This blog was provided Capstan, a premier sponsor of the PICPA.

By Terri S. Johnson, CRE  

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As we approach the Aug. 16 anniversary of the passage of the Inflation Reduction Act of 2022, now is a good time to remind practitioners and CPAs in industry of its impact on federal energy-efficiency tax incentives. This blog summarizes the major changes the act made to the EPAct Section 179D deduction and Section 45L credit, including updated clarifications from Announcement 2023-01 (Dec. 23, 2022) and Notice 2022-61 (Nov. 30, 2022 – see sidebar at bottom).

EPAct Section 179D Tax Deduction

Created as part of the Energy Policy Act (EPAct) of 2005, the Section 179D tax deduction was made permanent by the Consolidated Appropriations Act of 2021 (CAA). The federal deduction may be applied to ground-up energy-efficient construction projects as well as to energy-efficient retrofits. Section 179D applies to all types of energy-efficient commercial buildings (EECB) and residential rental buildings that are at least four stories high.  

The Inflation Reduction Act increases and expands the utility of 179D in several ways, including the following:  

Lowers the minimum EECB efficiency standard required to qualify – Under the Inflation Reduction Act, taxpayers must demonstrate a 25% reduction in total annual energy and power costs relative to benchmark. Previously, taxpayers had to demonstrate a 50% reduction in costs relative to benchmark.  

This is a win for taxpayers. The Consolidated Appropriation Act stepped up the benchmark standards quite a bit, in essence mandating a 75% efficiency gain over the previous 2004 standard. The new standard will make it easier for taxpayers to achieve the 179D deduction moving forward.  

Increases the maximum potential deduction to $5.00/square-foot (sf) – The deduction is determined using an applicable dollar value (ADV) multiplication factor. The initial value and eventual cap of the ADV varies, depending on whether prevailing wage and apprenticeship requirements are satisfied (see sidebar at bottom).

As mentioned above, 25% is the new minimum energy reduction threshold that must be met to qualify for the deduction. The ADV will reward taxpayers who exceed this minimum threshold up to a certain cap.

 

	If Requirements Are Satisfied	If Requirements Are Not Satisfied
Minimum Initial Value of ADV	$2.50/sf	$.50/sf
For Every 1% Point of Energy Reduction Beyond 25% Threshold, the ADV will Increase By	$0.10	$0.02
Maximum Value of ADV	$5.00/sf	$1.00/sf

 

The previous max deduction was $1.80/sf, which was increased to $1.88/sf in 2022 due to inflation. This was derived from a maximum of $0.63/sf from each of three focus areas – HVAC, lighting, and building envelope. (If taxpayers could not fully demonstrate savings in all three categories, they could claim a partial deduction. Partial deductions are no longer permissible under the Inflation Reduction Act. The legacy 179D interim lighting rule has also been eliminated.)  

The new method of calculation may be extremely promising, particularly if prevailing wage and apprenticeship requirements are met. Consider this example: a 100,000/sf qualified property demonstrates a 50% reduction in total annual energy and power costs. This is a change of 25 percentage points beyond the minimum threshold, as you can see in the tables below.  

 

Old Law: Pre-2023
HVAC	$0.63/sf
Lighting	$0.63/sf
Building Envelope	$0.63/sf
TOTAL	$1.88/sf
TOTAL BUILDING DEDUCTION:	$188,000

 

 

New Law: Post-2022	If Requirements Satisfied	If Requirements Not Satisfied
Base ADV	$2.50/sf	$.50/sf
For Every % Point Below Energy Threshold, ADV will Increase by	$0.10	$0.02
	25 % Points x $0.10 = $2.50  The base ADV will increase by $2.50	25% Points x $0.02 = $.50  The base ADV will increase by $0.50
FINAL ADV	$5.00/sf	$1.00/sf
TOTAL BUILDING DEDUCTION:	$500,000	$100,00

 

If the prevailing wage and apprenticeship requirements are met, the 179D deduction under the new law would more than double.  

