Credits Against Tax
Several provisions in the Code provide tax credits to individual taxpayers who install energy-efficient property in their residences. One such provision, Sec. 25D, allows for an income tax credit for a taxpayer's expenditures for residential energy-efficient property. Originally enacted in 2005 as part of the Energy Policy Act of 2005, P.L. 109-58 (Section 1335(a)), the credit has been modified and extended several times since its inception. Before Sec. 25D, no credit existed for these expenditures; however, under Sec. 136, a taxpayer could exclude from income the value of a subsidy a public utility provided to purchase or install energy conservation measures.
The current version of Sec. 25D(a) provides for a credit against a taxpayer's income tax equal to 30% of the expenses incurred for installing certain energy-efficient property in a qualified dwelling unit. The energy-efficient properties eligible for the credit include qualified solar electric property, qualified solar water heating property, qualified fuel cell property, qualified small wind energy property, and qualified geothermal heat pump property. All must be placed in service on or before Dec. 31, 2016 (Sec. 25D(g)). Although Treasury has never issued regulations under Sec. 25D, the IRS has released notices, in question-and-answer (Q&A) format, detailing the procedures and certification processes to use the credit, and the Environmental Protection Agency (EPA) has released rules under the Energy Star program defining the property requirements and specifications. The following aims to cover the myriad rules from all sources and present them in a concise and comprehensive format while focusing specifically on geothermal heat pump property.
A taxpayer can claim the credit for expenses associated with geothermal heat pump property if the property is qualified geothermal heat pump property and the expenses meet the expenditure rules of Sec. 25D(d)(5). If the taxpayer meets these requirements, he or she must also comply with the special rules for labor costs, cooperative/condominium rules, allocation requirements, and basis adjustments.
Qualified Geothermal Heat Pump Property
Sec. 25D(d)(5)(B)(i) defines a geothermal heat pump as a piece of equipment that uses the ground or groundwater as a thermal energy source to heat a structure and/or as a thermal energy sink to cool a structure. For the geothermal heat pump to be a qualified heat pump, Sec. 25D(d)(5)(B)(ii) requires that it meet the eligibility criteria of the EPA's Energy Star program in effect during the time the expenditures are made.
Energy Star eligibility requirements: Energy Star's eligibility criteria define heat pump property in terms of scope, efficiency ratings, minimum warranty requirements, and testing requirements. Specifically, Energy Star defines the geothermal heat pump components to include heat exchangers, compressors, pump models, hydronic space conditioning distribution systems, temperature controls, and thermal storage tanks (see "Energy Star Program Requirements, Product Specification for Geothermal Heat Pumps: Eligibility Criteria," Version 3.1 (rev. March 2012), available at www.energystar.gov).
Notice 2013-70 limits this definition by stating that any distribution systems for the home, as well as backup emergency heating or cooling systems, are not considered qualified geothermal heat pump property and are therefore not eligible expenditures for the credit (Notice 2013-70, Q&A No. 31). Although the Energy Star guidelines specifically preclude a heat pump intended for commercial use from the definition of a qualified geothermal heat pump, Sec. 25D provides for the allocation of expenditures in certain cases where the property is used for both business and nonbusiness purposes (see below). To qualify as an Energy Star geothermal heat pump, the pump must be tested and pass minimum performance and energy-efficiency ratio ratings. Furthermore, a geothermal heat pump model qualifies only if (1) a manufacturer's limited warranty is offered, as standard, for all parts and labor for a minimum of two years, and (2) the major refrigerant circuit components are warrantied for parts and labor for a minimum of five years.
Certification: Although a taxpayer may still qualify for the credit without a manufacturer's certification statement from an Energy Star certified partner, the taxpayer must then prove that the property meets the required efficiency standards. The taxpayer would need to obtain and retain sufficient documentation to establish the qualification for, and the amount of, the available credit (see Notice 2013-70, Q&A No. 16).
Notice 2009-41 (as amplified and clarified by Notice 2013-70) provides guidance on how a manufacturer of geothermal heat pump property can certify to the purchaser that the heat pump property is qualified under Sec. 25D. The notice delineates that a manufacturer of geothermal heat pump property can establish the property's eligibility for the credit by providing the taxpayer with a certification statement that contains specified required information, optional information, and a declaration. The certification statement can be provided to the taxpayer by including it with the packaging of the heat pump property, by providing a printable version on the manufacturer's website, or by any other method that allows the taxpayer to retain the certification statement for tax recordkeeping purposes. A manufacturer that makes this certification must retain documentation that the property meets the requirements and provide it to the IRS if requested.
The manufacturer certification statement is required to contain the manufacturer's name and address, identify the property in question as geothermal heat pump property, and provide the make, model number, or other identifying features of the property. Although not required, the statement may also provide that the heat pump property meets the requirements of the Energy Star program that are in effect at the time the expenditures are actually made. The final requirement necessitates that the manufacturer acknowledge that the statements made are true and complete under penalties of perjury. If the IRS determines that a manufacturer's certification is erroneous, the manufacturer will no longer be allowed to provide certifications to future purchasers. However, taxpayers that received the certification before then will continue to be allowed to rely on it.
