A&E Firms: Unlock Savings and Go Green with the 45L Tax Credit

Imran Syed on March 28, 2024

The Architecture & Engineering (A&E) industry plays a crucial role in shaping sustainable communities. Did you know your firm’s commitment to energy-efficient design can be rewarded with significant tax savings? The 45L tax credit offers a powerful incentive specifically for A&E firms working on residential projects that prioritize energy efficiency.

What is the 45L Tax Credit and How Does it Benefit A&E Firms?

The 45L tax credit, established by the Internal Revenue Code, allows eligible builders and developers to claim a tax credit for qualified new energy-efficient homes. A&E firms benefit by working on projects that meet these qualifications. Here’s a breakdown of the advantages:

Reduced Tax Liability: For each qualified energy-efficient home your firm designs, the builder or developer can claim a tax credit, which translates to a lower tax burden for your clients. This frees up valuable capital to invest in innovative sustainable design solutions and new technologies.
Clean Energy Commitment and Client Attraction: By incorporating energy-efficient features into your designs, you create a portfolio of sustainable projects. This not only showcases your firm’s commitment to environmental responsibility but also attracts environmentally conscious clients seeking eco-friendly homes. This translates to a potential competitive edge and increased business opportunities.
Smoother Collaboration and Streamlined Process: Working with builders and developers familiar with the 45L credit and energy consultants can lead to smoother project collaboration. Early integration of energy-efficient features into the design phase ensures a streamlined process for achieving qualification and maximizing the tax credit benefit.

Don’t miss out on this valuable opportunity! Partnering with tax credit experts will ensure you leverage the 45L program effectively. By embracing sustainable design and optimizing this tax incentive, your A&E firm can achieve financial success while contributing to a greener future.

How Does a Tax Credit Work? Federal Tax Credits Explained

Brian Coddington on March 11, 2024

What are Federal Tax Credits?

Tax season can be a daunting time, filled with forms, calculations, and the question: am I getting the most out of my tax return? One often overlooked benefit that can significantly impact your tax liability is tax credits. But how exactly do they work?

Think of a tax credit like a coupon for your taxes. Unlike deductions which reduce your taxable income, tax credits directly decrease the amount of tax you owe, dollar-for-dollar. This means a $1,000 credit reduces your tax bill by $1,000, making them a powerful tool for saving money.

Here’s a breakdown of how they work:

Eligibility:
Each tax credit comes with specific requirements you need to meet to claim it. These typically involve income levels, qualifying expenses, or specific actions taken.
Claiming the Credit:
When filing your tax return, you identify the credits you’re eligible for and the amount you’re claiming.
Reducing Your Tax Bill:
The claimed credit directly reduces the taxes you owe.
Potential Refund:
If the credit amount exceeds your tax liability, some credits (refundable credits) can result in a tax refund, putting money back in your pocket.

Here are some examples of tax credits that are available to claim:

Research and Development (R&D) Tax Credit: This credit incentivizes businesses to invest in research and development activities by offering a tax credit against their federal income tax liability.

Learn More About R&D Tax Credits

Section 45L Energy Efficient Home Tax Credit: This credit encourages the construction of energy-efficient homes by offering a tax credit to builders for qualifying improvements made to new or existing homes.

Learn More About 45L

Tax laws can be complex, and eligibility for specific credits can change from year to year. Consulting with tax professionals like Source Advisors can ensure you’re claiming all the credits you’re entitled to and maximizing your tax savings.

By understanding how tax credits work, you can proactively manage your tax liability and potentially save significant money come tax season.

Notice 2023-65: New Guidance on Section 45L Energy Efficient Home Credit

Imran Syed on October 28, 2023

Notice 2023-65: New Guidance on §45L Energy Efficient Home Credit

Section 45L Energy Efficient Home Credit was extended and amended by the Inflation Reduction Act. The qualifying criteria and the tax credit amounts were modified for homes acquired (leased or sold) from 1/1/2023.

