Tax issues

QER Expenditures May Provide Tax Breaks for Brownfield Redevelopers

When commercial real estate professionals advise their clients on redeveloping brownfield properties, they should consider the tax implications. The treatment of costs incurred to remediate environmentally damaged sites might affect a project's economic feasibility.

Remediation Cost Considerations
The time during which remediation costs can be deducted is the main tax consideration in brownfield redevelopment. Do the costs represent necessary business expenses that can be deducted in the current tax year, or does the nature of the costs require the taxpayer to capitalize into the basis of the remediated property?

Generally, costs must be capitalized when they materially add to the value of the property, prolong the useful life of the property, or are used to adapt the property to a new use. Another consideration is the extent to which the costs produce future benefits. Also, capitalized costs may produce deductions over time in the form of depreciation.

Concerning brownfield properties, the Internal Revenue Service decided that costs incurred to remediate contaminated soil and groundwater are necessary business expenses that can be deducted. The IRS concluded that these cleanup activities did not result in an improvement of the property or provide a future benefit. Conversely, costs incurred by the same taxpayer to construct a groundwater treatment facility to prevent recurring contamination would need to be capitalized.

The party that incurs the remediation costs also can affect whether those costs must be capitalized. Previous IRS rulings have constructed a restoration principle that supports the deduction of costs incurred to restore a property to its condition prior to contamination. However, a key feature of the restoration principle is that the taxpayer that owned the property when the contamination occurred must undertake the remediation. The reasoning is that the taxpayer is restoring lost value. Consequently, taxpayers acquiring contaminated properties do not benefit from the restoration principle — since they cannot restore a value to which they had no claim — and may be required to capitalize the same expenditures.

Qualified Expenditures
To encourage the cleanup of contaminated sites and simplify the treatment of remediation costs, the U.S. Congress enacted Internal Revenue Code Section 198 that permits taxpayers to make elections to deduct qualified environmental remediation expenditures. QER expenses are certain costs that otherwise would be subject to capitalization. While the legislation covers a wide range of cleanup activities, properties must satisfy very specific criteria to claim a deduction for remediation expenditures under this provision. Originally set to expire in 2001, this legislation has been extended through 2003.

Section 198 generally allows taxpayers to deduct expenditures incurred to remediate certain geographically targeted areas that have been exposed to various hazardous substances. Due to such exposure, these sites often are fallow or underused and require environmental remediation for continued use or redevelopment.

QER expenditures include any cost that otherwise is chargeable to a capital account and that is paid or incurred in connection with the abatement or control of hazardous substances at qualified contaminated sites. QER expenditures do not include property acquisition costs for which depreciation deductions are allowed. As an exception, any depreciation on a qualified contaminated site that otherwise would be included in the capitalized cost of remediation is treated as a QER expenditure.

An area must meet four requirements to be classified as a qualified contaminated site. First, the area must be held for use in a trade or business, for production of income, or as inventory. Second, there has been a release, threat of release, or disposal of a hazardous substance at the area. Third, the area cannot be listed on the national priorities list under Section 105(a)(8)(B) of the Comprehensive Environmental Response, Compensation, and Liability Act of 1980. Fourth, the taxpayer must get a statement from the appropriate state environmental agency confirming that the area satisfies the second condition.

Regarding brownfield properties, hazardous substances are defined as such by CERCLA Section 101(14) or Section 102. Substances identified in these sections include toxic pollutants defined by the Clean Water Act, hazardous wastes listed by the Solid Waste Disposal Act, hazardous air pollutants denoted by the Clean Air Act, and hazardous chemicals, elements, compounds, or mixtures defined by CERCLA.

A Section 198 election must be made on or before the due date for filing the income tax return for the taxable year in which the QER expenditures are paid or incurred, including extensions. The election is made with respect to a single expenditure; thus, a taxpayer may make the election even if he chooses to capitalize other such expenditures, regardless of whether the expenditures are of the same type or are made with respect to the same contaminated site. Further, a Section 198 election is effective only for the tax year in which it is made. Therefore, a taxpayer must make an election for each year in which he intends to deduct QER expenditures.

Consult a tax professional for further information.

Steven M. Friedman and Jin H. Bahk

Steven M. Friedman is a tax partner in the McLean, Va., office of Ernst & Young. Contact him at (703) 747-1000 or Jin H. Bahk is a manager in the Baltimore office of Ernst & Young. Contact him at (410) 783-3736 or


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