The Investment Tax Credit for Energy
The federal investment tax credit (ITC) under Section 48 of the Internal Revenue Code (IRC) was extended, expanded, and modified by the Inflation Reduction Act in a number of important ways, many of which are of particular benefit to real estate. As a result, attaining a “green” building is now more incentivized than ever.
For example, while solar is the most common energy credit property, ground-source (i.e., geothermal) HVAC, fuel cells, and combined heat and power are also adaptable to multifamily housing.
The Section 48 energy credits were generally extended for 10 years. They were also modified to add new prevailing wage and apprenticeship requirements, starting in 2023, for larger energy systems (generally above 1MW) unless such project is properly grandfathered before Jan. 29, 2023. Fortunately, many energy projects and/or retrofits on multifamily properties fall below the 1 MW threshold. For those that do not, in order to claim the full basic 30% ITC, new rules published under IRS Notice 2022-61 must be followed. Otherwise, the ITC may be reduced to 6% (from 30%) where the wage and apprenticeship rules are operative.
In addition to the above wage-related change, new so-called ITC “adders” are now in play, beginning also in 2023, where the attainment of certain “domestic content” thresholds and/or locating an energy project in an “energy community” could allow up to a 10% additional ITC amount for EACH such criteria met. IRS guidance on determining domestic content and/or locating in an energy community is currently pending.
And last, but not least, is another IRA expansion of the credit of an additional ITC for projects located in a “low-income community” (a 10% adder) or for a “qualified low-income residential building project” or a “qualified low-income economic benefit project” (a 20% adder), as each are defined in IRC Section 48. These low-income-related ITC adders are subject to a yet-to-be-released federal tax credit application process, which is expected in the coming months. The project with the perfect fact pattern could qualify for an ITC of as much as 70% for solar or wind energy property.
The definition of energy property eligible for the ITC is expanded to now include stand-alone storage, dynamic glass, and certain specific “interconnection” costs, thus adding to the opportunities for financing of multifamily and other green building projects.
One caution is that the Inflation Reduction Act also implemented an ITC basis reduction in the case of energy property financed by tax-exempt bonds, so on 4% low-income housing tax credit (LIHTC) deals, it is important to document that bond proceeds are not being used on energy property. The ITC reduction can be up to 15%. This bond rule applies to an energy project that begins construction after the IRA implementation date. Fortunately, the rules for determining beginning of construction of the energy property (not the LIHTC building) are essentially unchanged from those in IRS Notice 2018-59 and its progeny. There are more restrictive transition rules that apply for projects beginning in 2025, so please consult your tax advisor on these deals.
IRC Section 42-related provisions
IRC Section 48 credits
While IRC Section 42 itself was not amended by the Inflation Reduction Act, Congress specifically benefitted the LIHTC by imposing basis reduction relief in 2023 for both IRC Sections 48 and 45L when either of these separate tax credits are part of a project.
The general requirement is that energy property under IRC Section 48 has a basis reduction equal to half the ITC, and under prior law that reduction of the depreciable basis would trigger a reduction of the LIHTC eligible basis. The Inflation Reduction Act now expressly states that such a basis reduction does not apply for determination of the LIHTC eligible basis. This change mitigates the negative financial implications of claiming the IRC Section 48 credit on a LIHTC project.
IRC Section 45L credits
Among the most notable changes potentially impacting LIHTC projects is the relief provided under the Inflation Reduction Act in cases where the project could qualify for the IRC Section 45L credit. Generally, the Section 45L credit results in a decrease in the depreciable basis equal to the amount of the credit claimed. In a move similar to that of the basis reduction relief just described, a similar basis reduction relief rule for Section 42 projects was also implemented beginning in 2023. In addition, the IRA removes the prior three-story height limitation and increases the credit amounts for 45L, according to the energy efficiency status of the building (Energy Star, Zero Energy Ready, etc.).
The Section 45L credit is worth exploring for a multifamily owner because it is a per-unit credit. In the past, the credit was $2,000. Now the credit can be as much as $5,000 per unit if the unit meets the Zero Energy Ready standards and uses prevailing wages. On a 100-unit building, that could be a $500,000 credit that brings in additional equity from an investor.
In conclusionThese new provisions in the Inflation Reduction Act make it much more likely that owners will use these tax incentives to finance energy improvements in their real estate developments. The rules are complex, and guidance is still forthcoming, so please contact your tax advisor for the rules that apply to your deal.
Subject matter expertise
JD, Senior Manager
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