Key points from the Inflation Reduction Act:

Energy Star or Zero Energy Ready Home (ZERH) Certification is the pathway to qualify for § 45L tax credit, effective 1/1/2023.
Single Family and Manufactured Homes: Credit increased to $2,500 for Energy Star and $5,000 for ZERH
Multifamily: Tax credit of $500/unit for Energy Star and $1,000/unit for ZERH; Tax Credit increases to $2,500 for Energy Star and $5,000 for ZERH, if prevailing wage requirements are met.
Eliminates the requirement to reduce the LIHTC eligible basis by the Section 45L credit.

On September 27, 2023, IRS issued Notice 2023-65 which provides guidance and clarity on the certification requirements, eligible program versions under Energy Star and ZERH, exceptions to reducing the tax basis, and substantiation requirements.

Highlights of Notice 2023-65 and Energy Star/ZERH program requirements:

In the case of a single-family or multifamily unit, the eligible contractor is the person that has ownership and basis during construction and sells or leases the unit to the end-user.
In the case of a manufactured home, the eligible contractor is the person that produces the homes and has ownership and basis during production.
Certification as per the rules of Energy Star or ZERH is a requirement to be eligible for 45L tax credit.
Substantiation Requirements:
- Retain the Energy Star or ZERH certificate including the date of certification.
- Records to establish the address of the qualified home, taxpayer’s eligibility to avail the credit, and proof of sale or lease.
- Multifamily developers: To be eligible for the $2,500 or $5,000 tax credit, maintain records of meeting or exceeding prevailing wages for construction as per the Davis-Bacon Act.

§ 45L for Single-Family Homes (includes duplexes and townhomes):

Applicable Versions for Energy Star:
- Homes acquired before 1/1/2025: Energy Star SFNH National Program Version 3.1 and applicable regional program requirements.
- Homes acquired starting from 1/1/2025: Energy Star SFNH National Program Version 3.2 and applicable regional program requirements.
- California, Florida, Hawaii, Oregon, and Washington must be certified under the regional program requirements as shown on the Energy Star website.
- Program Version for homes acquired in 2026 will be determined on/after January 2024.

Applicable Versions for Zero Energy Ready Home:
- Homes with permit date on/after 1/1/2023: ZERH Version 1.
- Homes with permit date on/after 1/1/2024: ZERH Single Family Version 2.
- Homes in California will be certified under CA Version 1 (permit date before 1/1/2024) and CA Single Family Version 2 (permit date on/after 1/1/2024)

§ 45L for Multifamily New Construction:

Applicable Versions for Energy Star:
- Homes acquired before 1/1/2027: Energy Star MFNC National Program Version 1.1
- California, Florida, Hawaii, Oregon, and Washington must be certified under the regional program requirements as shown on the Energy Star website.

Applicable Versions for Zero Energy Ready Home:
- Homes with permit date on/after 7/20/2017: ZERH Version 1 (Limited to 5 stories)
- Homes with permit date on/after 1/1/2024: ZERH Multifamily Version 2 (No limitation on number of stories)
- Dwelling units in California will be certified under CA Version 1 (permit date before 1/1/2024) and CA Multifamily Version 2 (permit date on/after 1/1/2024)

sourceadvisors.com | 800.806.7626

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.

Qualified Leasehold Improvements

Franklin Chow on August 2, 2019

What is a Qualified Leasehold Improvement Property?
Qualified vs. Non-Qualified Leasehold Improvements

From 2001 through 2017, Qualified Leasehold Improvement Property (QLIP) were most improvements to a building’s interior made under a lease. This includes interior improvements such as HVAC, fire protection systems, alarm systems, and security systems. It only applies to commercial buildings, such as retail or factory buildings. Tangible personal property identified in a cost segregation study was not QLIP. Improvements made the first three years a building was in service were not QLIP.

