The Tax Incentives Keeping the LED Lights On

Q&A with: David Diaz, Managing Partner at Walker Reid Strategies

As energy efficiency initiatives become common procedure for new construction, many in the real estate and construction industries could be eligible for tax incentives but not taking advantage of them. For a closer look at the cost saving opportunities for real estate operators and contractors, we spoke with David Diaz, Managing Partner with Walker Reid Strategies, a BDO Alliance firm specializing in energy efficiency and specialty tax services.

What are the energy incentives available to the real estate and construction industry?

There are two tax incentives that intersect with the real estate and construction industries: section 179D tax deductions for commercial buildings and section 45L tax credits for residential properties. The latter is most commonly leveraged by developers of large multi-family buildings or complexes. The commercial deduction—179D—is also available for contractors, architects and engineers on eligible government projects.

What are examples of common energy improvements that qualify?

For energy savings, changing lighting is the low-hanging fruit. This can be as simple as updating fluorescent lights to LED. One common misconception with 179D is that if you make those improvements, you can only claim the lighting portion of the credit, but if your lighting is efficient enough, you can claim the whole thing.

How has market pressure for corporations to be more environmentally conscious impacted the energy-efficient building sector?

External factors have had a tremendous influence on energy efficiency initiatives. We’ve seen a substantial increase in the number of qualifying projects since around 2011. I see two factors at play in that growth. First, and most importantly, a lot of new construction automatically meets the energy tax incentive targets that have been set by the IRS and the Department of Energy. Second, the public’s expectations to increase environmentally friendly building practices, building standards and technological advancements have all progressed faster than the tax code.

On the commercial real estate side, who are the best candidates for taking advantage of tax incentives?

Developers, landlords or contractors that have an appetite to reduce their tax liabilities—perhaps they just built a new building or received a major influx of capital—are at the perfect juncture to consider their energy incentive options and leverage accelerated depreciation. We have a lot of clients that are great candidates from an energy perspective, but they are highly liquid and not actively investing, so they have less need.

Once savings are realized from energy tax incentives, the value really comes from putting that money to work. The smartest use of energy tax credits is to directly reinvest it into the business. Among those strategies is funding other energy improvements.

What is the biggest reason builders or landlords aren’t taking advantage of the credit?

Both tax credits available for the real estate and construction industries are extremely underused.  Savvy real estate professionals and investors are usually aware of cost segregations and local rebates to drive tax savings, but they often overlook the energy angle. Many in the industry also wrongly assume that their buildings aren’t “green enough” to qualify for the deduction and don’t pursue the credits. In reality, most building codes align with and meet IRS requirements for energy efficiency, so the majority of new construction projects at least partially meet 179D requirements.

The deduction is particularly underused in the fixed asset space. Only 10 to 20 percent of eligible building owners making improvements to their fixed assets are taking advantage of the available credits. Lack of awareness is really the primary driver for underuse, but there are other considerations as well. Developers and property owners have a lot of tax saving options available to them that they may prioritize before energy tax credits. Cost segregation, for instance, is an option that yields a better return on investment than the 179D certification. Taxpayers that have already performed cost segregation and still have the appetite to reduce their tax liability are good candidates to explore tax savings in energy.

How do the requirements compare between the residential and commercial credits? 

While most new commercial construction will fulfill the 179D requirements, qualifying for the residential credit (45L) is a bit more difficult. To meet the standards, homebuilders need to consider energy efficiency before breaking ground. It needs to be a more intentional process. Common green building strategies for single and multi-family homes include building envelopes for windows and doors and integrating efficient heating, ventilation and air conditioning (HVAC) technology.

Despite the stricter requirements on the residential side, most projects we review do qualify for the credit. Before 2013, only about 20 percent of projects Walker Reid reviewed qualified for 45L. Today, that number has climbed to around 60 to 70 percent of projects. Over the course of our collaboration with BDO, we’ve certified over 3,000 residential units with 45L.

Are there any frequent audit issues related to the tax incentives?

The most common audit risk occurs with government-owned buildings. Since governments and municipalities are non-taxable entities, those organizations can’t qualify for the credit themselves. For qualifying projects, however, governments can allocate the tax savings to individuals and companies that design the energy efficient aspects of the building. This clause extends the credit to contractors, architects and engineers contracted by governments for energy efficiency projects.

The audit risk comes into play because there is some gray language in the tax code about the definition of “designer,” and what kind of professionals and work are eligible for the credit. As a result, a lot of contractors and subcontractors are taking this incentive even though they didn’t complete design work. In these cases, the designers that created the specifications and deserve the credits aren’t claiming them because they are going to other firms.

In audits, individuals that claim this credit are being asked to prove they completed design work for the energy efficient building. Designers should document their role in the design process, including design meetings, design specifications and energy-specific equipment to prepare for this audit risk.

What is the outlook for these tax incentives?

The 179D tax credit expired for projects in 2017, so the industry is waiting on a legislative extension and there is a very real possibility the credit will change. While there is one piece of legislation on the table that proposes making the credit permanent—HR 3507—the outcome of that bill and the credit overall remains uncertain.

The policy details are still being ironed out, but it’s likely that the bar for qualifying energy efficient projects will be raised in the future. As the tax code catches up to the public’s expectations for energy efficiency and technology continues to advance, I expect more green building projects will start to shift beyond lighting retrofits to a more holistic efficiency plan.

This article originally appeared in BDO USA, LLP’s “Real Estate & Construction Monitor” newsletter (Winter 2018). Copyright © 2018 BDO USA, LLP. All rights reserved.

Harris CPAs is an independent member of the BDO Alliance USA, a nationwide association of independently owned local and regional accounting, consulting and service firms

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