179D Archives - Source Advisors

The IRA’s Impact on Your Real Estate Clients’ 2023 Tax Returns

Franklin Chow on January 19, 2024

The Inflation Reduction Act of 2022 brought changes to the §179D Energy Efficient Commercial Building Tax Deduction, a flagship federal tax incentive. Knowing how to navigate the updates is going to be important for CPAs this tax season.

It started as the ‘Build Back Better’ bill, and in an eleventh-hour change in mid-2022, it became the Inflation Reduction Act of 2022 (the ‘IRA’).

While the IRA included a wide range of changes and updates, a central theme throughout the bill was clean energy.

As we enter the first tax season since the IRA became law, being aware of the key changes introduced by the Act will not only help CPAs build credibility among their real estate clients but may also help their clients uncover substantial tax benefits too.

Section §179D Energy Efficient Commercial Building Tax Deduction

Having been introduced into law in 2005, the §179D Tax Deduction (179D) may not be new, but it did undergo substantial updates as part of the IRA in 2022.

179D is a tax mechanism that was implemented to reward the developers of contemporary and energy efficient commercial or high-rise residential buildings.

To take the deduction, a series of steps need to be followed, including the development of an energy model using Department of Energy approved software, and a site inspection undertaken by a third-party professional engineer licensed.

From a tax standpoint, taking the deduction for a building placed into service in a previous year requires a change of accounting method (through form 3115), and the basis of the building is to be reduced by the deduction taken.

The Tax Side of 179D

As noted, 179D is a deduction, not a credit. For the actual tax benefit to be calculated, the deduction needs to be multiplied by the company’s tax rate.

If the company has a tax liability, it can use these deductions to reduce its assessable income and ultimately reduce its tax liability. Without a tax liability, it can be carried forward indefinitely.

Additionally, the basis of the building needs to be reduced by the amount of deduction taken. This is important to note that if the company decides to sell the property shortly after taking the deduction, capital gains are likely to be higher due to the lower basis value. As the years go by, this becomes less of an issue due to depreciation.

How 179D Worked Pre-IRA

Before the introduction of the new laws, energy efficiency was measured across (1) lighting, (2) envelope, (3) HVAC systems, and a tax deduction of up to $1.80 (adjusted for inflation depending on the year) was available for eligible buildings.

For developments that only demonstrated efficiency across one or two of the systems, a deduction of $0.60 (again, adjusted for inflation) was available per system.

Additionally, REITs were unable to take advantage of the incentive.

How the IRA Changed 179D

The IRA overhauled the incentive by removing the concept of ‘partial qualification’ and increasing the value of the deduction. Now, the deduction starts at $2.50 per square foot for a building that is 25% more efficient than a 2007 reference building, and increases $0.10 for every percentage of increased efficiency, capped at $5.00 per square foot (adjusted for inflation).

Under the new laws, REITs are also able to benefit from the deduction, and the developer is now required to have met apprenticeship and prevailing wage requirements to be eligible for the increased deduction.

You can find the rules for apprenticeship and prevailing wage outlined by the Department of Labor here.

Grace Period

In some guidance released by the IRS on the revamped 179D program, it was put forward that buildings on which construction began prior to 29 January, 2023, and were placed in service after that date are not required to meet the prevailing wage and apprenticeship requirements.

This guidance means that the larger deduction range is accessible for many developers who placed their buildings into service during 2023, or still plan on doing so in 2024.

Key 179D Questions for CPAs To Ask This Tax Season

Considering the changes to this tax incentive, here are some direct questions CPAs can ask their real estate client to determine whether 179D is relevant.

Did you complete any real estate construction, renovation, or retrofit projects over the last few years?
This is a great qualifying question to see if it is worth your client’s time to look at accessing the incentive.
Did any of those projects have a gross square footage of 30,000 square feet or more?
While this is not an eligibility question per say, this size is generally the minimum size for the cost of undertaking a 179D study to be worthwhile.
When did the projects break ground?
This should give a clear indication as to whether the project is covered by the grace period where prevailing wage and apprenticeship requirements are not needed to be met. It is still uncommon for standard commercial development projects to meet those standards, so the chances of qualifying increase substantially if the project broke ground prior to January 29, 2023.
When were the projects placed in service?
This should provide insight into the version of the incentive the project may be eligible for.

