How the Inflation Reduction Act Changed Section 179D for Energy Efficient Buildings

Section 179D (“179D”) was originally, albeit initially temporarily, signed into law in 2005 to reduce energy use in the US. The provision has been extended numerous times over the years until the provision was made permanent in 2020. Although there were minor tweaks to the provisions of 179D since its inception, the most drastic changes occurred with the Inflation Reduction Act (“IRA”) of 2022. It’s important to review what the old (pre-2023) section 179D entailed to understand the changes made as part of the IRA, effective January 1, 2023. 

The pre-2023 179D allowed for a deduction for energy efficient upgrades — either during initial construction or later improvement to an established building — of up to $1.80 per square foot adjusted for inflation ($1.88 for 2022), not to exceed the cost of the improvement. To qualify for the deduction, a taxpayer had to make an improvement that increased energy efficiency by a cumulative 50% in the following three areas: 

1. Interior lighting
2. Heating, cooling, ventilation, and hot water (“HVAC”)
3. Building envelope

If improvements were made in only one or two of those areas, taxpayers could also receive a partial deduction. No matter which deduction the taxpayer took, whether partial or full, the taxpayer would be entitled to the deduction strictly once and would not be entitled to deductions for future improvements. Further, the deduction is permitted for non-tax-exempt entities that own a commercial or four (or more)-story residential building.

Changes Made to the 179D Deduction 

The IRA made significant changes on how to qualify for and calculate the 179D deduction. The new law increased the maximum deduction from $1.88 to $5 per square foot and cannot exceed the cost of the improvement. However, the taxpayer must now meet a prevailing wage and apprenticeship requirement, which can be costly. The prevailing wage requirement dictates that the taxpayer pays wages at the prevailing rate in the area the construction is being performed. Additionally, the apprenticeship requirement states that 12.5% effective 2023 (15% effective 2024) of total trade hours incurred during the construction are at the apprentice level. If the taxpayer does not meet both the prevailing wage and apprenticeship requirement, the potential deduction is reduced from $5 to $1 pr square foot. 

The IRA also provided an alternate route to qualify for the 179D deduction: the ability to make retrofits to a building every 3 years (4 years for tax exempt entities). The retrofit procedure offers the taxpayer additional opportunities to receive the 179D deduction, so long as the retrofit shows a 25% decrease in energy use intensity as compared to the building pre-retrofit. 

Considerations for the 179D Deduction 

Although the potential benefit of the 179D deduction has been drastically improved, there are still downsides to the deduction. The taxpayer must get a certification from a qualified engineering firm, which is expensive. The second drawback is that the taxpayer must recapture the deduction as ordinary income instead of a potential 25% rate when they sell the building. Additionally, the prevailing wage and apprenticeship requirement can add substantial cost to a project. As such, the taxpayer should consider their personal situation and consult with a tax professional who will review and analyze whether the 179D deduction is the best approach for the taxpayer’s business.