Buried within the 730-page Inflation Reduction Act that Congress recently passed is a dizzying array of proposals that directly and indirectly impact the commercial real estate sector. It also includes corporate tax reform, a huge expansion of the IRS, efforts to lower cost of prescription drugs, and energy initiatives. For that last piece, the bill authorizes $369 billion in spending on energy and climate policies, making it the most significant piece of federal legislation ever to address climate change.
The legislation, which is a scaled-back version of the ill-fated Build Back Better Act, is meant to bring the U.S. closer to the Biden administration’s goal of reducing greenhouse gas emissions to 50 percent below 2005 levels by 2030. It covers a wide range of clean energy and energy efficiency measures with effects that won’t be realized for quite some time. The impacts on commercial real estate could be massive, especially the expansion of tax credits intended to spur building owners and developers to decarbonize their assets. According to the Rocky Mountain Institute, a nonprofit dedicated to the clean energy transition, the IRA could reduce real estate carbon pollution by an estimated 33 to 100 million metric tons.
One piece of the bill used to incentivize investment in sustainable infrastructure is the expansion of 179D Energy Efficient Buildings Tax Deduction. Starting next year, the tax deduction will go from $1.88 per square foot to $5 per square foot. There is a maximum allowable benefit for this deduction of 250,000 square feet, which means that for an eligible building, the deduction would go from a $470,000 tax break at the current rate to a $1.25 million with the new rate. The 179D tax break requires the use of a tiered energy-use reduction system to receive the full benefit. But, it also allows fractional reductions for partial compliance. Buildings must reduce the energy cost of lighting, HVAC, and hot-water systems by 50 percent or more to comply fully with 179D, which is built around the energy efficiency engineering standard ASHRAE 90.1.
The expansion of tax credits like 179D (made a permanent part of the tax code in 2020) is expected to nudge commercial building owners to make energy-efficiency retrofits that many previously thought were too expensive. Some industry analysts say the incentive boost tips the scales in justifying the costs of these energy retrofits, which could significantly increase the number of building owners undertaking them.
The 179D incentive was also modified so that REITs could use the deductions. If a building owner makes an energy retrofit to an existing building, a large share of the price can be deducted in the first year instead of being spread out over several years. The accelerated deduction of 179D primarily applies to large properties, and it isn’t something that should be claimed without expert preparation from a tax professional because some strings are attached. For example, maximizing the tax incentive may, in some cases, require the construction wages for the project to be paid at or above local prevailing wage rates as determined by the U.S. Secretary of Labor.
Another rule for claiming a 179D deduction is that the energy savings must be certified by an independent licensed engineer or, in some cases, an architect. Experts say the best way to claim the deduction is to hire a consulting firm with tax professionals and engineers that’ll design a retrofit to maximize the incentive. However, the consulting fees for calculating the deductions are said to be very pricey.
Unpacking the benefits
As developers and building owners learn about the legislation, they’ll find many ways to maximize the tax credits for full financial benefit. Some of the benefits, like the ones dedicated to multifamily properties and affordable housing, are pretty significant.
For example, the High-Efficiency Electric HOMES Rebate Program directs money to states for the electrification of low- and moderate-income households, including single-family and multifamily properties. The provisions cover up to $1,750 for a heat pump water heater, $8,000 for a heat pump for heating and cooling, and funding for upgrading electric load service and insulation.
The HOMES Rebate program also includes $250 million for contractor training that is expected to ramp up the number of energy retrofits, including in multifamily properties, from the current levels of about 200,000 homes annually. The comprehensive energy improvements spurred by the program could reduce annual utility bills for units in multifamily properties by $210 per year, according to Lowell Ungar of the American Council for an Energy-Efficient Economy.
Another part of the legislation that will help commercial building owners is the extension of the commercial tax credit for solar panels to 2034, with a phase-out starting in 2032. The credit (Section 48 of the IRC) begins on January 1, 2022, and allows for maximum tax savings of 30 percent of whatever the solar panels cost the business or real estate activity. So, for example, if a building owner installs a $20,000 solar panel system on a property and they qualify for the credit and meet wage and apprenticeship requirements, the IRS pays 30 percent of the cost, equating to $6,000. The legislation adds 10 percent to the credit if the solar panels are installed in a low-income community and 20 percent if installed at a qualified low-income residential building.
There are also bonus credits if the solar project uses domestic materials and is installed in an ‘energy community,’ defined as including brownfield sites or communities with an unemployment rate at or above the national unemployment rate in the previous year.
The IRA also specifies that architects and contractors of tax-exempt buildings owned by entities like private schools, nonprofits, and charitable organizations are now eligible to benefit from the expanded 179D tax rebate. Ralph DiNola, CEO of the New Buildings Institute, a Portland, Oregon-based think tank that works to improve building energy performance, told me this ‘direct-pay’ provision could be a game-changer. “It’s hard to grasp the scope and scale of the direct pay provision,” DiNola said, noting that these organizations haven’t been able to take advantage of the tax incentives before.
