By now, most people have heard of the changes resulting from the Inflation Reduction Act of 2022, including those affecting the 179D and 45L. But what do these changes mean in practice? Will the average taxpayer qualify for a larger deduction or credit, or will their eligibility drop?
Let's start by looking at these programs prior to this new law. The 179D, also known as the energy efficient building deduction, allows real estate owners to claim a deduction of up to $1.80 per square foot for the installation of energy efficient improvements to a building. Further, the 179D deduction can be transferred in the case of buildings owned by federal, state or local governments to the entity responsible for the energy efficient design. This deduction was made permanent under the Consolidated Appropriations Act in 2021, but it was changed dramatically under the new Inflation Reduction Act of 2022.
To qualify for the full 179D deduction under the old rules, a taxpayer needed to show an energy savings of 50% as measured by the American Society of Heating, Refrigerating and Air Conditioning Engineers standard 90.1-2007. The tax code also allowed for partial deductions of $0.60 per square foot for savings related to the lighting, HVAC and building envelope.
Starting in 2023 under the new law, the partial deduction is replaced with a sliding scale for deductions when a building realizes a reduction in energy consumption from 25% to 50%. If the taxpayer reduces energy use by 25%, the deduction is now $0.50 per square foot but goes up to $1.00/sf if the building reduces energy consumption by 50%. The law does allow for a larger deduction if the property is constructed using "prevailing wages" as set forth by the Secretary of Labor. If the prevailing wage requirements are met, the deduction will increase to $2.50/sf for a 25% reduction up to $5.00/sf for a 50% reduction.
As opposed to 179D, which is a deduction taken against depreciable basis, 45L is a tax credit for the construction of energy efficient homes. This credit expired at the end of 2021 but was extended with little change for 2022 and then modified for tax years through 2032. Under the old rules, which will stay in place through 2022, the home's efficiency is compared to the 2006 International Energy Conservation Code. If the home is 50% more efficient than the IECC requirements, the contractor is eligible for a $2,000 per residence tax credit. Starting in 2023, the amount of the credit and the calculation both change.
Starting in 2023, the base credit goes to $2,500 with a potential credit of $5,000 for single-family homes. For multifamily homes, the base credit goes to $500 per unit with a potential of up to $1,000. However, to qualify, the new law requires homes to meet the efficiency requirements of the Energy Star Residential New Construction Program, with the higher credits requiring meeting the requirements of the Zero Energy Home Program. Further, multifamily homes are eligible for the credit to increase to $2,500 to $5,000 per unit if prevailing wages are met.
So what does this mean for taxpayers? For the 179D deduction, the biggest factor will be the prevailing wage requirements. To satisfy them, all laborers, mechanics, contractors and subcontractors must be paid wages at the prevailing rate as determined by the Secretary of Labor, and apprenticeship requirements must be met. For many construction projects, this might be hard to do, which will limit a taxpayer's qualification for the larger deduction. In states where union labor is more common, it might be less problematic. But either way, taxpayers will need to see how the IRS interprets this position.
For the 45L tax credit, the new standard may affect what properties qualify. Since the IECC and Energy Star differ substantially, contractors will need to verify that the properties meet the requirements. Additionally, the larger credits on multifamily homes will require that prevailing wages are met.
For some taxpayers, these new requirements will be a welcome change, as they will increase the tax savings on an annual basis. However, other taxpayers might see their savings drop or their properties not qualify. The actual effects of these changes will be hard to gauge until the IRS finalizes regulations and taxpayers start modeling their properties for 2023 and beyond.