Connect With a Specialist

When discussing 179D with your clients, make sure to have a 179D specialist in your corner. The signs of a reliable specialist are:

These advisors are not only out there, but would likely be delighted to be your point of contact for engineering-based real estate incentives going forward.

R&D & Energy For Real Estate: Tax Accounting Methods

Brian Coddington on November 15, 2021

What Does the IRS Extending the R&D Tax Credit Claims Transition Period Mean?

Construction and real estate firms often ask us: “How do we qualify for the R&D tax credit?” Our boilerplate answer is to review the 4-part test below to ensure you have a qualification marker that covers the activities you are performing to create or improve your products or processes

Qualification: The 4-Part Test

Permitted Purpose

The activity must be intended to develop or improve a business component’s (product, manufacturing process or software):

Elimination of Uncertainty

The activity must be intended to discover information to eliminate technical uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of business component design.

Technological in Nature

Source Advisors reclassified 9% or $2,013,000 into Qualified Leasehold Improvement Property 3% or $605,000 to 15-year land improvements and 20% or $4,421,000 as 7 and 5-year tangible personal property. In this example, the taxpayer had chosen to opt-out of bonus depreciation in most years, if the full benefits of bonus depreciation were realized, the benefits would have been higher.

Process of Experimentation

Substantially all of the activities must be elements of a process of experimentation:

Developing one or more hypotheses (design alternatives or prototyping)
Designing and conducting experiments to test and analyze those hypotheses
Refining or discarding those hypotheses to design the business component
Modeling, simulation, trial and error testing

Qualified Research Expenses Include:

Wages including direct support & direct supervision
Supplies
Contract Research Expenses
- Must retain rights & risks to the research performed
- Limited to 65% of total costs
Computer Rental and Cloud

The next question we often get is: “How do we accumulate the expenditures for the R&D tax credit?”

1. Salaries & Wages

Your expenditures for R&D include internal costs such as salaries, wages, supplies, computer rental, lease, etc. and external expenditures such as your contractor costs. There are three components of salaries and wages:

Direct research. This includes people specifically performing the activities, (researchers, engineers, CAD associates, project managers, etc.) and is the core of the credit.
Supervisors. Anyone who is directly supervising employees doing the direct development.
Direct support of research. Let’s say a researcher has a direct assistant who is strictly taking notes and
accumulating data. Their time assisting the direct researcher is also included.

2. Supply Costs

If you are doing prototyping and testing of materials, the cost of those materials can be included as well. When you look at the construction and A&E industries, we’ve seen applicability for things like a new formulation of concrete or other building materials.

3. Computer Rental or Lease

This one is not seen as often, although it’s becoming more prevalent with software development needed to run complicated research algorithms and testing techniques. You can take the cost to lease a powerful computer for research activities. We’re also seeing it on the cloud storage space that’s specifically dedicated to research activities.

4. Contract Research

Often you can include contractors/outside resources that you hire as long as those resources are directly associated with your research activities. For instance, if you need to hire a specialist with electrical engineering expertise, you can include 65% of those expenditures for research activities for outside researchers.

A typical construction project has several stages. At each stage there are levels of qualification, typically toward the front end of the process in which you’re doing your estimating, bidding, design, development, and documentation. Once you get into the construction and completion phases, you start to see the phaseout of R&D qualifying activities. That’s because your uncertainties have been mostly phased out, if not entirely. Again, we want to focus on uncertainty. When you start a project, you have uncertainties. Over time you work through them. Once you are certain to a high degree that your proposed method is going to work, then you are through your R&D process.

