be met. This means that the larger deduction range is accessible for many developers who placed their buildings into service during 2023 or plan on doing so in 2024.
Key 179D Questions for CPAs to Ask Their Clients
Considering the changes to this tax incentive, here are some direct questions CPAs can ask their real estate clients to determine whether Section 179D is relevant:
- Did you complete any real estate construction, renovation, or retrofit projects over the last few years? This is a great qualifying question to see if the incentive is worth your client’s time.
- Did any of those projects have a gross square footage of 30,000 square feet or more? While this isn’t an eligibility question, this is generally the minimum size for the cost of undertaking a 179D study to be worthwhile.
- When did the projects break ground? This should give a clear indication as to whether the project is covered by the grace period where prevailing wage and apprenticeship requirements don’t need to be met. It’s still uncommon for standard commercial development projects to meet those standards, so the chances of qualifying increase substantially if the project broke ground prior to Jan. 29, 2023.
- When were the projects placed in service? This should provide insight into what version of the incentive the project may be eligible for.
With tax season kicking off, now’s the time for CPAs to familiarize themselves with this IRA tax deduction incentive. Not only will it help CPAs build credibility among their real estate clients, but it’ll also help them uncover substantial tax benefits for these clients.
When in doubt, CPAs are encouraged to have a 179D specialist in their corner to answer any questions. A reliable specialist generally possesses both engineering and tax capabilities, doesn’t outsource their site inspections, and has a track record of being thorough in their practice.
These advisors aren’t only out there but would likely be delighted to be your point of contact for engineering-based real estate incentives going forward.
Benjamin Kluwgant is the director of business development at Source Advisors, a tax consultancy firm that specializes in research and development, cost segregation, LIFO inventory, energy efficiency, employee retention credit, and SALT credits.
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