Owners of commercial buildings may be able to reduce their taxable income by making energy efficiency upgrades. Section 179D of the Internal Revenue Code allows a taxpayer to take a deduction for the cost of energy efficiency upgrades placed in service during the tax year if certain requirements are met. This deduction, commonly referred to as the § 179D deduction, has been around since 2005. Over the years, there have been several modifications to the § 179D deduction, the most recent of which came with the passing of the Inflation Reduction Act of 2022 (the IRA). This article provides a brief introduction to the §179D deduction and issues that should be taken into consideration when deciding whether this deduction may be appropriate. Although this article focuses on energy efficiency upgrades, the § 179D deduction is also available for the cost of energy efficiency materials that are installed in a newly constructed building.
There are two options for a deduction under I.R.C. § 179D. The general deduction, found under I.R.C. § 179D(a), is for energy efficient commercial building property (EECBP). The alternative deduction, found under I.R.C. § 179D(f), is for energy efficient building retrofit property (EEBRP). A discussion of the differences between these two options follows, but it is important to note at the outset that a threshold requirement for both options is the establishment of a plan to install upgrades that will improve the building’s energy efficiency by 25 percent or more. Therefore, before making any decisions regarding energy efficiency upgrades, building owners interested in the § 179D deduction should consult with their contractors and create a plan that includes conducting an analysis of the building to determine which upgrades, if any, will meet the requirements of I.R.C. § 179D.
I.R.C. § 179D(a) provides that “[t]here shall be allowed as a deduction an amount equal to the cost of energy efficient commercial building property placed in service during the taxable year.” “Energy efficient commercial building property” is defined as property that is (i) depreciable (i.e., materials used to run a business such as machinery, equipment, buildings, vehicles, furniture); (ii) installed on a building located in the United States and within the scope of Reference Standard 90.1 (discussed below); (iii) installed as part of the building’s interior lighting systems, its heating, cooling, ventilation, and hot water systems, or the building envelope (i.e., walls, windows, roof, and foundation); and (iv) certified as being installed as part of a plan designed to reduce the total annual energy and power costs with respect to the interior lighting systems and the heating, cooling, ventilation, and hot water systems of the building by 25 percent or more in comparison to a reference building that meets the minimum requirements of Reference Standard 90.1. To qualify for the general deduction under I.R.C. § 179D, materials installed as energy efficiency upgrades must meet all four requirements.
Reference Standard 90.1 is mentioned twice in the definition of EECBP. What is Reference Standard 90.1? Every three years, the American Society of Heating, Refrigeration, and Air Conditioning Engineers (ASHRAE) and the Illuminating Engineering Society of North America (IES) publish the minimum requirements for energy efficient designs for certain buildings. Standard 90.1 is the Energy Standard for Buildings Except Low-Rise Residential Buildings. All buildings except single-family homes, multifamily buildings less than four stories, mobile homes, and modular homes are within the scope of Standard 90.1. I.R.C. § 179D(c)(2) defines Reference Standard 90.1 as the more recent of (i) Standard 90.1-2007, meaning the minimum requirements published in 2007; and (ii) the most recent Standard 90.1 that the US Department of Energy and Secretary of the Treasury have approved for purposes of I.R.C. § 179D within the four years prior to the upgrades being placed in service. Pursuant to IRS Announcement 2024-24, Reference Standard 90.1-2007 is to be used for EECBP placed in service after December 31, 2014, and before January 1, 2027. Reference Standard 90.1-2019 is to be used for EECBP placed in service after December 31, 2026, and before January 1, 2029, and Reference Standard 90.1-2022 is to be used for EECBP placed in service after December 31, 2028.
Computer modeling is used to determine whether energy efficiency upgrades will reduce the total annual energy and power costs of a building by 25 percent or more. To do this, two virtual models of the building are created. The first model, Model A, is created to show the building as including energy efficiency materials that meet the minimum requirements of the applicable Reference Standard 90.1. If a building owner is looking to install energy efficiency upgrades by 2025, Model A of its building will incorporate energy efficiency materials meeting the minimum requirements of Reference Standard 90.1-2007 because that is the applicable Reference Standard 90.1 for EECBP placed in service after December 31, 2014, and before January 1, 2027. The second model, Model B, is created to show the building’s inclusion of the desired energy efficiency upgrades. The two models are then compared. If the results show that Model B’s total annual energy and power costs are less than Model A’s by 25 percent or more, this requirement is met for EECBP.
