Can Tax Policy Support the Real Estate Sector's Low-Carbon Transition?

Preamble:

The ideas presented in this article are based on work conducted in late 2023 by the Low-Carbon Prescribers Hub[1].

Real Estate: A Sector Forced to Transform in Times of Crisis

The economic crisis facing the real estate sector This is not the first crisis to occur, but what makes it unique is that it is taking place against the backdrop of a parallel environmental crisis. The challenges related to climate change, the preservation of biodiversity, and—more specifically—the conservation of natural and forested areas are therefore forcing industry stakeholders to envision a different path out of the crisis and to reinvent the housing production model. The National Conference on Land and Territories (ANFT) which took place on February 6 and 7 in Nancy underscore the urgency of identifying “solutions for land use that is more environmentally responsible and more beneficial economically and socially.”

Decarbonizing the real estate sector will require a massive renovation of the existing housing stock

The Carbon Footprint of the Real Estate Sector is now largely driven by emissions associated with the operation of the existing building stock.

In fact, according to the most recent figures from the SGPE[2], 65% of the sector’s national emissions are linked to the combustion of fossil fuels in the existing infrastructure, primarily for heating. When “indirect” emissions—linked to the consumption of electricity and heat/cooling from urban networks—are factored in, as much as 75% of the sector’s national emissions can be attributed to energy consumption in existing buildings.

Therefore, while it is essential to ensure a very low-carbon design of new buildings that still need to be built (role of RE2020[3]), that will be nowhere near enough given the decarbonization targets set by the SNBC[4], it is also essential to undertake a large-scale and rapid renovation of the existing housing stock.

To achieve this ambitious two-fold goal renovation of France's building stock However, given the time constraints, we must examine all existing obstacles and drivers. In this article, we propose to examine one of the components of this transition, namely: the role of taxation in the sector's low-carbon transition and, more specifically, the role that taxation can play in steering real estate practices toward new construction versus the renovation of existing buildings.

It is worth examining the role—as either a brake or an accelerator—that the current tax framework may play in the sector’s environmental transition

With regard to renovations, current tax law[5], driven by an underlying goal of improving energy efficiency, promotes “major renovation” projects that result in the refurbishment of a significant portion of construction materials and equipment.

While this encouragement to maximize energy savings through extensive renovation is entirely appropriate, it also appears that this automatic assumption of “restoring to like-new condition” runs into a significant limitation once the “energy” perspective is broadened to an “energy + carbon” perspective in Life Cycle Assessment (LCA).

In fact, in the context of a life cycle assessment (LCA), the systematic tendency to demolish existing structures—even those that are still functional and efficient—can, in some cases, be counterproductive from a carbon perspective.

The purpose of this article is thus to examine the ability of tax doctrine to maintain the driving force provided by tax incentives for renovation while allowing project owners to benefit from existing exemptions by adopting a cost-effective approach (in this case, retaining functional elements) and provided that they incorporate environmental goals commensurate with today’s challenges.

An Existing Tax Doctrine That Needs to Be Reexamined in Light of Current Challenges

Summary of Applicable Tax Law

Real estate transactions are currently subject to two tax regimes: VAT, which goes to the State, and the Transfer Tax (DMTO), which goes to local authorities (departments). Tax policy aims to avoid full double taxation on these two taxes by applying reduced rates depending on the nature of the transaction: a sale of an existing property or the purchase of a “new” property—or one restored to new condition. More specifically, Article 1594-0 G A of the CGI 3 entitles the taxpayer to “a total exemption from proportional DMTO and the application of only the fixed fee of 125 euros, with the VAT rate remaining unchanged,” provided that thecommitment to build.

However, in order to meet the necessary conditions to comply with this commitment to build, the project owners must undertake to restore the acquired property to new condition within the meaning of Article 257 I, 2, 2° of the CGI 4, under which “the following are considered new buildings: properties that have not been completed for more than five years, whether they result from new construction or from work on existing properties that consisted of adding additional stories or that restored the property to new condition:

The point that will be of particular interest to us in this article is the last one listed above, namely “the restoration to like-new condition of all finish work elements (non-load-bearing floors, exterior door frames, interior partitions, plumbing, electrical, and heating systems) to at least two-thirds of their original condition.”

In fact, most renovation projects aimed at substantially reducing greenhouse gas emissions do indeed involve replacing most of these components in order to improve not only the building’s environmental performance but also its usability after the work is completed. However, while most renovation projects plan to replace some of these components, it is by no means standard practice for all of them to be replaced, whether for functional, aesthetic, economic, or environmental reasons.

Thus, the exemption requirement as described in current legal doctrine leads to the systematic replacement of a significant portion (at least two-thirds) of a set of finish work elements, without regard for the performance and functionality of the construction products and equipment to be dismantled.

However, the latest research by the Low-Carbon Prescribers Hubhave shown that preserving existing buildings is one of the three main pillars of low-carbon renovation (along with drastically reducing energy consumption and phasing out fossil fuels).

