Before the changes brought by the IRA, the Sec. 179D deduction was generally restricted to the owners of commercial properties and residential properties having four stories or more. Government entities with qualifying buildings could assign their deductions to qualified designers, including:
Environmental consultants, and
Energy services providers.
A qualified designer is one who creates technical specifications for the installation of energy-efficient commercial building property. Merely installing, repairing or maintaining such property isn’t sufficient to qualify.
To claim the deduction pre-IRA, a taxpayer had to show a 50% reduction in energy and power costs. The deduction amount was as much as 63 cents per square foot for each of three eligible systems:
HVAC and hot water,
Interior lighting, and
The building envelope.
The maximum deduction was $1.88 per square foot (adjusted for inflation). A partial deduction was allowed if the taxpayer couldn’t demonstrate the required savings in all three systems. Whether full or partial, you could claim the deduction only once per property.
Under the IRA, these requirements continue for the remainder of 2022, but 2023 will bring some big changes. For example, the qualification threshold falls to 25% energy savings, with a base deduction of 50 cents per square foot.
While the base deduction might seem relatively low, a “bonus deduction” could hike the ultimate deduction dramatically. If a project satisfies prevailing wage and apprenticeship requirements, you’ll be allowed to deduct up to $2.50 per square foot. And the deduction amount increases as the energy savings exceed 25% as follows:
If you meet the labor requirements, the deduction rises by 10 cents for each percentage point of savings over 25%, up to 50%, resulting in a maximum deduction of $5 per square foot.
If you don’t qualify for the bonus, the deduction rises by 2 cents for each additional percentage point up to 50%, producing a maximum deduction of $1 per square foot.
The IRA also changes the standard for calculating the amount of energy savings. The current rules apply the American Society of Heating, Refrigerating and Air Conditioning Engineers (ASHRAE) standard in effect two years before the start of construction. The IRA replaces that with the ASHRAE standard from four years prior to the completion of construction.
The law eliminates the partial deduction but allows taxpayers to claim the full deduction more than once. It generally can be claimed every three tax years for subsequent energy-efficient improvements. The IRA also provides a new alternative deduction for renovation projects.
Special Rules for Designers
For designers, the most important change under the IRA is that all tax-exempt entities will be permitted to allocate their deductions, not just governmental entities. That means qualified designers that work on properties for a wide range of clients — including charities, religious institutions, nonprofit schools and universities, hospitals, and museums — can claim the deduction.
Not surprisingly, it’s easier for a building owner to claim the Sec. 179D deduction than a designer. But, with a deduction of up to $5 per square foot, it’s certainly worth jumping through the additional hoops.
For starters, a designer must obtain a Sec. 179D study that calculates the deduction amount. The study is conducted by a qualified third party who’s a contractor or professional engineer licensed in the state where the property is located.
IRS-approved energy software is used to model the energy performance of the property at issue and compare it against the applicable ASHRAE standard. The third-party will also make a site visit to the property to confirm that the property has met or will meet the energy-savings targets in the design plans and specifications.
In addition, the third party must sign a certification to be included with the study. Among other things, the certification should state that the signer has examined the energy model and supports the allocation of the deduction to that particular designer.
Designers also need to provide an allocation letter, signed by both the designer and an authorized representative of the entity allocating the deduction. The letter must include:
The cost of the energy-efficient property, with labor,
The date it’s placed in service, and
The amount of the Sec. 179D deduction allocated to the designer.
The entity can allocate the entire credit to a single designer or make proportional allocations to multiple designers. It remains to be seen if different or additional information will be required when the deduction is allocated by a tax-exempt entity that isn’t governmental.
Valuable Cash Flow Tool
With the Sec. 179D deduction, qualified builders and designers can reduce their tax bills and, in turn, improve their cash flow. Contact your tax advisor to help you make the most of this and other energy-efficiency tax incentives.