Tax issues

Power Savings

Implementing environmentally friendly features speeds up the benefits of tax incentives.

The Energy Policy Act of 2005 contains tax incentives that can benefit owners of both new and retrofitted commercial property. Part of a $14 billion package, these incentives provide new deductions for green properties and improvements placed in service in 2006 and 2007.

Before the act, these improvements generally would have been depreciated over the standard 39-year period. Now deducting the cost provides property owners an immediate tax benefit. However, there also are consequences: When property is sold taxpayers must reduce the basis in the property by the deduction amount. Any gain from the deduction may be subject to recapture and taxed as ordinary income.

New Tax Guidelines

The act changes the way costs for energy-saving improvements placed in service in 2006 and 2007 are treated. Primarily these costs can be deducted, rather than depreciated, when computing taxes for the year the improvements were placed in service. To be eligible, the property, which must be located in the United States, also must be one for which depreciation or amortization is allowed. The energy-efficient improvements must be part of the building envelope or for interior lighting, heating, cooling, ventilation, and hot water systems, and they must be part of a professionally certified plan to reduce annual energy costs by at least 50 percent. The federal government is expected to provide guidelines on certification early this year.

How Much Can Be Deducted?

The deduction is for the actual cost of the energy-efficient improvements and is capped at $1.80 per square foot. Improvements that don't meet the 50 percent energy cost reduction requirement may be eligible for a partial deduction of up to 60 cents psf.

For example, XYZ Manufacturing constructs an energy-efficient commercial building for $10 million, spending $100,000 for qualified energy-efficient equipment and placing the building in service in 2007. The building contains 50,000 square feet of office space and meets the 50 percent annual energy savings. XYZ can take a current deduction equal to the lesser of actual cost or $1.80 x 50,000 sf in computing its 2007 taxes. In this example, the deduction would be $90,000. Some years later, XYZ sells the building. In computing taxes due upon sale, XYZ reduces its basis in the building by the $90,000 deduction, on which it pays tax as ordinary income.

If the building is partially energy efficient but does not meet the 50 percent threshold, XYZ can take a current deduction of $30,000, or 60 cents psf. Like the maximum deduction, this amount also must be deducted from the building's tax basis and eventually taxed as ordinary income.

Alternatively, if the 50,000-sf building already was in service, it could be retrofitted with energy-efficient lighting - an area in which the act provides interim guidelines - that would qualify for the 60-cent psf deduction. Suppose the property has between 600 and 650 light fixtures and consumes around 300,000 kilowatt hours per year. Retrofitting to achieve a 40 percent decrease may cost between $35 and $50 per fixture, or $21,000 to $32,500 total. At 60 cents psf, the building could deduct the retrofit costs up to a maximum of $30,000. As in the new construction, the deduction would be figured into the basis when the building eventually was disposed of or sold.

Additional Guidance Needed

The act is somewhat complex, and not all of the guidelines needed to claim benefits under it were published as of December 2005. Areas needing further clarification follow.

The 50 Percent Energy Savings.
The 50 percent figure is arrived at by comparison to a reference building meeting the requirements of Standard 90.1-2001 of the American Society of Heating, Refrigerating, and Air-Conditioning Engineers and the Illuminating Engineering Society of North America (as in effect on April 2, 2003). Establishing the savings so that the deduction can be taken will require detailed documentation from professionals who are qualified in calculating and verifying energy and power costs.

Lessee Vs. Lessor? The act does not specify whether a lessee can take a deduction for installing qualified improvements. This silence can become an issue if a lessee - rather than the owner - pays for the costs of retrofitting a property.

Defining the Target. In order to meet the partial allowance requirement for the 60-cent psf deduction, there must be certification that the energy-efficient system satisfies the energy-savings targets, which will be established by the Internal Revenue Service and U.S. Department of Energy's clarifying regulations.

What About Government Buildings? Federal, state, or local government-owned property presents a different scenario - one that is of particular interest to builders. In the case of a government-owned energy-efficient commercial building, the new law says the party primarily responsible for designing the property can take the deduction. Regulations on the implementation of this rule have not yet been promulgated, but it may be that builders can claim the deduction if their services included design.

Qualified Computer Software. To certify that required thresholds of energy saving have been met, the energy-savings percentage must be calculated using qualified computer software that meets all procedures and detailed methods for calculating energy, power consumption, and costs as the IRS requires. The software also must provide required IRS forms for filing in connection with energy efficiency of property and the deduction allowed for energy-efficient property, and it must provide a notice form documenting the energy-efficient features of the building and its projected annual energy costs. The legislative history indicates that software accepted by the state of California in 2005 for its energy calculation requirements - EnergyPro 4.0 and Perform 2005 - should be accepted by the IRS.

Other Benefits

Commercial property owners also may be entitled to federal tax credits for qualified fuel cells, micro-turbines, and solar-energy systems. In addition, state and local tax codes may include energy-related benefits. Added to federal incentives, these may make it especially worthwhile for a building to go green.

Jude Coard

Jude Coard, CPA, is a tax partner in Berdon LLP\'s New York City office. Contact him at (212) 699-8812 or jcoard@berdonllp.com.

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