The construction industry was a big winner when the Inflation Reduction Act (IRA)1 passed in August 2022. According to Section 13801(a), which enacts Code Section 6417(a), builders can now make the most of enhanced benefits that are claimed directly on their tax returns, but according to Section 13801(b), which adds Code Section 6418(a), there are also indirect applications for taxpayers who hire contractors — including the opportunity for entities with no liability to receive tax benefits in cash.
The Inflation Reduction Act
The IRA introduced three specific revisions for residential and commercial contractors:
- The modified Section 45L New Energy Efficient Home Credit for residential builders aims to reward builders that construct energy efficient homes with financial benefits.2
- The Section 179D Energy Efficient Commercial Buildings Deduction and the Section 48 Energy Credit provisions offer financial incentives for the construction of energy-efficient commercial buildings.3
Each of these provisions have specific target audiences, benefits, and unique characteristics, which are valuable financial tools for the construction industry.
Additionally, the IRA has introduced new significant features including the promotion of union labor through prevailing wage and apprenticeship enhancements. Also, some tax benefits provided by the law can be sold to other entities. In certain cases, tax-exempt entities can even receive direct cash payments for expenditures that would otherwise provide tax credits to taxable entities.4
Section 45L
Introduced in 2005, Section 45L established a tax credit for contractors constructing energy efficient homes. The credit varied based on the home type and projected energy savings:
- $2,000 credit for new homes projected to use 50% less energy than the standards outlined in the 2006 International Energy Conservation Code.
- $1,000 credit for manufactured homes meeting a 30% projected energy use reduction standard.
- $1,000 credit for manufactured homes certified under the Energy Star Labeled Homes Program.
Additional rules previously applied relating to the building envelope. Taxpayers were required to reduce the property’s basis by the credit amount, leading to an additional gain upon property sale.
Previously, there were no separate credits for multifamily construction. The restriction limiting the provision to buildings of three stories or less functioned as a limit on multifamily construction, but it wasn’t described as such.5
Changes to Section 45L Under the New IRA
Contractors that build or substantially renovate both multifamily and single-family homes utilizing energy-efficient building components that meet the new standards are eligible for tax credits based on the number of units they construct.
Before the IRA, the credit was limited to single-family homes and low-rise apartments, with an available credit of $2,000 per home.6 However, with the implementation of the IRA, new rules have come into effect for properties occupied after 2022.7
For single-family homes, there are now two credit tiers — one at $2,500 per home and one at $5,000 per home. A $5,000 credit is available if the unit is certified as zero-energy ready under the Department of Energy’s zero-energy ready home program. Additionally, the three-story height limitation has been eliminated.
Multifamily Rules Under the New IRA Prove to Be More Complicated
For the first time, the IRA imposed a separate set of rules applying only to multifamily construction. While there are two credit tiers, like the single-family program, the tiers are $500 per unit and $1,000 per unit. However, these tiers can increase to $2,500 and $5,000 per unit if prevailing wage standards are met.
The $1,000 or $5,000 credit is reserved for units certified as zero-energy ready under the zero-energy ready home program in effect as of January 1, 2023.8
Prevailing Wage Rules Under Section 45L
Contractors working on federal government projects have long been required to comply with prevailing wage regulations.9 However, these regulations were not part of the Section 45L rules before 2023.10
According to Section 45L(g)(2)(A) of the IRA, the prevailing wage rules are satisfied only if the wages paid to any laborers and mechanics involved in the construction of such residence — whether employed directly by the taxpayer or by any contractor or subcontractor — are not less than the prevailing rates for similar construction, alteration, or repair work in the locality where the residence is located, as determined by the Secretary of Labor.
To provide further clarity on this rule, the IRS issued additional guidance; Notice 2022-61 directs taxpayers to refer to Department of Labor guidance and outlines procedures to seek clarification when specific guidance is unavailable.
Case Study
A residential developer built a 56-unit townhome complex in Sioux Falls, SD in 2022. The developer used R-17.2 wall insulation, the windows had a U-Value of 0.32, and the heating was fuel-fired aid distribution using natural gas with a 95.5 AFUE.
These specifications were put through IRS-approved energy simulation modeling software and achieved a rating and certification qualifying for the 45L credit. The residential developer received $112,000 in tax credits on its current year tax return (56 units multiplied by $2,000 per unit).
Section 179D11
Over the years, the available amount for this deduction has increased, making it more powerful. This deduction offers two significant advantages:
- It allows a substantial portion of deductions related to building lighting; heating, ventilation, and air conditioning (HVAC); and building envelope costs to be immediately deducted rather than spread out over many years through property taxes.
- It enables designers of government-owned qualifying property to utilize the deduction for costs incurred in constructing buildings for federal, state, or local governments, which would typically not be accounted for in a business tax return.
Under the pre-IRA version, taxpayers could immediately deduct up to $1.88 per square foot of otherwise capitalized costs in 2022.
To qualify for the pre-IRA version, technical requirements involved meeting standards established by the American Society of Heating, Refrigerating, and Air Conditioning Engineers and the Illuminating Engineering Society of North America (ASHRAE/IESNA), as well as achieving a 50% reduction in energy use as compared to a baseline standard. If the entire project fell short of meeting the standard, then partial deductions were still available for the building systems that met the criteria.
While the new law provides enhanced benefits, it also introduces complications including prevailing wage and apprenticeship rules.
Changes to Section 179D Under the New IRA
The previous deduction of $1.88 per square foot has been replaced with a new deduction of $0.50 per square foot. However, this amount can increase based on the percentage of annual energy and power cost reduction certified for the building, with an additional $0.02 per percentage point, up to a maximum of $1 per square foot.
Another key development is the introduction of an enhanced deduction for projects that comply with prevailing wage standards. This enhanced deduction starts at $2.50 per square foot and can be further increased based on the level of energy efficiency attained, up to a maximum of $5 per square foot. To account for inflation, adjustments have been factored in that allow for a maximum deduction of $5.36 per square foot for properties placed in service in 2023.12
One change worth noting is the elimination of the previous partial deduction for building systems within a larger project.13 The new tax law has also modified the energy efficiency standards applicable to qualify for the deduction.14 These modifications aim to ensure that the deduction encourages the adoption of higher energy efficiency levels.
The scope of entities eligible to assign deductions to designers has also been expanded to include more government entities as well as encompass tax-exempt entities, providing greater flexibility in assigning deductions to the relevant parties. Real estate investment trusts (REITs) can now also benefit from the deduction.15
The deduction is reduced for buildings not meeting the prevailing wage requirements, but a reduction in the percentage of energy savings required may help more projects qualify.