Commercial building owners and tenants have been entitled to deductions under Section 179D since 2006. While the deduction has served as an incentive to make commercial buildings energy efficient, it may not have been impactful enough to sway decisions on improvements that move the needle.
Under the Inflation Reduction Act of 2022 (IRA), however, the deduction now attached to energy-efficient improvements for tax years beginning after December 31, 2022, has the potential to generate significant tax savings. These enhanced savings may be the incentive owners and tenants need to help commercial buildings take the leap into higher levels of energy efficiency.
What is Section 179D?
Section 179D is a deduction available to commercial building owners, as well as tenants, architects or engineers, under certain situations, who make energy-efficient investments into new or existing commercial buildings. To qualify, an improvement must reduce annual energy and power costs by at least 25% relative to certain industry standards — previously this rate was 50%. This reduction must be certified by a contractor or engineer, and often can be part of a cost segregation study.
The amount of the deduction is based on the square footage of the building being improved multiplied by an “applicable rate.” The IRS annually publishes the applicable rate, which is tied to the number of building systems being improved. There are three potential building systems available for 179D treatment:
- Interior lighting systems
- Heating, cooling, ventilation and hot water systems
- Building envelope
It is important to note that this incentive is an accelerated deduction of otherwise depreciable property and not a credit against tax owed. As a result, the deduction allows for building owners to expedite cost recovery of improvements into the year placed in service, rather than over longer depreciable lives of typically 39 or 40 years.
A Revised Applicable Rate for 179D
The most important change to Section 179D under the IRA is the applicable rate for tax years beginning after December 31, 2022. Previously, the maximum applicable rate for Section 179D deductions was $1.80 per square foot, indexed for inflation ($1.88 in 2022). Each building system improved entitles a taxpayer to one-third of the applicable rate.
For example, if only HVAC was improved in 2022, this would provide a deduction of $0.63 per square foot. However, if all three applicable building systems were improved, the full $1.88 per square foot would be deducted. Under the IRA, the partial deduction rules for each building system above have been removed and the applicable rate has been increased to a maximum of $5 per square foot, but there are also new requirements:
- The applicable rate is based on a sliding scale, determined by the amount of energy reduction created by the improvements. The applicable rate can range from $2.50 per square foot for 25% energy reduction, up to $5 per square foot for 50% energy reduction or more. The applicable rate increases by $0.10 for each percentage point increase over 25%.
- The taxpayer must pay prevailing wages and follow apprenticeship requirements during the installation of energy efficient property. If a taxpayer does not meet these requirements, the sliding scale for the applicable rate slides from $2.50-$5 down to $0.50-$1. The prevailing wage and apprenticeship requirements also come with harsh penalties for taxpayers that claim to meet them but did not. Prevailing wage and apprenticeship requirements are a common aspect of energy tax credits and deductions under the IRA.
Read “What Prevailing Wage and Apprenticeship Requirements Mean for Energy Tax Credits”
More Opportunities to Benefit from 179D
The IRA also expanded eligibility for the deduction to tax-exempt and governmental organizations. As these entities by nature would not benefit from a tax deduction, the IRA allows them to pass the deduction onto the property designer, including architects and engineers. This makes 179D important even to a tax-exempt organization. Passing on the deduction should reduce the organization’s overall cost of energy efficient improvements on a project since the contractor will receive a special tax deduction from being involved on the project.
What to Consider When Evaluating Section 179D Improvements
When deciding if certain energy-efficient improvements are worth their cost, there are several factors to consider:
- Cost of the improvements versus less expensive alternatives
- Cost of paying prevailing wage and meeting apprenticeship requirements
- Cost of certifying a Section 179D deduction
- Length of a taxpayer’s holding period of the property
- Cost savings of energy-efficient property over the improvement’s life (or the holding period)
- Impact on the value of property with energy-efficient improvements
- Extent of tax savings, considering aspects such as:
- Applicable federal, state and local income tax rates in the year of deduction
- Loss limitations, including those on passive and business losses
- Future recapture of deduction if the property is sold
It is best to model out all expected costs and savings expected from a project to understand the investment’s ROI both initially and over time. On an ongoing basis, keeping an eye on any relevant tax law changes will be critical.
Keep in mind since this is not a new deduction, if you believe an improvement may have qualified for Section 179D treatment previously but you didn’t claim it, you may still have time. This deduction can be included as part of an amended return for a period of time after the original tax return was filed, so you will want to act quickly. Regardless of whether you are considering new improvements to capitalize on the increased applicable rates or want to look at benefiting from older projects, contact your tax adviser and start the conversation.
Contact Justin Gartner at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.