The Often Forgotten Section 179D Deduction
JEFFREY C. NEWMAN, CPA, JD
Claiming the energy-efficient commercial buildings deduction
Businesses that have invested in energy efficiency — or are considering doing so — should not overlook the Section 179D deduction for energy-efficient commercial buildings. This tax break offers valuable deductions (up to $1.80 per square foot) for the cost of energy-efficient improvements to new or existing commercial and some residential rental buildings.
The Section 179D deduction was first added to the tax code in 2005 as a temporary incentive, but it has expired and been renewed several times over the years. Fortunately, tax legislation enacted in late 2020 made the deduction permanent and provided for the maximum deduction amount to be adjusted for inflation in future years.
Who is eligible and what qualifies?
Generally, the deduction is available to the taxpayer who incurs the construction expenses associated with the project. Usually, that means the building owner, but in some cases, it may be a tenant. For buildings owned by federal, state or local governments, the owner may allocate the deduction to the taxpayer primarily responsible for the design — typically, an architect, engineer, contractor or energy consultant.
The Section 179D deduction is available for commercial buildings of any size. It is also available for multifamily residential rental buildings that are at least four stories above grade. Eligible projects may include new construction, additions to existing buildings or renovations of existing buildings.
What improvements are deductible?
Section 179D allows taxpayers to immediately deduct, rather than depreciate, the cost of eligible energy-efficient improvements. The maximum deduction is $1.80 multiplied by the building’s square footage. Eligible improvements must otherwise be depreciable and installed as part of an eligible building’s interior lighting system, HVAC and hot water systems, or building envelope (meaning its walls, insulation, exterior windows and doors, roof systems and foundation).
The improvements must be part of a plan designed to reduce annual energy and power costs by at least 50% compared with a reference building constructed according to American Society of Heating, Refrigerating and Air-Conditioning Engineers (ASHRAE) standards. Note that the applicable standards have become increasingly strict over time. For example, improvements placed in service from 2006 to 2015 were subject to the 2001 ASHRAE standards and those placed in service from 2016 to 2020 were subject to the 2007 ASHRAE standards.
For improvements placed in service after 2020, the applicable ASHRAE standard will be the one in effect two years before construction begins. To qualify, you will need to obtain a certification from a licensed engineer or contractor stating that the improvements meet applicable energy-efficiency targets.
A couple of things to keep in mind: When measuring energy and power savings for purposes of the 50% test, you should consider only reductions in the cost of interior lighting, HVAC and hot water systems. Reductions in energy and power costs for other uses — such as refrigeration, elevators or certain manufacturing processes — do not count toward the 50% target.
Also, the $1.80 per square foot maximum deduction is a lifetime limit for the particular building. For example, if the owner of a 100,000-square-foot building claims a Section 179D deduction totaling $90,000 ($0.90 per square foot) in 2021, any Section 179D deductions in future years for the same building would be limited to a total of $90,000.
Are partial deductions available?
As ASHRAE standards become more stringent, it is getting increasingly difficult to meet the 50% target previously described. However, even if a building fails to achieve an overall 50% reduction in energy and power costs, a partial deduction of up to $0.60 per square foot may be available for:
- Interior lighting systems that meet a 25% savings target;
- HVAC and hot water systems that meet a 15% savings target; or
- Building envelopes that meet a 10% savings target.
There is also a special “interim lighting rule” that permits prorated deductions for improvements that reduce lighting power density by 25% to 40% (50% for warehouses).
Generating tax savings
If you plan to improve the energy efficiency of a new or existing building, be sure to consider the availability of Section 179D deductions. Your ORBA tax advisor can help you determine whether the project qualifies for the deduction, calculate the deductible amount, obtain the necessary certifications and document your deductible expenses.
How to recover tax benefits you missed
What if you were entitled to Section 179D deductions for energy-efficient improvements placed in service in a previous year, but you neglected to claim them at the time? Is it possible to recover the tax benefits you missed? Possibly.
There are two ways to claim missed Section 179D deductions. One is to report them on an amended return for the tax year in question and seek a refund of the tax savings. The deadline for filing an amended return is usually three years from the filing date, so this is not an option for older projects.
The second method is to file Form 3115, Application for Change in Accounting Method, and claim “catch-up” deductions in the current tax year. This method avoids the statute of limitations for amended returns, so conceivably you could use it to claim missed deductions going back to 2006.
Related Read: Energy Efficiency Makes “Cents”
If you would like additional information regarding the Section 179D deduction or other incentives, please contact Jeff Newman at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.
Real Estate Professional — Do I qualify?
TAMARA PARTRIDGE, CPA, MST
The COVID-19 pandemic has resulted in many property and business owners experiencing financial losses. While the losses may have hurt businesses, have they at least helped save tax dollars? It depends.
When an active business owner recognizes a loss it is generally considered nonpassive and can offset other income. However, a business investment in which the individual does not have much involvement will likely be considered passive. Passive investments are placed in a separate bucket meaning passive losses can only offset passive income. If a taxpayer only has passive losses in a given tax year, then those losses will not be utilized and will be suspended until either: 1) the taxpayer has passive income from that activity or another activity; or 2) the business/property is sold. By default, rental real estate is considered a passive investment. Rental property owners may build up several years of losses before they can actually be recognized, resulting in potentially significant and delayed tax savings. However, a rental real estate trade or business is not considered passive if the taxpayer qualifies as a real estate professional.
To qualify as a real estate professional, an individual must spend more than 50% of her working hours in real property trade or businesses in which she materially participates and must spend over 750 hours of service during the year in those businesses. A real property trade or business includes everything from, but not limited to, real property development, construction, acquisition, conversion, rental, operation, management, leasing or brokerage. The key term is “materially participates.” Material participation occurs when a taxpayer is involved on a “regular, continuous and substantial basis” and there are various tests to determine this involvement.
There are seven tests to determine if you materially participate in a business. A spouse’s participation in the activities can also be counted to determine material participation, but one spouse must still satisfy the 50% and 750-hour rules to be considered a real estate professional.
Most people can meet the requirements as long as they satisfy at least one of the tests below.
- The individual spends more than 500 hours in the activity during the year;
- The individual is the only one who substantially participates in the activity;
- The individual spends more than 100 hours participating and no one else spends more hours;
- The activity qualifies as a “significant participation activity” (trade or business, other than rental, with greater than 100 hours participation) and aggregate participation by the individual for all significant participation activities exceeds 500 hours for the year;
- The individual met material participation requirements for any five of the ten prior tax years;
- The activity is a personal service activity and the individual materially participated for any three prior tax years. A personal service activity is a service such as law, accounting, health, consulting, etc., but does not include real estate; or
- Facts and circumstances determine that the individual participates in the activity on a regular, continuous and substantial basis during the year and he/she participates more than 100 hours.
Since each activity is considered separate, some taxpayers (including real estate professionals) may have activities that do not individually meet the material participation standard. There is an election that can be made on the individual tax return to combine all activities into one, which will deem all of the taxpayer’s real estate activities as nonpassive. Once this election is made, then it cannot be changed unless there is a material change in facts and circumstances.
If you are still unsure if you qualify as a real estate professional, make sure to keep a record of your hours. This will not only verify the qualifications for yourself, but will be good audit protection from the IRS. An hours log is especially important for those who work extensively in real estate, but also work in a different industry on a regular basis.
The tax laws are constantly changing and complicated, so make sure to discuss your status with your ORBA CPA to verify whether you qualify as a real estate professional and if an election makes sense for you.