Perhaps the most significant potential benefit of the legislation is what it’s expected to do to accelerate green building technology. The Inflation Reduction Act could substantially grow the demand for energy-efficient technology by providing funding for tech that improves building envelopes, HVAC systems, and interior lighting. “Many solutions of next-generation green building materials that weren’t economically viable for builders before, the IRA will tip them over and make them easier to use,” said Jameson Hartman, Vice President at RET Ventures, a venture fund focused on real estate tech companies in the multifamily sector.
The law could be a significant inflection point for building envelope solutions like roofs, floors, and walls, as developers will be incentivized to use new materials previously deemed too expensive. For example, new insulation technology that includes materials and structural redesigns could lead to $500,000 in additional tax rebates for a 300,000-square-foot building.
Proponents of the IRA hope it will plant seeds for green building tech development that’ll drive real estate decarbonization beyond 2030. These advocates say that climate policies like taxes, subsidies, and mandates have created virtuous cycles of higher demand that accelerate innovation. An often cited example of this is solar power. The cost of a photovoltaic solar module between 1980 and 2012 declined by 99 percent, according to a 2018 MIT study. The research attributed about 30 percentage points of this reduction to public and private research and development, which spurred more efficient solar panels.
Another 60 percentage points in the reduction of solar panel cost in this period were attributed to “learning-by-doing,” which refers to manufacturing process improvements and economies of scale. Between 1980 and 2012, the average solar plant capacity increased roughly 200-fold. These advancements were triggered by the promise of demand that government investment and subsidies made possible, some of which didn’t even come from the U.S.
Cost of Commercial Rooftop Photovoltaic System in the U.S. (200 kW)
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The massive spending in climate and building decarbonization in the Inflation Reduction Act are intended to spur the same types of investment cycles and economies of scale that helped make solar energy more accessible. “The legislation will enable a lot of green building technology that has been on the periphery in real estate,” Hartman of RET Ventures told me. “It will lead to a significant influx in technology investment.”
Carbon capture is one of the nascent commercial building technologies that could benefit from the Inflation Reduction Act. Under the law, any carbon capture project starting construction in the next decade can qualify for a federal tax credit known as 45Q. The tax credit has been around for a while, but the legislation dramatically improved it. In the past, 45Q provided a credit of $20 per metric ton of carbon dioxide permanently stored, but the new bill raised the credit to $60 per ton. Securing the credit used to mean capturing a minimum of 25,000 metric tons of carbon, but the new bill has dropped the threshold to 12,500 metric tons.
Carbon capture has typically been used by utilities and direct producers of carbon emissions, but the tech may be increasingly used in new or existing commercial buildings. For example, 42 percent of building carbon emissions in New York City come from heating and hot water, which can be difficult to decarbonize in some cases. Commercial buildings can choose to electrify their heating and cooling systems with heat pumps or other technology, but carbon capture could be another option. The equipment is set up on-site with carbon capture, diverting gasses from emissions and turning them into liquid. From there, the captured carbon can be used to manufacture fuels and building materials or stored deep underground in geologic formations.
Only 26 commercial-scale carbon capture projects are currently operating around the world, mostly at power plants and industrial facilities, according to the Center for Energy and Climate Solutions. But Anna Pavlova, VP of Strategy & Market Development at CarbonQuest, said her company is currently working to install carbon capture systems at hospitals, multifamily buildings, and other commercial real estate assets. The company recently installed its first fully-operational system at the Grand Tier in Manhattan, a 375,000-square-foot multifamily building owned by Glenwood Management. “The reason carbon capture in buildings is so new is that in the past, laws were focused on energy intensity,” said Pavlova. “Now, laws like Local Law 97 focus on carbon intensity, which has spurred interest in carbon capture tech in commercial real estate.”
Other provisions that could potentially help the commercial real estate industry include the creation of a federal “green bank” that would help subsidize and finance larger energy-efficiency projects than existing state and regional green banks. The legislation will also make a variety of investments in green building tech in buildings much more possible, including heat pumps, battery storage, energy recovery utilization, and smart building controls and thermostats. “I have a feeling we don’t really understand the magnitude of the Inflation Reduction Act yet, but it will be very significant,” DiNola of the New Buildings Institute said.
Advocates of this sprawling legislation claim the effects could be truly transformational and felt far and wide for a long time to come. But the legislation is of course not without its detractors. Some claim that while the IRA does put pressure on (and incentivize) building owners to adopt new technologies, many are not convinced that their efforts will actually reduce climate change or make economic sense. The expense of a faster green energy transition has been a low priority or financially out-of-reach for most commercial building owners. However, proponents of the IRA believe this legislation will make net-zero energy and net-zero carbon emissions buildings much more attainable. Real estate firms with ambitious net-zero emissions goals may find it easier to move toward those objectives thanks to the spending included in the legislation.
Rather than relying solely on laws, mandates, and taxes to prod building owners into decarbonizing their assets, this ambitious new legislation attempts to shower the real estate sector and other industries with lavish incentives and subsidies. In the best case scenario, the IRA’s $369 billion in spending over the next decade may spur a sustainable virtuous cycle of further investment and innovation that could help property owners for years, if not decades to come.