Note that the ADV cap has been met. Even if the building managed to achieve a 60% reduction in energy – a 35 percentage point change beyond the threshold – the total building deduction would not exceed $500,000.  

It’s important to note that the total deduction is still dependent on building size. Whether you are working under the old or new laws, large buildings will consistently generate the greatest 179D benefit.  

Changes ASHRAE standard used for benchmarking – 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. Previously, the most recent standard published two years before the building’s construction was used. As of August 2022, the most recently published standard remains ASHRAE 90.1-2007. On Dec. 23, 2022, the IRS released Announcement 2023-01 to clarify the use of ASHRAE reference standards moving forward.

Allows the EPAct Section 179D deduction on building projects for tax-exempt entities – Designers, architects, and engineers may use the deduction on projects for religious and charitable organizations, private schools, Native American tribal governments, and various nonprofits. Previously, the deduction could only be taken by designers of energy-efficient government-owned or leased building projects.  

Establishes an alternative deduction election for retrofit projects – Retrofits can now qualify by showing at least a 25% decrease in “energy use intensity” compared with the building preretrofit. A qualified retrofit plan is required, and the election must be taken in the year of final qualifying certification. Also, the property must have been placed-in-service at least five years before the establishment of the qualified retrofit plan. The relative simplicity of this Alternative Deduction Election should encourage energy retrofits, resulting in greater 179D benefits.  

Permits deduction reset – A deduction may now be taken every three years on a commercial building and every four years on a building owned by a tax-exempt entity. In the past, a property owner was permitted to take the 179D deduction only once.  

The deduction reset allowance in the Inflation Reduction Act encourages developers to continue to improve property efficiency. This will be beneficial to long-term, multiphase energy upgrade projects.

Section 45L Tax Credit

The Section 45L tax credit is a one-time federal tax credit that promotes the construction of energy efficient residential dwellings. The credit is available to builders, developers, and others who build homes for sale or lease. Credit is allocated per dwelling unit.  

The Inflation Reduction Act retroactively extended the initial 45L tax credit for properties placed in service through 2022. For projects placed in service in 2022, the $2,000 credit per dwelling unit and the existing qualification criteria remain unchanged. Residential rental property no more than three stories above grade are eligible for the credit.  

The Inflation Reduction Act also extends the 45L tax credit for projects placed in service from Jan. 1, 2023, to Dec. 31, 2032. For these projects, several major changes are in effect:  

• The energy efficiency requirement for the 45L tax credit changes from 50% better than the 2006 IECC energy code to Energy Star and Zero Energy Ready (ZER) home standards.  
• Energy Star and ZER home programs don’t include a height requirement for qualification. Residential projects of any size may be eligible for the 45L tax credit under the Inflation Reduction Act.  
• The maximum tax credit increases to up to $5,000 per dwelling unit:
  • The maximum tax credit for a single-family Energy Star home is $2,500.
  • The maximum tax credit for a single-family ZER home is $5,000.
  • For the Energy Star Multifamily program (five units or more), the credit is $2,500 per unit, subject to prevailing wage provisions. If these provisions are not followed, the credit is reduced to $500 per unit.  
• Section 42 Low Income Housing Tax Credit (LIHTC) projects will not need to take the 45L credit into account when determining adjusted basis of a property for the LIHTC.

Single-Family Dwelling Units Under the Inflation Reduction Act

Single Family Unit Type	Leased or Sold in	Requirement Criteria	Maximum Tax Credit Per Unit
Energy Star Home	2023	Energy Star Single-Family New Homes National Program Requirement 3.1	$2,500
Energy Star Home	2024	Energy Star Single-Family New Homes National Program Requirement 3.1	$2,500
Energy Star Home	2025-2032	Energy Star Single-Family New Homes National Program Requirement 3.2 AND must meet most recent set of local Energy Star Single-Family New Homes Requirements (published within two years of dwelling unit acquisition)	$2,500
Mobile Home	2023-2032	Energy Star Manufactured Home National Program Requirements (most recent version published within two years of dwelling unit’s acquisition)	$2,500
Zero Energy Ready Home	2023-2032	Zero Energy Ready Home Program of the Department of  Energy in effect on January 1st, 2023 (or the successor program)	$5,000