General Construction

Development of estimates based on designs provided by architects or engineers
LEED and green initiatives
Evaluation of engineering and construction methods for improvement in build time or overall performance and reliability
Development of prefabrication processes
Development of unique material transfer systems on project sites (e.g. crane design)
Development of temporary support structures for active construction
Testing and validation of new mechanical systems to solve technical uncertainties
Building Information Modeling (SIM), AutoCAD and Revit modeling activities
Design and development of construction management software

If your construction clients develop a proposed methodology, plan or design, they often don’t know if will be successful (even when using CAD modeling), until they put it into place in the construction stage. Then they must do onsite testing to ensure it passes the required benchmarks. There could be some flow into the construction stages from a qualification standpoint. But generally, when they get to the development-of-estimate phase, they’re doing initial feasibility planning and generally coming up with multiple hypotheses or methods in which they can design a building or component of a building. This is typically a good starting point for R&D activities.

LEED or green initiatives, for instance, are big qualifiers for R&D tax credits. We’re also seeing a lot of modular design or spatial design to optimize the use of space in a building tend to have good qualification potential. Typically, with construction, it’s about how we can design more efficiently in a faster, more reliable manner.

Clients often ask us: “We’re designing an entire building. How do we differentiate our time on the project between qualifying and non-qualifying?”

Typically, we rely on accounting data or time data to understand the level of tracking we have (based on employee, project and activities). We understand the project may qualify and the employee may have qualifying time. If the time is broken down into an activity basis, we can look to see if that specific activity qualifies when we look back on the construction stages. Does that activity take place at a stage that typically qualifies? If those benchmarks are passed, then we get a reasonable percentage of time applied toward that employee’s wage. We call that a PAD (Project Accounting Data) analysis. PAD helps us get a reasonable amount of time related to qualifying projects.

Real World Example

A full-service construction client of ours ($115 million in revenue) averaged over $5 million in qualified expenditures annually.

Their main activities were new building design, LEED development, electrical and plumbing systems. Their annual credit was about $450,000. The PAD analysis told us what they were working on and who was working on it. In A&E, you also have to look at fee types, since the type of fee heavily influences whether or not a project qualifies. A time and material fee is considered no-risk since you can continue to do the work without the risk of losing money no matter how long it takes. But fixed fee, by contrast, means you’re under pressure to stay on time and under budget, and stay within the design which means higher risk and potentially not being able to qualify.

Architecture

Development of schematic design, design development, and final construction documents
Design modification to overcome conflicts when coordinating drawings from multiple trades
Design of unique buildings and structures
Development of unique/custom structural support solutions
Evaluation of multiple design solutions for technical problems
Involving structural Integrity and custom architectural design elements

Design activities Including estimating and programming
Design review and modification for cost reduction and energy efficiency
Evaluation of alternative materials for unique design requirements (e.g. sound absorption, energy efficiency, etc.)
Development of architectural master plans
Development of curtain wall, facade, and other building envelop systems

Typical Examples of Qualifying A&E Activities:

If you have a project that’s going to take a vast amount of design and there are uncertainties about ability, methodology and materials to be used, you will have a lot of different opportunities for R&D applicability. However, if you don’t have uncertainties, because you use the same design over and over, for instance, then there won’t be R&D qualifying activities.

If you have good project time accounting data, it really helps. You can test the projects and then figure out what your qualifying expenditures are.

Impact of recently signed Inflation Reduction Act (IRA) on Commercial and Residential Tax Incentives

Engineering

Foundation design based on geotechnical findings
Development of design alternatives to overcome project site issues
Structural designs for seismic retrofits
Development of industrial processes for production facilities
Environmental remediation activities

Performing CAD & BIM modeling to develop 30 building plans
Computer modeling and simulation of design and site conditions
Utilization of AutoCAD, REVIT, BIM, HEC·RAS, STAAD, and ANSYS
Design changes and modifications due to regulatory compliance issues

1. Commercial

EPAct §179D, is a tax deduction for commercial building owners, and design firms that have built, installed, or retrofitted their properties to be more energy efficient. They can deduct all or part of the costs associated with the construction, installation or retrofit in the amount of up to $1.88 per square foot.

The three main components needed to qualify for §179D are:

The interior lighting system.
The HVAC and domestic hot water system.
The building envelope (roof, walls, window systems).

Now that the IRA has passed, starting in 2023 the deduction increases to between $2.50/sf and $5.00/sf for 25% to 50% energy savings that meet new prevailing wage and apprenticeship requirements. If those conditions ARE NOT met, the deduction is reduced to $2.50/sf and $5.00/sf.

