Tax Treatment Changes to Real Estate Investments in 2023 and Beyond

Updated on: March 7, 2023

Authored By Jim Wilhelm | Director, Tax

Two recent tax updates have placed an emphasis on investing in real estate property by updating and enhancing the tax treatment afforded to them. The first change stems from the Inflation Reduction Act of 2022, which included an enhancement to Internal Revenue Code Section 179D. The second and most recent change was published in Revenue Procedure 2023-9, creating a new optional and beneficial safe harbor accounting method for real estate developers.

Section 179D – Energy-Efficient Commercial Building Deduction

Made a permanent tax provision in 2020, Internal Revenue Code (IRC) Section 179D was created with the intent of incentivizing property owners and, most importantly, property designers to design and build commercial real estate that utilizes energy-efficient property.

Original Section 179D Guidelines

For tax years 2022 and prior, Internal Revenue Code Section 179D allowed for a deduction based on a certain amount per square foot if energy savings of 50% was achieved. A maximum of $1.88 per square foot – capped for the lifetime of the building – could be achieved if investments were made into three components:

  • Interior lighting
  • HVAC
  • Building envelope (roofing, windows, etc.)

Deductions for energy-efficient expenditures made in prior years, as far back as 2006 in some cases, were available.

Eligible properties were primarily commercial buildings and multi-family properties of four stories or higher located in the United States. The deduction was available to both eligible property owners and designers of governmental buildings, such as:

  • Architects
  • Engineering firms
  • Electrical contractors

As the deduction under IRC 179D was of no value to governmental agencies, the designers were allowed the deduction. By allowing the designers to benefit from the deduction, building owners, in theory, had the possibility of negotiating lower prices for their projects.

Enhancements Made to IRC 179D

With the passage of the Inflation Reduction Act of 2022, there were a few key changes made to IRC 179D that will go into effect for tax years beginning on or after January 1, 2023:

  • Designers of commercial buildings owned by tax-exempt organizations – colleges, hospitals, etc. – may receive an allocation of this deduction.
  • The standards for energy efficiency improvement have been modified, in particular for existing buildings undergoing a retrofit.
  • The core deduction under IRC 179D is now $.54 per square foot if energy savings of 25% is achieved – down from the 50% threshold.
  • Additional deduction amounts can be achieved if energy savings are above 25% and if you meet the test for the prevailing wage and apprenticeship wages.
    • In total, the maximum benefit is now $5.36 per square foot – tripling the benefit in place before 2023.

It is important to note that these enhanced benefits provided by IRC 179D come with some extra work for those looking to claim the deduction and should be considered when planning.

Given the substantially larger benefit, the movement towards energy reduction, and the need to replace aging energy systems in many buildings constructed more than 20 years ago, the newly robust IRC 179D deduction is something property owners and designers should revisit in 2023.

Safe Harbor Accounting for Real Estate Developers

The IRS recently issued Revenue Procedure 2023-9, replacing the 30-year-old guidance initially laid out in Revenue procedure 92-29. This new guidance provides an alternative method to account for certain common area improvement costs.

Initial Guidance: Revenue Procedure 92-29

Real estate developers are often mandated by local law or contracts to cover the costs of certain common improvements related to their development projects, such as:

  • Common areas
  • Stormwater management ponds
  • Recreational facilities
  • Streets
  • Sidewalks

To qualify, these projects had to benefit two or more units in the development that were separately held for sale. The Rev. Proc. 92-29 allowed developers to elect to accrue these expenses before they were deemed to have been incurred under the all-events test under the IRC 461(h) and other standard accrual method accounting requirements. As units were sold, the developers were able to deduct a portion of the associated common improvement costs that had been allocated among them. Without this election, costs could not be deducted until the rules under IRC 461(h) were met – this meant common improvement costs incurred in the final year or two of a project would be backloaded – thus causing more income to be recognized earlier in the lifetime of the project.

Newly Issued Revenue Procedure 2023-9

This revenue procedure is now the operative guidance for developers to utilize for tax years beginning in 2023. Some key impacts and changes brought forth by this procedure are:

  • Adopting the rules under Rev. Proc. 2023-9 is considered an accounting method change, necessitating the filing of Form 3115. This new method must be used across all developmental trades or businesses of the taxpayer.
    • To help taxpayers, streamlined filing may be created for developers already utilizing Rev. Proc. 92-29.
  • Developers no longer need to separate consent from the IRS for each project, which was required under Rev. Proc. 92-29.
  • Any reasonable method may be used for cost allocation, allowing for some creativity to be applied in certain circumstances.
  • Developers must maintain adequate records of the estimated costs for each project and allocations, amongst other requirements.
    • Records will need to be retained for at least three years after the project’s costs have been fully deducted.

With Revenue Procedure 2023-9, interest expense capitalization under IRC 263A still applies. Failure to follow these new rules will likely result in taxpayers owing more tax in the earlier stages of a long-term project and deferring expenses into the later/final year of a project.

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