Multifamily Dwelling Units Under the Inflation Reduction Act

Multifamily Unit Sold or Leased In	Requirement Criteria	Maximum Tax Credit Per Dwelling Unit
2023-2032	Energy Star Multifamily New Construction National Program Requirements (most recent version published within 3 calendar years of construction/renovation) AND Energy Star Multifamily New Construction Regional Program Requirements applicable to location of dwelling unit (most recent version published within 3 calendar years of construction/renovation)	$2,500/unit if prevailing wage requirements are met  $500/unit if prevailing wage requirements are not met
Multifamily Unit Sold or Leased In	Requirement Criteria	Maximum Tax Credit Per Dwelling Unit
2023-2032	Zero Energy Ready Multifamily New Construction National Program Requirements (most recent version published within 3 calendar years of construction/renovation) AND Zero Energy Ready New Construction Regional Program Requirements applicable to location of dwelling unit (most recent version published within 3 calendar years of construction/renovation)	$5,000/unit if prevailing wage requirements are met  $1,000/unit if prevailing wage requirements are not met

This is a win for LIHTC developers. In the past, claiming the 45L credit resulted in a mandatory basis deduction and a corresponding decrease in the subsequent LIHTC credit.   

Under the legacy 45L program, 45L eligibility was limited to residential rental property with a maximum of three stories. Under the Inflation Reduction Act, all residential properties may be eligible for 45L credit. This change in qualification criteria means that multifamily projects that are four or more stories high may now qualify for both 179D tax deductions and 45L tax credits.  

These legislative extenders and enhancements may positively impact your clients. If eligible, they certainly will want to take advantage of these powered-up incentives. 

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The Prevailing Wage and Apprenticeship Catch

The increased benefit levels for energy-efficient incentives under the Inflation Reduction Act may only be obtained when prevailing wage and apprenticeship requirements are satisfied. The following applies to facilities that began construction on or after Jan. 30, 2023. Notice 2022-61 permits taxpayers to rely on prior guidance, including the Physical Work Test and the 5% Safe Harbor, to determine the beginning of construction.

Prevailing Wage Rate Requirements  

The prevailing wage requirement states that mechanics and laborers must be paid no less than the prevailing wages required to be paid for federal construction work. (The wage will vary based on exact job description and geographic location.)   

A taxpayer fulfills the prevailing wage requirement for Sections 179D and 45L by ensuring that laborers and mechanics employed in the construction, alteration, or repair of an energy-efficient commercial building or retrofit are paid no less than the prevailing wage expected in that location. The taxpayer must document the payment of the prevailing wage, “…including books of account or records for work performed.” The Notice specifies that “sufficient records” must be maintained, but doesn’t specify exactly what would be considered “sufficient.” Records would likely include, but are not limited to, identifying the applicable wage determination, the laborers and mechanics who performed construction work on the facility, the classifications of work they performed, their hours worked in each classification, and the wage rates paid for the work.  

The prevailing wage rate is generally made by the U.S. Secretary of Labor. Taxpayers can rely on the prevailing wage determinations published on www.sam.gov, which lists the prevailing wage for most labor classifications and geographical areas. If a specific classification is not listed, contact the Department of Labor, Wage and Hour Division.   

Apprenticeship Requirements  

Taxpayers must satisfy two sets of requirements regarding apprenticeships and sufficient records must be kept:  

• Qualified apprentices must be used for certain minimum percentages of the total hours worked on a construction project.  

- If construction begins before Jan. 1, 2023, 10% of total labor hours must be performed by qualified apprentices.
- If construction begins in 2023, 12.5% of total labor hours must be performed by qualified apprentices.  
- If construction begins after Dec. 31, 2023, 15% of total labor hours must be performed by qualified apprentices.

• Apprenticeship participation requirements: If a taxpayer employs four or more individuals in a construction project, the taxpayer must also employ one or more qualified apprentices.

 

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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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Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.