Two years into the Inflation Reduction Act (IRA), the several tax credits that are eligible for “elective pay” are starting to catalyze investment in renewable energy, electric vehicles, and EV charging by nontaxable entities like local governments and nonprofit organizations. Slower to develop is a robust, cohesive response by nontaxable entities to the main tax tool for energy retrofits of their buildings – offices, schools, hospitals, and even multifamily housing – the Section 179D tax deduction. This means that while local governments and community groups are hard at work seeking to maximize federal investment for clean energy and clean transportation, they are less aptly positioned to reduce building energy use, a primary driver of greenhouse gas pollution in many cities.
The discrepancy in tax incentive uptake can largely be explained by the difference between tax credits and tax deductions. A tax credit is a dollar-for-dollar reduction in a taxpayer’s tax liability, while a tax deduction is an amount subtracted from a taxpayer’s taxable income, the amount from which tax liability is calculated. For entities that have sufficient tax liability, the cash value of a credit is 100 percent of the credit amount, while the cash value of a deduction depends on the claimant’s tax rate. For nontaxable entities like local governments and nonprofits, which by definition have no tax liability, the IRA makes several tax credits eligible for elective pay, a mechanism through which these parties can claim the value of a given credit in cash. Businesses without sufficient tax liability may also monetize tax credits by transferring them to parties with greater tax burdens. Congress did not extend the same treatment to tax deductions, likely at least in part because a tax deduction’s cash value depends on the taxpayer’s tax rate, which varies from taxpayer to taxpayer and is not immediately discernable.
Under the IRA, clean electricity technologies like distributed solar and wind, battery storage, and geothermal energy, along with electric vehicles and charging stations, are the subject of tax credits that cover between 30 and 70 percent of eligible project costs. In contrast, the IRA’s main tax tool for building decarbonization is a tax deduction that nontaxable entities can transfer to a limited set of other parties but cannot use directly. Section 179D offers a $0.50 to $5.00 per square foot tax deduction (inflation-adjusted) for whole-building energy efficiency retrofits that achieve a 25 to 50 percent reduction in energy costs as compared to the ASHRAE 90.1 Reference Standard or a 25 to 50 percent reduction in building energy use intensity (a measure of energy use per square foot) as compared to the building’s own baseline. In either case, the deduction is capped at the cost of qualifying equipment and retrofits: interior lighting systems, HVAC and water heating equipment, and improvements to the building envelope.
Though the 179D deduction is not eligible for elective pay, it is available to local governments and other nontaxable entities in that a public or nonprofit building owner can transfer the deduction to the designer (specifically an architect, engineer, contractor, or subcontractor) of the building improvements underlying the deduction. Thus, they can offer the deduction to a designer in the hopes of negotiating down the designer’s price. In this way, Congress allowed for the broad applicability of the 179D deduction in the public and nonprofit sectors, but these sectors face significant practical challenges in taking advantage of it.
In particular, nontaxable entities are acting with imperfect information when transferring the 179D deduction, as the project designer will almost certainly balk at disclosing the sensitive business information – taxable income and tax rate – that would help the parties properly value the deduction and use it to negotiate price. The transaction costs associated with negotiating the value of the deduction can be significant, with the municipal representative or nonprofit building owner either using internal capacity or hiring outside advisors to assess the value of the deduction and ensure that qualifying costs are spent in connection with whole-building energy reductions – a more difficult endeavor than a simple percentage or set deduction amount with no performance requirement.
Moreover, the 179D deduction is likely to disincentivize public sector contracting with small, local design businesses – architects, engineers and contractors – because they operate with less taxable income and have lower tax rates than do large national and multinational companies. The international infrastructure consulting firm AECOM, for example, reported $114 million in net income for its fiscal year 2023, with a roughly 26 percent effective tax rate. Thus, a $500,000 tax deduction (for a 100,000 square foot building achieving the full $5 per square foot) is worth roughly $130,000 in tax savings to AECOM. It is, however, likely to be worth much less to smaller firms. A small firm that pays out most of its earnings in salaries and other expenses, or an S-corporation that passes corporate income through to shareholders, will have a diminished capacity to use the Section 179D deduction. Simply put, unless the taxpayer’s income is $500,000 or more, they won’t be able to take full advantage of the $500,000 deduction. AECOM, on the other hand, could use these deductions many times over, and is better positioned to share its savings with customers. This oversight in policy design preferences large businesses at the expense of growing needed building energy design expertise in local communities.
Section 179D is, of course, just one of many provisions in the IRA that seek to encourage building energy retrofits and electrification. Households will be able to use efficiency and electrification rebate programs and can already use tax incentives. Discretionary grant programs from the specific (e.g., support for innovative building codes) to the general (e.g., Climate Pollution Reduction Grants) can center building decarbonization measures; tax credits for private housing developers are available for ENERGY STAR and Zero Energy homes; and the green banking entities funded through the IRA’s Greenhouse Gas Reduction Fund will offer products to finance building decarbonization efforts.
But 179D represents a missed opportunity for the electrification and retrofit of buildings owned by nontaxable entities, particularly at the smaller and more local scale. The lack of direct benefit to municipal and nonprofit building owners puts these entities at the whims of their negotiating counterparties and devalues these nontaxable entities’ work to move decarbonization projects forward in their buildings. Communities further stand to lose out on gains in local business and workforce development, because national and multinational firms are better able to use the Section 179D deductions and therefore take on major building decarbonization projects for universities, hospital campuses, municipal operations, and other large nonprofit real estate portfolios. (179D contains incentives for workforce development, with a five-times multiplier for projects that meet prevailing wage and apprenticeship criteria, but the architectural, engineering, or contracting work could still be done at a large company’s headquarters rather than in the community surrounding the project.)
The Section 179D deduction does have value, particularly if cities, nonprofit organizations, and local businesses are able to get up to speed on the how the deduction works and develop low-friction ways to share the tax savings. But there will be a steep learning curve and transaction costs that will proportionally burden small businesses much more than large ones, and that will leave nontaxable entities without perfect information in their negotiating. In an ideal scenario for nontaxable entities, Congress would enact a building decarbonization tax credit payable directly to nontaxable entities via elective pay. Absent such a solution, support will be needed help nontaxable entities value their 179D deductions, negotiate with designer counterparties, document their agreements in contract and ensure designers are properly reporting 179D transfers with the IRS. As the elective pay process for tax credits begins to hit its stride, 179D is a natural place for the IRS, technical assistance providers, and advocates to next turn their attention.
Amy Turner is the Director of the Cities Climate Law Initiative at the Sabin Center for Climate Change Law at Columbia Law School.