Under these circumstances, if current tax policy encourages, in certain cases, the dismantling of functional and high-performance construction products and equipment, might this approach not lead to a counterproductive outcome in terms of carbon emissions?

Could current tax policy be counterproductive in terms of carbon emissions?

To answer this question, let's consider a practical example and focus on the orders of magnitude derived from the work of the Low-Carbon Prescribers Hub.

To answer the question posed above, we will examine recent work conducted by the Low-Carbon Prescribers Hub on theThe challenge of decarbonizing renovation projects, and more specifically, a real-world use case led by one of the program’s project owners. This case study involved a renovation project that included changing the use of a commercial building to a senior assisted living facility. Although this major renovation project involved the demolition of a large portion of the existing structure, the project owner wished to retain the exterior joinery (windows) for reasons of cost-effectiveness and following a favorable technical audit regarding both the performance and functionality of these elements.

Unfortunately, in order to qualify for the exemption defined by tax doctrine as outlined above, the exterior windows and doors were ultimately replaced in their entirety to achieve a “refurbished” condition and thus satisfy the “commitment to build” required by the law.

To better understand the decision to replace a significant number of windows—even though they are energy-efficient and functional—it is helpful to use this example and add some economic context (fictitious figures are used here) to illustrate the orders of magnitude involved (figures also sourced from the Hub):

Concrete proposals and an open-ended approach for further discussion

Possible courses of action to maintain the energy efficiency approach and expand it to a broader environmental efficiency framework (carbon, resources, etc.)

It therefore seems essential to examine the scope of current tax policy to ensure that it effectively serves as an incentive for low-carbon renovation. One possible solution would be to ensure that a renovation meeting the criteria for a low-carbon project can fall within the scope of the commitment to build and benefit from the tax incentive provided under this framework.

It will therefore be necessary to define the criteria for such a low-carbon renovation in order to adjust the scope of tax policy accordingly. We propose addressing this through a two-pronged approach:

1. enable the implementation of the measures identified as essential for low-carbon renovation (drastic reduction in energy consumption + phase-out of fossil fuels + maximization of the preservation of existing buildings);
2. ensure an objectively ambitious carbon footprint by setting a specific carbon threshold, for example, based on the regulatory thresholds for new construction (RE2020)

Regarding the second point, the main challenge lies in the fact that there is not yet a consensus on the method for quantifying the carbon footprint of renovation projects (unlike new construction, which is covered by the RE2020). Nevertheless, a great deal of work is underway within the real estate sector, particularly the initiatives led by the Hub, aimed at establishing a common method and shared objectives for all stakeholders.

Although these efforts to harmonize carbon footprint standards in renovation projects are still under consideration, it is worth exploring what a future revision of tax policy might look like—one that meets the two criteria defined above and enables the achievement of the objective described in this article. One solution (inspired by Proposal No. 4 from the États Généraux de Paris La Défense[6]) would be to include an exception to the replacement of certain finishing elements if, and only if, two fundamental conditions are met:

1. a resource assessment[7] demonstrated that the components in question are in good condition and functioning properly;
2. An LCA study of the renovation project demonstrated that the building’s environmental performance after the work is sufficiently ambitious (to be defined, for example, in light of the goals for new construction).

Finally, it is also evident that this tax issue lies at the heart of current concerns regarding the environmental transition of the existing housing stock, as illustrated by the example of public housing, for which a similar analysis has already been conducted in the past through the “Seconde Vie” program.[8]. This program aims to provide an alternative to systematic demolition and reconstruction for landlords seeking to undertake major renovations of their properties with the goal of improving the environmental performance and livability of their housing units. To this end, the program offers a series of tax benefits (reduced VAT, expanded property tax exemption) provided that the renovation project results in an A or B rating on the Energy Performance Certificate (DPE) and meets safety, health, and accessibility standards approaching those of new construction. We can see here that the approach is similar to the one discussed in this article, as it aims to bridge the gap with the exemption framework available for new construction.

Conclusion and Thoughts for the Future

In conclusion, it is important to keep in mind, first and foremost, that these tax exemption mechanisms, on the other hand, pose a risk to the finances of local governments, which would no longer benefit from them. The main purpose of the analysis presented in this article is therefore to highlight that current tax doctrine already favors certain types of projects (major renovations, new construction) and that it might be worthwhile to reevaluate the scope of these exemptions in light of the goal of a large-scale renovation of France’s building stock.

One can therefore imagine that a gradual modification of this tax framework could contribute to the ongoing paradigm shift—particularly evident in the housing stock—aimed at moving away from the view that “the need for new housing = the construction of new housing” toward a more complex perspective “need for new housing = renovation and repurposing of vacant housing + conversion of offices/retail spaces into housing + rehabilitation/additional stories to existing buildings + construction of new housing,” as discussed in particular in the recent report[9] Co-published by the USH (Union Sociale pour l’Habitat) and the PUCA (Plan Urbanisme Construction Architecture) on trends in the housing needs indicator in France.