Sec. 25D(d)(5)(A) defines a qualified geothermal heat pump property expenditure briefly and broadly as "an expenditure for qualified geothermal heat pump property installed on or in connection with a dwelling unit located in the United States and used as a residence by the taxpayer." However, Notices 2009-41 and 2013-70 provide more comprehensive guidance.
Dwelling unit: Notice 2013-70 clarifies that a qualified dwelling unit can be either an existing home or a newly constructed home. In the case of an expenditure that is incurred in connection with either the construction or reconstruction of a dwelling, the taxpayer cannot claim the credit for the eligible expenditures until the year the taxpayer uses the constructed or reconstructed dwelling. For taxpayers that own more than one dwelling, the credit is available for qualifying expenditures for a dwelling that is a taxpayer's second home or vacation home, as long as the dwelling is not investment property.
The credit is available for dwellings used partially for business uses if the taxpayer follows the allocation rules contained in Sec. 25D(e)(7). Under this three-prong rule, no portion of the credit is available for property used solely for business purposes, a corresponding percentage of the credit is available if the business use of the property exceeds 20%, and the full credit amount is available if the business use of the property is 20% or less (see Notice 2013-70, Q&A No. 7). Secs. 25D(e)(5) and (6) provide that taxpayers who own their dwellings as tenant-stockholders in cooperative housing corporations or as members of condominium management associations may also take the credit equivalent to their proportionate share of the expenditures.
Accounting for the expenditures: Qualified geothermal heat pump property expenditures eligible for the credit are limited to the costs of the heat exchange equipment located in the ground outside the dwelling and the labor costs incurred to install the equipment. Under Sec. 25D(e)(1), the labor costs must be properly allocable to the on-site preparation, assembly, and/or installation of the geothermal heat pump property. The taxpayer may request and rely on the homebuilder to determine the reasonable allocation of the credit-eligible expenditures or use any other reasonable method to determine the cost of the property eligible for the credit (Notice 2013-70, Q&A No. 21).
Expenditures for piping or wiring used to connect the equipment to the dwelling can also be included as a cost eligible for the credit. However, any costs for distribution systems inside the home or backup emergency heating or cooling equipment are not eligible for the credit and should not be included as qualified expenditures (Notice 2013-70, Q&A No. 31). Also includible in the amount of the expenditures eligible for the credit is the amount of sales tax paid on the qualified geothermal heat pump property, including labor costs (Notice 2013-70, Q&A No. 9). Under Sec. 25D(e)(8), expenditures are generally treated as being made upon completion of the installation of the heat pump property or, in the case of a constructed or reconstructed dwelling, when the original use of the structure begins.
Claiming the Credit
The credit for geothermal heat pump property is claimed by filing Form 5695, Residential Energy Credits, and attaching it to the taxpayer's individual income tax return. The credit is a nonrefundable personal tax credit and, as such, is limited solely to reducing the amount of the taxpayer's income tax liability. Sec. 25D(c) allows the taxpayer to carry forward the unused portion of the credit to the succeeding tax year and add it to any credit allowable in that year. Upon using the credit for the qualified geothermal heat pump property, the taxpayer must decrease the basis in the property by the amount of the allowable credit.
Termination and Planning Opportunities
The current version of the credit terminates after Dec. 31, 2016; therefore, the taxpayer must install all property, or, in the case of a new or reconstructed structure, begin his or her original use of the structure in which the property is installed, by Dec. 31, 2016, to take advantage of the credit. If a home containing geothermal heat pump property is built during 2015 and 2016 and the taxpayer does not begin use of the home until 2017, the credit will not be available for the expenses incurred during the 2015–2016 construction period. Because of this strict timing requirement, it is important for the taxpayer to begin using a newly constructed or reconstructed structure no later than Dec. 31, 2016. Not all parts of the construction must be finished, but the original use of the structure must begin and the qualifying expenditures must be made before 2017.
The taxpayer should also aim to use the services of a manufacturer that can certify the property is Energy Star-compliant for the year at issue. Although a taxpayer may claim the credit without a manufacturer's certification that the property meets the qualifications, extra caution should be exercised when no certification is present. The taxpayer must be able to demonstrate that the property meets the required efficiency standards and must retain documentation sufficient to prove entitlement to the amount of credit claimed.
To confidently claim the credit for residential energy-efficient property, specifically the credit for geothermal heat pump property, a taxpayer should have an in-depth understanding of the various rules and regulations that delineate how to use the credit and how much of a credit can be taken. Because of the amalgamation of rules from different bodies of authority, Sec. 25D can trip up even the savviest taxpayer.
Mindy Tyson Weber is a senior director, Washington National Tax for McGladrey LLP.
For additional information about these items, contact Ms. Weber at 404-373-9605 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with McGladrey LLP.