By Terri S. Johnson, CRE

The Inflation Reduction Act was signed into law on Aug. 16, 2022, but several of its provisions only took effect for properties placed in service on or after Jan. 1, 2023. We are still waiting for additional guidance to further flesh out the Inflation Reduction Act adjustments to Internal Revenue Code (IRC) Sections 179D and 45L, but we certainly know more now than we did at the start of 2023.

This blog provides a one-year update of what we’ve learned and what we need to learn regarding the act’s changes to the 179D tax deduction and 45L tax credit.

179D Tax Deduction

IRC Section 179D tax deductions are for property owners who put in service energy-efficient materials or energy-efficient retrofits. To that end, property owners must demonstrate a reduction in energy consumption versus the benchmark standard. Before the Inflation Reduction Act was passed, taxpayers had to demonstrate at least a 50% reduction in energy consumption. Under the Inflation Reduction Act, this threshold was lowered to 25%, making it easier for properties to qualify.The reference standard to be used is the most recent American Society of Heating, Refrigerating, and Air-Conditioning Engineers (ASHRAE) standard published in the four years before the property was placed in service. Currently, that is 90.1-2007 (Announcement 2023-01).

The 179D deduction value depends on the energy efficiency increase over the baseline (from 25% to 50%) and on whether a contractor meets prevailing wage and apprenticeship (PWA) requirements. (Find additional detail for Notice 2022-61.) On Aug. 29, 2023, the IRS released proposed regulations that expand on PWA requirements. The proposal states that taxpayers must “maintain and preserve sufficient records to establish compliance.” These records may include the following:

• Payroll records that reflect the hours worked in each classification.
• Actual wages and fringe benefits paid to each laborer and mechanic performing construction, alteration, or repair work on the facility.
• Records of any correction payments made to a laborer or mechanic.
• Copies of any written requests for apprentices by taxpayer (or contractor/subcontractor).
• Copies of any agreement entered into by taxpayer (or contractor/subcontractor) with a registered apprenticeship program.
• Documents reflecting any registered apprenticeship program sponsored by the taxpayer (or contractor/subcontractor).
• Documents verifying participation in a registered apprenticeship program by each apprentice.
• Records reflecting the required ratio of apprentices to journeyworkers prescribed by each registered apprenticeship program from which qualified apprentices are employed.
• Records reflecting the daily ratio of apprentices to journeyworkers, and the payroll records for any work performed by apprentices.

It’s still unclear exactly how the documentation must be maintained, how long it must be preserved, and which pieces, if any, must be submitted when filing.

The IRS released a new form for claiming the 179D deduction (Form 7205) in February 2023. However, the IRS is likely to roll out an even newer version of this form that may require demonstrated compliance with PWA requirements.

Deduction for Designers – The benefit of the deduction is not exclusive to property owners. Designers of government buildings have been able to benefit from the 179D deduction too. While the deduction can’t be claimed directly, it can be transferred through an allocation letter to an architect/engineer.Under the Inflation Reduction Act, designers of tax-exempt entity properties may do the same. Part IV of Form 7205, in fact, is exclusively for designers. The name of the building owner’s representative who executed the allocation letter must be included.

Alternative Deduction Election for Retrofits – The Inflation Reduction Act established an easier way for retrofits to qualify for the deduction. Instead of comparing to an ASHRAE standard, a building’s energy usage post-retrofit is compared to its energy usage pre-retrofit. To do so, building owners will likely compare two years of utility bills – the year before the retrofit and the year after the retrofit. Unfortunately, this will lead to a lag effect: taxpayers will need to wait a full year after a retrofit to get the data required to claim the deduction.

There are a lot of unanswered questions about this election:

• Will a full model be required, or will utility bills be sufficient?
• A “qualified retrofit plan” is required according to the Inflation Reduction Act, but what exactly does that entail?
• What kind of benefit is possible?
• Why should a taxpayer choose the alternative deduction election in light of the expected lag in receiving a benefit?

Guidance from the IRS on this program is expected.

Deduction Reset – Under the Inflation Reduction Act, the 179D deduction may be taken once every three years on a commercial building and once every four years on a building owned by a tax-exempt entity. This will be very beneficial for multiphase long-term projects.

45L Tax Credit

The 45L federal tax credit is intended for developers and home builders who produce energy-efficient homes and units. The legacy standard for the 45L was 50% better than the 2006 International Energy Conservation Code (IECC). Under the Inflation Reduction Act, however, taxpayers must meet Energy Star and/or Zero Energy Ready Home (ZERH) standards.

The IRS has released an updated version of Form 8908 for claiming the credit. This version of the form permits taxpayers to claim both legacy projects and Inflation-Reduction-Act-era projects simultaneously.

ZERH requirements vary by housing sector, which adds complexity to claiming this credit. The Department of Energy is coordinating with the IRS and will provide further guidance regarding certification requirements. Several program documents are still under development, and a schedule of expected release years is available here.

The 45L credit may reach up to $5,000 per dwelling unit for homes that meet the Department of Energy’s ZERH standards, or up to $2,500 per dwelling unit for homes meeting the Energy Star Standards. Like the 179D deduction, prevailing wage requirements must be met, but apprenticeship requirements do not apply.

On Sept. 27, 2023, the IRS clarified some documentation requirements with the release of Notice 2023-65. It explains that a contractor doesn’t need to file the Energy Star/ZERH Home Certification with his/her tax return, but must retain it under the IRC Section 6001 record keeping requirement. Furthermore, to substantiate the credit, the contractor must retain the dated certification along with records sufficient to establish the following:

• The home’s address.
• Taxpayer’s status as an “eligible contractor.”
• Name of person who acquired the home and proof that acquisition occurred during the tax year in which the credit is being claimed.
• Prevailing wage requirements when appropriate.

Builders must apply for Energy Star certification while still in the planning stages. This is a significant difference in procedure. Previously, builders just had to verify energy-efficiency after construction was complete. Planning ahead will be crucial in capturing the 45L credit moving forward.

We still need to learn how exactly this process works. From what we understand, an independent “energy consultant” will model a project before construction begins to ensure that Energy Star requirements will be met. If the model indicates a project will not meet the target, upgrades/adjustments must be made. During construction, a Home Energy Rating System (HERS) rater will make frequent field verifications and upload data to a home certifying organization. Finally, the project will be determined to be Energy Star compliant by home, unit, or lot.

This is a general understanding of the procedure, but further guidance on roles, timing, and documentation is eagerly anticipated.

Use with Other Credits – Multifamily structures that qualify for the Low Income Housing Tax Credit (LIHTC) may also qualify for the 45L tax credit. Under the Inflation Reduction Act, claiming the 45L tax credit will not impact the property’s adjusted basis and will not affect the value of the LIHTC.

Regarding concurrent use with the 179D deduction, the 45L credit was initially restricted to properties no more than three stories above grade. However, the Inflation Reduction Act eliminated this restriction.

It seems possible that, given the elimination of the height restriction, the 45L credit could be claimed concurrently with the 179D deduction, but we await additional direction on this matter.

Terri S. Johnson, CRE, is a partner at Capstan Tax Strategies. She enjoys helping entrepreneurs and tax professionals benefit from cost segregation, R&D tax credits, and federal energy incentives. She can be reached at tjohnson@capstantax.com.

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