IRA clean energy tax credits support real estate improvements
Authors: Noah Brooks, Rocky Wiltsey
September 10, 2024 / 6 min read
2022’s Inflation Reduction Act introduced and expanded clean energy business tax credits to help real property owners make energy-saving improvements. The tax incentives are significant, but affected taxpayers must comply with complex documentation and certification requirements.
The Inflation Reduction Act (IRA) enacted in 2022 has created or expanded several tax provisions that can help property owners, developers, and real estate professionals who want to reduce the carbon footprint of their projects. Several of the IRA tax credits can increase significantly in value when coupled with other credits and tax-planning strategies available to real estate developers and contractors. Much of the discussion about these changes has lumped several different tax incentives into the generic term “energy tax credits,” so it might be helpful at the outset to distinguish between some of the different incentives and identify which opportunities are best suited to which types of taxpayers.
Clean energy tax credits and deductions
The IRA expanded two significant tax code sections that help property owners and developers make energy-efficient improvements to new and existing buildings. The Section 45L “new energy efficient home credit” (45L) allows homebuilders and owner-operators of multifamily residential units to claim a tax credit of $500 to $5,000 per unit or home, depending on the level of energy efficiency certification obtained. The Section 179D “energy efficient commercial buildings deduction” (179D) allows owners and tenants of commercial property and multifamily residential structures that are four stories or greater to claim accelerated tax deductions up to $5 per square foot if they improve the energy efficiency of the structures above certain thresholds.
The IRA expanded two significant tax code sections that help property owners and developers make energy-efficient improvements to new and existing buildings.
The IRA also broadened the investment tax credit (ITC) available under Section 48 for investments in renewable energy technologies. The changes to the ITC allow taxpayers who invest in infrastructure projects focused on renewable energy generation, such as solar installations, to claim a base credit of 6% on the eligible costs of the investment. That base credit is increased to 30% if either the project has a net maximum output of less than 1 megawatt, or prevailing wage and apprenticeship hour requirements are satisfied. Additionally, bonus credits are available, in increments of 10% of the eligible basis, if any of the following criteria are met:
The project is located within an “energy community” (see this map from the Department of Energy for details).
Domestic content rules are satisfied with respect to steel and manufactured equipment.
The project involves solar or wind technologies and is located in a low-income community or on tribal land, or is part of a qualified low-income residential building project or economic benefit project.
The expanded ITC is an attractive tax incentive for many projects, but it does require enhanced documentation. In that respect, an ITC study is a key tool for substantiating project eligibility.
Rebates funded by the Inflation Reduction Act
The IRA also includes a benefit for taxpayers in the real estate sector that isn’t exactly a tax benefit. The legislation earmarked funds to state and local governments to provide rebates to taxpayers who make energy-efficient improvements to their properties. These can be earned by installing more energy-efficient appliances or making improvements to a structure that help to reduce the costs of heating and/or cooling. These programs are typically managed through local utility companies, and the rebates are often paid to the utility holder for the property. It should be noted that these rebates may reduce the depreciable basis of the related asset, as well as the amount of basis available to calculate other IRA clean energy tax credits, but they can provide valuable cash flow and/or gap financing funds to other parts of a real estate project.
“Twinning” of basis for business tax credits
Many real estate professionals who have worked with tax advisors in the past to qualify projects for tax incentives like the low-income housing tax credit (LIHTC), the historic rehabilitation tax credit (HTC), the New Markets Tax Credit (NMTC), or opportunity zone (OZ) benefits may recall that the taxable basis of the project gets reduced by the benefit of each successive credit. This has often resulted in discussions with tax consultants about how best to divvy up the basis of a project to take full advantage of the credits available as the basis available to calculate each new credit is reduced by the credits claimed before.
In an unusual step for tax legislation, the Section 48 energy tax credit allows for a “twinning” of tax basis that permits a rare form of “double-dipping” into available credits. The most notable combination here is the availability for a project to qualify for Section 48 IRA tax credits while still carrying over its full basis for a LIHTC calculation. Often, the LIHTC projects will also qualify for the low-income census tract criterion that increases the value of the Section 48 credit by 10%.
The Section 48 energy tax credit allows for a “twinning” of tax basis that permits a rare form of “double-dipping” into available credits.
Cost segregation and the complexity of qualifying for clean energy tax credits
Tax advisors have stressed the importance of cost segregation to real estate professionals for decades as a way to accelerate depreciation deductions and recover the cost of real estate investments more quickly. Cost segregation studies can take on an added value in the case of energy-efficient new construction or occupied rehabs where tenants remain in a space while improvements are made to qualify for energy tax credits. In these instances, the cost segregation study not only separates out the assets with a shorter recovery period to generate higher depreciation deductions in early years, but it also identifies assets that may qualify for some of the IRA tax credits in order to generate additional tax benefits from the improvements.
In addition to tax segregation studies, taxpayers looking to gain the full benefit of IRA clean energy tax credits will need to request additional documentation from contractors to track qualification for prevailing wage standards, and also enlist the help of energy credit certification third parties who can verify that improvements reach energy efficiency thresholds set forth in the legislation. In short, a best practice would be to consult with a tax advisor during the planning phases of an energy improvement project, so that the affected parties have a clear picture — at the outset — of the documentation, verifications, and certifications that will be needed to claim the full benefit of IRA clean energy tax credits when it’s time to file a tax return.
The benefits of the expanded business tax credits are significant, but the costs of documenting and certifying compliance should weigh into the analysis before undertaking a qualifying project. If an investment group projects its after-tax return expecting to qualify for the full 30% ITC, but instead only qualifies for the 6% base credit, those responsible for the shortcomings will face some very difficult discussions.
The benefits of the expanded business tax credits are significant, but the costs of documenting and certifying compliance should weigh into the analysis.
IRA tax credits expand real estate options
The IRA has provided significant tax incentives that can help property owners and real estate professionals improve the energy efficiency of their buildings and provide contractors and developers with new funding options to make projects more affordable. The new law includes some relatively rare opportunities to combine tax benefits in ways that are usually not permitted in the tax code, but it’s clear that these additional benefits come with significant costs in terms of complexity. Taxpayers looking to optimize the full benefit of these new and expanded clean energy tax credits will need to coordinate the work of contractors, certification professionals, business advisors, and tax consultants to a degree rarely required under previous tax laws.
