Commercial Real Estate Benefits from Inflation Reduction Act’s Climate Change Incentives

Winter 2022/2023 Issue
By: Aquiles Suarez
The Inflation Recovery Act expands use of the Section 48 Investment Tax Credit, which can be applied to eligible investments such as solar installations.

The bill expands tax breaks for energy-efficiency improvements in buildings.

This August, long-stalled negotiations over President Joe Biden’s original $3.5 trillion Build Back Better program concluded with Senate Democrats agreeing to pass a $1.7 trillion budget reconciliation they dubbed the Inflation Reduction Act of 2022. Much of the ensuing commentary derided the bill as actually doing little to reduce inflation. But one thing is demonstrably true: the Inflation Reduction Act (IRA) represents the largest federal investment ever to fight climate change. It includes $369 billion in new programs, as well as new and expanded tax incentives to help in that effort.

Proponents of the legislation claim it will reduce the nation’s carbon footprint by 40% by 2030, measured against 2005 levels. Other estimates of carbon emission reductions range from 24% to 42%. Incentives in the bill for the commercial and residential real estate industries are expected to help the building sector make major contributions to that reduction. The key provisions of the IRA for the commercial real estate sector include a revised and expanded Energy Efficient Commercial Buildings Tax Deduction (Section 179D); the Section 48 investment tax credit (ITC); and a tax credit for the installation of electric vehicle charging stations (Section 30C).

Section 179D

The legislation changes the Section 179D tax incentive to make it more usable and valuable for commercial real estate owners and developers. Congress established the tax deduction in the Energy Policy Act of 2005 as an incentive for building owners to implement energy-saving measures and improvements in their developments. Prior to the IRA’s passage, Section 179D allowed owners to deduct $1.80 per square foot for buildings that reduced their energy consumption by at least 50% when compared to a building that meets standards set by the American Society of Heating, Refrigerating and Air-Conditioning Engineers (ASHRAE).

The problem with the Section 179D incentive was that in many cases, the tax benefit was not sufficient for a developer or building owner to incorporate more costly energy-efficiency improvements into their building design. In addition, because it is structured as a deduction from taxable income, real estate investment trusts (REITs), which by law are required to disburse most of their profits to shareholders, were limited in their ability to use Section 179D.

Finally, because the energy-efficiency savings needed for a building to qualify for the deduction are measured against ASHRAE energy codes that themselves require greater levels of energy efficiency, many existing older buildings that could be retrofitted to reduce their energy usage still would not qualify for the deduction to any meaningful financial extent. Since approximately 75% of buildings in the United States were built before the year 2000, this means that potential energy savings, and therefore large reductions in greenhouse gas emissions associated with the built environment, were not adequately incentivized through the Section 179D deduction.

To some extent, the IRA addressed the concerns with Section 179D, but it also adds a component that could work against its larger goal of dealing with climate change. The bill expands the deduction from $1.80 per square foot to a sliding scale ranging from $2.50 to $5.00 per square foot depending on the energy efficiencies achieved over the baseline of current ASHRAE standards. For existing buildings, however, energy-efficiency gains would be measured against the energy baseline of the individual building. As a result, retrofits of existing buildings that could markedly increase their energy efficiency are more likely to be eligible for a Section 179D tax benefit than under prior law.

In addition, the IRA includes a provision that allows a REIT to reduce its earnings and profits by the amount of the Section 179D deduction in the year the energy improvements are made. This would result in an immediate financial benefit to the REIT’s shareholders. However, the positive changes to the Section 179D come with a catch: the higher benefits apply only to owners who pay workers prevailing-wage rates for their jurisdictions. Those who do not get a maximum benefit of $1.00 per square foot, a reduction from the $1.80 per square foot under prior law. Arguably, the prevailing-wage requirements would make energy-efficiency improvements and retrofits in certain areas more expensive, undermining the financial benefit of the incentive and reducing its appeal.

Sections 48 and 30C

Apart from the beneficial changes made to the Section 179D program, the IRA also expands potential uses of the Section 48 Investment Tax Credit (ITC) for real property developments. The ITC can be used to offset taxable income, and eligible investments include such things as solar installations and geothermal heat pumps. The IRA adds expenses connected with improved energy storage, including thermal energy storage, as well as dynamic glass, biogas and other energy-efficiency-related investments. Like Section 179D, the ITC is also a sliding scale, with increasing value tied to non-energy-efficiency factors such as payment of prevailing wages, whether the project meets “made in the U.S.A.” statutory requirements, and whether the project is in certain locations such as brownfield sites.

With more local jurisdictions requiring the addition of electric vehicle (EV) charging stations in commercial buildings, continuation of Section 30C, the federal tax incentive offsetting the cost of these installations, is an important consideration for the real estate industry. The IRA extends the 30C tax credit for EV charging stations through 2032. The credit is capped at $100,000 per station, and it is transferable to a third party by an owner who may have insufficient tax liability to make use of it. The transferability of the credit should expand its reach, but the IRA also imposes significant new geographic limitations on where EV stations must be located to be eligible for the maximum benefit. These include certain low-income census tracts and rural areas.

The Power of Incentives

The real estate industry has made great strides in reducing the energy usage of commercial structures, which has lessened the built environment’s greenhouse gas emissions. Voluntary government programs, such as the Energy Star program administered by the Environmental Protection Agency (EPA), and Portfolio Manager, its online tool used to track energy and water consumption in buildings, have been important elements in helping the industry advance its own goals on energy usage and greenhouse gas reductions. Buildings that meet certain EPA criteria for energy efficiency are deemed “Energy Star certified,” making them more attractive to tenants and investors.

Undoubtedly, the largely incentives-based approaches included in the IRA, including changes designed to make energy-efficiency retrofits of existing structures more likely, will accelerate the current trend in the industry toward improved energy usage and reduced greenhouse gas emissions.

Aquiles Suarez is the senior vice president for government affairs for NAIOP.