The 2022 Inflation Reduction Act updated the Section 179D energy efficient commercial buildings tax deduction for tax years beginning after December 31, 2022. This enactment primarily enables building owners and commercial real estate investors to claim a tax deduction for installing qualifying energy efficient systems in their buildings.
Energy Efficient Commercial Buildings Tax Deduction
The energy efficient commercial buildings tax deduction is allowed for all or part of the cost of installing energy efficient devices or systems on commercial building property in the following areas:
- Interior lighting systems
- Heating, cooling, ventilation, and hot water systems
- The building envelope (e.g., windows and roofing)
Installation of energy-efficient commercial building property occurs when constructing a new, or improving an existing, commercial building or government building. The deduction was enacted to encourage commercial building owners or lessees to install energy efficient property. Beginning January 1st, 2023, eligibility for the deduction has expanded to include commercial building owners or lessees, designers of energy efficient commercial building property installed in government-owned buildings, Indian tribal governments, Alaska Native Corporations, and tax-exempt organizations. It acts as an incentive to practice healthy energy use and implement new processes across businesses and individuals nationwide.
Updates to the Tax Deduction from the Inflation Reduction Act of 2022
The Inflation Reduction Act of 2022 increased the maximum deduction for the energy efficient commercial buildings tax deduction. It also updated the eligibility requirements for the reduction of energy costs, in addition to other changes. Notably, the act also provided updated guidance on clean vehicle energy tax credits and energy efficient home improvement tax credits.
Efficiency Standard Eligibility
The 2022 Inflation Reduction Act updates eligibility requirements for the energy efficient commercial buildings tax deduction. The new requirements state that the property must achieve a reduction in energy costs that is equal to or greater than 25% when compared to a reference building. The reference building is one that meets the most recent standard for energy efficiency. So, the evaluated property must demonstrate a significant improvement in energy efficiency, resulting in lower energy costs compared to the reference building.
This is a decrease from the previous eligibility requirement of 50% or more. Smaller projects may now be eligible for the energy efficient commercial buildings tax deduction. By reducing the baseline annual energy savings percentage requirements and adding a sliding scale, the new regulations broaden the scope of eligible properties for energy savings deductions. This change addresses the challenge faced by owners of older properties who struggled to meet the previous 50% energy savings threshold.
The applicable dollar value of the deduction is $0.50 per square foot, increased by $0.02 for each full percentage point above 25% that a building’s total annual energy cost savings are increased. The amount cannot be greater than $1.00 per square foot. However, the maximum amount of the deduction in any tax year cannot exceed $1 per square foot minus the total deductions taken in the previous three tax years (or during a four-year period in cases where the deduction is allowable for someone other than the taxpayer). The applicable dollar value will be adjusted for inflation for tax years beginning after 2022.
Assume a 20,000 square foot commercial facility completed a renovation to their HVAC system and interior lighting in 2023. Assume that the energy cost savings achieved on the HVAC system is 15.8% and interior lighting cost savings is 21.3%. In the following table, the total energy savings is 37.1%
In this example, the building’s energy cost savings increase is 37.1%, which is 12.1% above the 25% threshold. Since each full percentage point above the 25% threshold increases the deduction rate by $0.02, the added dollar value over $0.50 per square foot is calculated as (12% * $0.02) = $0.24 per square foot. Adding the base deduction rate $.50/sf to the additional value of $0.24/sf sums to $0.74 per square foot, which amounts to $14,800 on a 20,000 square foot facility.
If the 50% or higher energy savings were achieved or prevailing wage requirements were met, the project table would be modified to look like one of the following tables depending on whether prevailing wage or apprenticeship requirements were met:
Project without Prevailing Wage
Note: the maximum deduction in any tax year is limited by the total deductions taken in the previous three tax years (or during a four-year period for someone other than the taxpayer) so limitations may apply in certain cases.
Alternative Tax Deduction for energy efficient retrofit property
Under the 2022 Inflation Act, taxpayers may elect to take an alternative deduction for a qualified retrofit of any qualified property. However, instead of a reduction in total annual energy power costs, the deduction is based on the reduction of energy usage intensity.
Additional details on the 2022 Inflation Reduction Act update are provided on the IRS website. For further information about the energy efficient commercial buildings tax deduction and how your business might qualify for the deduction, our CPAs are available for assistance to address the specific needs of your organization.