The alternative deduction under I.R.C. § 179D has more requirements and is more time consuming to pursue than the general deduction. Why would an owner of a commercial building be interested in the alternative deduction? The alternative deduction presents an opportunity to take a deduction for upgrades made to older buildings. Before being revised under the IRA, I.R.C. § 179D included only the general deduction and the energy cost saving threshold was set to 50 percent, double the current threshold. It was difficult for energy efficiency upgrades to older buildings to meet this threshold. Under the revised I.R.C. § 179D, however, not only is the threshold lowered to 25 percent, but the alternative deduction focuses on comparing the building’s own energy use over time, rather than the building’s energy cost in comparison to the ASHRAE Standard 90.1 reference building.
Energy use intensity (EUI) is calculated by dividing a building’s total annual energy consumption by the building’s total gross floor area. A lower EUI generally signifies that a building has good energy performance. Site EUI, which is generally reflected on the utility bill, is the amount of energy consumed by a building. Source EUI is the amount of all energy used to produce, transmit, and deliver energy to a building in addition to the energy consumed at the building. The I.R.C. § 179D alternative deduction considers the building’s site EUI.
The alternative deduction is for “energy efficient building retrofit property,” which is defined as property that is (i) depreciable (i.e., materials used to run a business such as machinery, equipment, buildings, vehicles, furniture); (ii) installed in or on a “qualified building,” which is defined as a building located in the United States and originally placed in service not less than five years before the establishment of the “qualified retrofit plan” (discussed below); (iii) installed as part of the building’s interior lighting systems, its heating, cooling, ventilation, and hot water systems, or the building envelope (i.e., walls, windows, roof, and foundation); and (iv) certified as installed on a qualified building and as part of the building’s interior lighting systems, its heating, cooling, ventilation, and hot water systems, or the building envelope.
The required “qualified retrofit plan” must be written and prepared by a “qualified professional” such as a licensed architect or engineer. The qualified retrofit plan also must specify the energy efficiency upgrades to be made to the building that are expected to reduce the building’s EUI by 25 percent or more in comparison to the building’s baseline EUI. Finally, the qualified retrofit plan must provide for three different certifications, all of which must be made by a qualified professional. The first certification must confirm the EUI of the building one year before the EEBRP is placed in service. This establishes the building’s baseline EUI. The second certification must confirm that the EEBRP is installed on a qualified building and installed as part of the building’s interior lighting systems, its heating, cooling, ventilation, and hot water systems, or the building envelope. And the third certification must confirm the building’s EUI more than one year after the EEBRP was placed in service. The I.R.C. § 179D alternative deduction can be claimed for the tax year in which the final certification reflects that the building EUI has been reduced by 25 percent or more.
The amount of the § 179D deduction is the lesser of (i) the cost of the energy efficiency upgrades, meeting the requirement of either EECBP or EEBRP, installed in the building; or (ii) the amount equal to the product of the building’s square footage multiplied by the “applicable dollar value.” The applicable dollar value ranges from $0.50 to $5.00, depending on the amount of the building’s energy savings and other factors. For buildings that obtain a 25 percent energy savings, the applicable dollar value is $0.50 per square foot. For buildings that obtain more than 25 percent energy savings, the applicable dollar value is $0.50 per square foot plus an additional $0.02 per square foot for each percentage point of energy savings above 25 percent, up to a maximum of $1.00 per square foot. See “Energy Efficient Commercial Buildings Deduction,” https://tinyurl.com/3jcwf79m.
If the federal prevailing wage and apprenticeship requirements are met, the applicable dollar value increases five times. Thus, for buildings that obtain a 25 percent energy savings, the applicable dollar value is $2.50 per square foot. And for buildings that obtain more than 25 percent energy savings, the applicable dollar value is $2.50 per square foot plus an additional $0.10 per square foot for each percentage point of energy savings above 25 percent, up to a maximum of $5.00 per square foot.
