Section 179D of the Internal Revenue Code offers a tax deduction for energy-efficient improvements made to commercial buildings.
Available since the Energy Policy Act of 2005 and made permanent in 2021, this deduction focuses on the energy efficiency of buildings and their systems. Specifically, it provides incentives for commercial property owners who install energy-efficient heating, ventilation, air conditioning, hot water systems, lighting, and components of the building envelope system.
At first glance, the post-Inflation Reduction Act (IRA) deductions seem limiting without investing a lot of time tracking for prevailing wage and apprenticeship. It’s important to remember that there may be significant benefits from the §179D deduction that could have been overlooked in previous years, potentially offering substantial tax savings worth exploring. This article aims to encourage commercial building owners and their CPAs to re-evaluate past investments and explore how they can still capitalize on §179D.
Looking Beyond the IRA (or Pre-IRA)
Before the changes stemming from the IRA, the requirements were focused solely on energy-efficiency standards, which included achieving a 50% reduction in energy and power costs compared to a baseline established by ASHRAE 90.1 standards. The maximum deduction amount was up to $1.80 per square foot for a qualifying commercial building that met the energy-efficiency requirements. Buildings that did not meet the 50% savings could still benefit under the provision that allowed for partial deductions. The benefit for these buildings meeting partial deduction was $.60 per square foot for each system that met specified savings percentages. Also available was the interim lighting rule that allowed for open air garages to benefit from the §179D deduction.
Keep in mind that this incentive applies not only to newly constructed buildings but also to any that have undergone energy-efficient upgrades, renovations, or additions.
Taxpayers can look back to 2006 to identify missed opportunities in those early years where the value of §179D may have been simply overlooked or undervalued. One of the most appealing aspects of claiming the §179D deductions for past projects for the private taxpayer is that the tax returns do not need to be amended. Instead, taxpayers can claim the deduction on their current return by filing Form 3115, Change in Accounting Method, to catch up the missed deductions.
Post-IRA
The IRA introduced some changes to the §179D deduction requirements. The energy reduction criteria adjusted to a sliding scale, now requiring a reduction between 25% to 50%. In addition, the provisions for partial deductions and interim lighting were eliminated. The new requirements also include stipulations for prevailing wage and apprenticeship.
The benefit amounts post-IRA also shifted into two tiers. The first tier, which is simply tied to the energy reduction, is between $.50 per square foot to $1 per square foot (adjusted for inflation). The second tier adds in the additional required layer of prevailing wage and apprenticeship. The deduction amount, if both the energy reduction requirement and the prevailing wage and apprenticeship rules are met, is $2.50 per square foot to $5 per square foot (adjusted for inflation).
While the intention is to encourage higher wages and enhance the long-term skill level of the construction industry in regard to energy efficiency, the prevailing wage and apprenticeship requirements can be challenging to fulfill. For projects placed in service on or after January 1, 2023 and seeking the higher deduction amounts, both requirements must be met. The prevailing wage rules specify that all laborers and mechanics on site during construction must not be paid less than local prevailing wages. These workers must be documented on a weekly basis along with records of hours worked, wage rates paid, job classifications, addresses, telephone numbers, and email addresses.
The rules for apprenticeship provide qualifications related to labor hour, ratio, and participation requirements. There is a minimum hour percentage starting with 12.5% for construction beginning in 2023 and 15% for construction beginning in 2024 or after. Any contractor, subcontractor, or vendor must have at least one apprentice if four or more employees will be on site during construction, alteration, or repair.
Another area of focus for missed opportunities is a potentially overlooked exception to tracking prevailing wage and apprenticeship that will allow projects meeting the energy reduction requirements to obtain the higher-tiered deduction. This exception alleviates the burden of maintaining complex documentation and simply allows these projects to qualify for §179D deduction in the $2.50 to $5 per square foot range. Projects that begin construction prior to January 29, 2023 that fall between 25% to 50% in energy reduction requirements are allowed to waive the prevailing wage and apprenticeship requirements. The IRS defines the beginning of construction as the point at which “physical work of a significant nature” on a project starts. Another way to determine the start of construction is based on the 5% safe harbor, which includes 5% that has either been paid or incurred on a project.
Taxpayers should carefully assess their project timelines and documentation to help ensure they can substantiate the construction commencement date. The exception for projects that commenced prior to this date provides a valuable opportunity.
As we look back at previous projects, it’s crucial to recognize that opportunities for tax savings and energy-efficiency improvements may still be within reach, so it is essential to take the time to review prior projects. The benefits of §179D potentially await those who are willing to look back.
If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.