Building enlargements, elevators or escalators, or the internal structural framework of the building did not qualify. Qualified Leasehold Improvement Property was gradually replaced by Qualified Improvement Property (QIP) between 2016 and 2017. QIP expanded upon QLIP by eliminating the three-year rule and also treated any qualifying improvement as QIP regardless of whether it was made under a lease.

Qualified Improvements Bonus Depreciation Rates

The bonus depreciation rates are as follows:

Eligibility of Building Improvements

Placed-in-service since 1987 though, generally speaking, most studies are limited to the last 5-7 years.
Currently depreciation over 27.5 or 39 years
$500,000+ in capitalized costs is a good starting point to begin thinking of Cost Segregation
Have been acquired, constructed, expanded, or remodeled
The property owner must be a tax-paying entity
Ideal building types include: auto dealerships, banks, casinos, distribution centers, grocery stores, health care facilities, hotels, manufacturing facilities, office buildings, restaurants, shopping centers, sports facilities, warehouses, and other specialized property types.

Typically, the more complex buildings will generate the greatest benefit from a Cost Segregation study.

Cost Segregation Standard Study for QIP

Identifies §1245 Property (5, 7, & 15 year property (Typ.))
§1250 Qualified Leasehold Improvements, Qualified Retail Improvements, & Qualified Restaurant Improvements (15-year straight-line property)
§1250 Qualified Improvement Property (15-year straight-line property and bonus depreciation for §1250 interior improvements after 12/31/2017)

Case Study: Food and Beverage Manufacturer with Retail Facilities

Facts

The subject manufacturer is a corporation that originally began production in 1993. Beginning in 2008, the company started a program of expanding its current facilities and acquiring other smaller producers. They also diversified by opening retail facilities and marketing offices, around the country, during this period. Some of these acquired properties were purchased and some were leased. The total costs of the acquisitions and improvements were $22,224,000. For tax years 2008-2018, the manufacturer erroneously classified some manufacturing personal property, Qualified Leasehold Improvement Property, Qualified Restaurant Property, Qualified Improvement Property, and site improvements as building property.

Execution

In 2019, the Source Advisors Cost Segregation engineers were engaged to do a full fixed asset review to identify opportunities to properly classify the costs of these transactions that spanned this 10-year period. Some of the properties required a full cost segregation study to properly allocate the capitalized costs using architectural plans with detailed cost files and invoices, while others required invoice reviews for proper classifications. They conducted a thorough inspection of some properties where improvement projects were done. Key property personnel were also interviewed. A detailed report was delivered, identifying and documenting all of the components that qualify for a shorter tax life.

Result

How Source Advisors Can Help

Founded as LIFO Systems in 1983, Source Advisors is a specialized tax consulting firm providing Qualified Leasehold Improvement, Cost Segregation, R&D Tax Credit, Energy Efficiency (§179D), and LIFO inventory solutions for more than 37 years. Our new name, Source Advisors, strengthens our resolve and commitment to partnering with companies and CPA firms as an advisory source in maximizing government-sponsored tax credits, deductions, and incentives.

Our team of experienced CPAs, attorneys, engineers, technology experts, and Big Four professionals help companies save money and create cash flow to stimulate businesses and drive overall growth. We are experts in the legislation that governs these incentives and assist CPA firms and companies navigate the laws that continue to evolve and change.

Frequently Asked Questions

What are considered Qualified Leasehold Improvements?

According to the IRS, Qualified Leasehold Property Improvements include any improvement to a building’s interior. But as the IRS states, these improvements do not qualify if they include the enlargement of a building, an elevator or escalator, the internal structural framework of a building. QLIP may include interior improvements such as drywall, electrical fixtures, and plumbing.

What is the difference between Qualified Leasehold Improvements and unqualified?

Qualified leasehold improvement property includes, as mentioned above, any improvement to a building’s interior. Unqualified leasehold improvements are things such as enlargement of the building, elevators or escalators, or the internal structural framework of the building.

How long to depreciate leasehold improvements?

Qualified Leasehold Improvements must depreciate over a 15-year period. This is done using the straight-line method.

Our Latest Insights