The federal prevailing wage and apprenticeship requirements, found under I.R.C. § 45(b)(7) and (8), generally require that the laborers and mechanics who are contracted for the construction of the energy efficiency upgrades be paid at or above the prevailing wage rates, as established by the US Department of Labor, for similar work performed in the area where the building is located; and that a certain number of the work hours for construction of the energy efficiency upgrades be performed by qualified apprentices. The rules related to federal prevailing wage and apprenticeship requirements are complex, and a detailed discussion is outside the scope of this article. When making decisions regarding the § 179D deduction, however, it is important to consider whether it is worth going through the additional effort (and possibly an increased cost) required for compliance with these requirements for the sake of getting the increased applicable dollar value.
The § 179D deduction can be claimed by commercial building owners or, solely in the case of buildings owned by a “specified tax-exempt entity,” can be allocated to and claimed by those responsible for designing the energy efficiency upgrades. A “specified tax-exempt entity” is defined as (i) the United States, any state, political subdivision, or possession of the United States, or any agency or instrumentality of the foregoing; (ii) an Indian tribal government or Alaskan Native Corporation; and (iii) tax-exempt organizations. Essentially, these are entities that do not pay taxes and therefore would not be able to use a tax deduction. Before being revised under the IRA, the § 179D deduction was allocable only for government-owned commercial buildings.
Under IRS Notice 2008-40, a designer is the person that creates the technical specifications for installation of the energy efficiency upgrades, such as an architect, engineer, contractor, environmental consultant, or energy services provider. At the discretion of the building owner, the § 179D deduction can be allocated among several designers, if two or more are working on the project. The amount that may be allocated to the designer includes all costs incurred by the building owner to place the energy efficiency upgrades in service, except any amounts paid as income to the designer.
To allocate the § 179D deduction, both the building owner and the designer must execute a document that includes the following details: (i) the name, address, and telephone number of the building owner; (ii) the name, address, and telephone number of the designer; (iii) the address of the qualified commercial building; (iv) the cost of the EECBP or EEBRP installed; (v) the date that the EECBP or EEBRP was placed in service; (vi) the amount of the § 179D deduction allocated to the designer; (vii) the signatures of the building owner and designer; and (viii) a declaration under penalty of perjury. The IRS does not have a specific form or letter template to use for this allocation document. The designer is not required to attach the allocation document to its tax return but must keep it, along with all other documents that may be helpful for substantiating the claimed deduction, in case of an audit.
I.R.C. § 179D(d) provides various other requirements that must be followed when pursuing the § 179D deduction. For example, the calculation and verification of a building’s energy and power consumption and cost can be prepared only by “qualified computer software.” On its website, the US Department of Energy maintains a list of computer software that meet the requirements for use with the § 179D deduction. Additionally, for the various certifications required under I.R.C. § 179D, there are rules regarding the certification process, including which professionals are allowed to be a part of the certification process.
Although I.R.C. § 179D(h) authorizes the promulgation of regulations related to the provisions of I.R.C. § 179D, none has been issued to date. The IRS, however, has issued guidance through Notices (Notice 2006-52, Notice 2008-40, and Notice 2012-26), a Chief Counsel Advisory (CCA 201451028), and Chief Counsel Attorney Memoranda (AM 2010-007 and AM 2018-005). Because of revisions of I.R.C. § 179D under the IRA, some of the information in these guidance documents may be obsolete. Nevertheless, these documents still assist with understanding how the § 179D deduction works, and much of the information is still relevant.
Determining whether it is possible to take the § 179D deduction requires some upfront work. The commercial building owner and contractor will need to take a few steps beyond simply discussing the desired energy efficiency upgrades and executing a contract. Modeling will need to be completed to determine whether the general deduction or the alternative deduction should be pursued and to ensure that the desired upgrades will meet or exceed the threshold requirement of improving the building’s energy efficiency by 25 percent or more. Both the general and alternative deductions require that the upgrades be installed pursuant to a plan, so that will need to be created. Additionally, the building owner should consult with its accountant to calculate the deduction amount and to determine the appropriate documents to keep or file with the IRS. And the building owner should also consult with an attorney knowledgeable in this area to ensure that the requirements of I.R.C. § 179D are being met. It may be a bit of a hassle at the outset, but for a deduction worth up to $5.00 per square foot, the § 179D deduction may be worth considering for some commercial building owners.
