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
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
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.
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.