Rethinking Sec. 199 Based on New Developments

Co-Editors: Michael Metz, CPA; Nick Gruidl, CPA, MBT

Beginning in 2006, there is a new deduction available for updating or constructing commercial building property to be more energy efficient. The Energy Tax Incentives Act of 2005 (ETIA), which took four years to pass, added new Sec. 179D. With so many commercial buildings exceeding 15 years in age, many business owners and landlords may be considering significant updates to enable more economical operation. Sec. 179D provides an immediate deduction for the cost of energy-efficient improvements to commercial property.

The maximum deduction allowed cannot exceed $1.80 per square foot of the building, less the aggregate of all prior-year deductions taken for the building under this provision. The property basis is then reduced by the deduction taken. Although this new deduction will primarily benefit real estate businesses, it will have some benefit to owners of commercial lease property.

Example: Corporation, B, operates a 10,000 square-foot manufacturing facility located in the U.S. In 2006, as part of a certified overall plan to reduce the total annual energy and power costs, it spends $50,000. Under new Sec. 179D, B can deduct $18,000 ($10,000 $1.80) immediately on its 2006 return. It will then capitalize the $32,000 remainder and depreciate this over the asset’s useful life. In 2007, B spent an additional $50,000 (which is also eligible for the Sec. 179D deduction). Because it already took the total deduction allowed under Sec. 179D in a prior tax year, B has to capitalize the entire amount spent in 20

Requirements

As with all new laws, there are specific requirements that must be satisfied to enable taxpayers to claim the new deduction. First, the building must be located in the U.S. and be within the scope of Standard 90.1-2001 as in effect on April 2, 2003. Standard 90.1-2001 is a publication of the American Society of Heating, Refrigerating, and Air Conditioning Engineers (www.ashrae.com) and the Illuminating Society of North America. It provides minimum requirements for the design of energy-efficient buildings. Further, it has general industry acceptance and its language is often used in new building codes.

Second, the property must be installed as part of (1) the interior lighting systems, (2) the heating, cooling, ventilation and hot water systems or (3) the building envelope. The term “building envelope” is not defined in Sec. 179D; however, under Sec. 25C(c)(2), the term is defined as including the wall and roof assemblies, insulation, air/vapor retarders, windows and weather-stripping and caulking. While Sec. 25C applies to residential property, it may be reasonable to assume that a similar definition would apply for Sec. 179D purposes.

Third, the property must be certified as being installed as part of a plan designed to reduce the total annual energy and power costs with respect to the building’s interior lighting systems and heating, cooling, ventilation and hot water systems by 50% or more in comparison to a reference building that meets the minimum requirements of Standard 90.1-2001. Note: to qualify for the full deduction, the cost reduction plan must target all the systems specifically identified in Sec. 179D(c) (1)(D). The reduction applies to overall energy savings and not the savings of any particular system.

The IRS is required to issue regulations that establish a specific, energy-saving target for each system (i.e., interior lighting, heating, cooling, ventilation and hot water) and de-scribe in detail the methods for calculating and verifying energy and power consumption and cost. The regulations will be based on the provisions of the 2005 California Nonresidential Alternative Calculation Method Ap-proval Manual.

Sec. 179D(d)(6) outlines the certification process. As part of the regulations, the IRS is expected to provide guidance on how to define qualified plan certifiers, to ensure compliance of buildings with energy savings plans and targets. Such procedures will probably be comparable to the requirements in the Mortgage Industry National Ac-creditation Procedures for Home Energy Rating Systems.

Other Circumstances

Sec. 179D(d)(4) provides a special allocation for improvements to public property. Because the governmental owner is likely not a taxpayer, this section requires the IRS to issue a regulation to allow an allocation of the deduction to the person primarily responsible for designing the property in lieu of the property owner. It is hoped that this tax incentive will further encourage the development and innovation of energy-efficient designs for use in municipal buildings.

Although a cost reduction plan should target a building’s overall systems, Sec. 179D(d)(1) provides a partial allowance if a taxpayer replaces one of the systems allowed under Sec. 179D(c) (1)(C), and the replacement meets the target for that system. The partial deduction available for the cost of the systems installed is up to $0.60 per square foot of the building. These system-specific improvements are also subjected to certification as designed by the IRS. This may be an incentive to owners of commercial lease properties, who pass on their utility costs to their tenants, to consider installing energy-efficient systems.

In addition to the above, Sec. 179D also directs the IRS to issue regulations as necessary to take into account new technologies and to provide for the recapture of the deduction if a plan is not fully implemented.

No final regulations have yet to be issued on these or any of the issues discussed herein.

Effective Date

If taxpayers believe that a major energy savings improvement to a commercial building will be necessary, new Sec. 179D may prove to be economical and thus worth considering. Further, taxpayers in the business of designing energy-efficient government property should be aware of allocated deductions that may be available to them.

The Sec. 179D provisions, as currently written, only apply to property placed in service after Dec. 31, 2005 and before 2008.