In the past, government projects were the only ones that could allocate the deduction to the architecture and engineering firms. Starting in 2023, the designer allocation will be open to all tax-exempt entities including Indian tribal governments, private colleges and universities.

If you have retrofit projects, until year-end 2022, you can still compare your proposed building to an ASHRAE 90.1 building and qualify those projects. Starting in 2023, however, you have an alternative tax deduction. The proposed building and its energy efficiency measures (i.e., lighting, HVAC, building envelope) must be compared to the existing building’s energy use intensity. You’re talking about collecting 12 months of utility data prior to construction starting, to establish your baseline. Then 12 months after the construction is completed you look at your new utility data and compare it to your utility data before construction began. Based on the post-construction savings you achieve; your tax deduction amounts to between $0.50 to $5.00 per square foot.

For existing buildings going through renovations, the key is to have a retrofit plan in place BEFORE construction starts. The retrofit plan must be signed by a registered architect or professional engineer and verifying that at minimum, there will be 25% savings compared to the existing building.

2. Residential

IRC §45L New Energy Efficient Home Credit is for developers of energy-efficient dwelling units, including single-family homes, multifamily buildings, and even mobile homes. The IRA extends the current §45L credit for dwelling units acquired by sale or lease for use as a residence through December 31, 2022. For units acquired starting on January 1, 2023, there are substantial changes to the credit rate and qualifications:

For single family homes:

Projects must meet the “ENERGY STAR” qualification in order to get the tax break. Energy Star is the government-backed symbol for energy efficiency.
If the new standard is met, the tax credit increases to $2,500 per unit from the current $2,000.
If you meet the Zero Energy Ready Home (ZERH) standard, the credit goes up to $5,000 per unit.
In either case there is no prevailing wage requirement.

For multi-family homes:

Projects must also meet the ENERGY STAR standard to get the tax break.
The credit increases to $2,500 for meeting ENERGY STAR certification or to $5,000 if meeting the ZERH program (assuming prevailing wage requirements are met).
If prevailing wage requirements are not met, the credit is reduced to $500 for ENERGY STAR certification and to $1,000 for the ZERH program.

TCJA Changes That Could Impact R&D

For A&E and construction firms, changes stemming from the 2017 Tax Cuts & Jobs Act (TCJA) could make the economics of the R&D credit more difficult to justify. No one knows for sure if these long-delayed changes will be enacted until after the mid-term election dust settles, but it pays to be prepared. TCJA said that in addition to requiring research expenditures to be amortized, all software development will now be considered an R&E expenditure. The research credit itself is not directly affected, but it does affect the economics of research in three primary ways:

You’re no longer looking at expense; you’re primarily looking at capitalized and amortized costs.
The §280C election allows you to take a reduced credit. If taxpayers DO NOT elect the reduced credit under §280C, the excess of the research credit over the current year R&E amortization deduction reduces the current year amount of R&E capitalized. For instance, in 2022, the research credit percentage will need to exceed 10% for a taxpayer to experience any addback. Electing the reduced credit will no longer be advantageous for many taxpayers.
The reasonableness requirement under § 174 is eliminated. That’s good news for research-oriented firms.

Compliance Issues

§45L issues + cost seg

For residential dwellings, be careful about taking the §45L energy efficiency credit if you’re also doing a cost segregation study on the property. Ordering matters! If you’ve already taken the credit, that’s no longer a 3115. You must pay the $11,500 IRS user fee and file by the end of the year in order to make a method change. It’s a lot of added expense. If you have the option, file the 3115, wait for it to be effective, then file the amended returns.

§179D

For Building Owners

179D is available on timely filed, original returns subject to normal 9100 late election relief.
179D elections can be made on automatic Form 3115, including for closed tax years.
Bonus depreciation (QIP) or 179 expensing (QRP) may eliminate federal benefit

For Designers

179D is available on timely filed, original returns.
179D is also available on amended returns for open tax years.
No Form 3115 late election relief available.

Conclusion

If your clients or organization would like amore guidance and resources about how claiming the maximum benefits of these and other credits and provisions, please don’t hesitate to contact us.

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