Dissecting new tax laws Featured

8:00pm EDT March 26, 2008

Many businesses are going “green” out of environmental consciousness and a desire to be more appealing to customers. But there is another reason to go “green.” The United States government is offering incentives in order to motivate those businesses that need a push in the “green” direction.

One of those incentives is the commercial buildings tax deduction, a tax incentive housed within the Energy Policy Act of 2005. In order to earn this deduction, businesses must adhere to a few qualifications.

Smart Business asked David Guevara, J.D., Ph.D., associate and member of Sommer Barnard PC’s Environmental Law and Litigation Practice Groups, about the commercial buildings tax deduction.

What is the Energy Policy Act of 2005?

The Energy Policy Act of 2005 established the first comprehensive national energy policy since 1992. One of its goals is to promote energy conservation and efficiency. For instance, the Energy Policy Act includes tax incentives for energy-saving technologies. One such tax incentive, the commercial buildings tax deduction, allows businesses to accelerate significant tax deductions.

Can you define and describe the new commercial buildings tax deduction?

The commercial buildings tax deduction establishes a tax deduction for commercial buildings that reduce annual energy and power consumption. The tax deduction is available to a taxpayer for part or all of the cost of energy-efficient property that’s installed in new or existing commercial buildings. The energy-efficient property, however, must be placed in service before Dec. 31, 2008, unless Congress extends the tax deduction, which was done once before.

Under the Energy Policy Act, energy-efficient property is defined as depreciable property that (1) is installed on or in any commercial building located in the United States; (2) is installed as part of the interior lighting, heating, cooling, ventilation or hot water systems, or a building’s envelope; and (3) is certified as reducing the total annual energy and power costs with respect to the combined usage of the building’s heating, cooling, ventilation, hot water and interior lighting systems by 50 percent or more when compared to a specified baseline.

What is the tax deduction amount?

The tax deduction equals the costs incurred for energy-efficient property, with a maximum deduction of $1.80 per square footage of the building within which the energy-efficient property is placed. The deduction is allowed in the year in which the property is placed in service and includes anything that can be capitalized, including labor.

For example, assume that ABC Corp. needs to upgrade an existing 10,000-square-foot facility and, as part of the renovation, decides to retrofit the existing facility with energy-efficient property. Under the terms of the Energy Policy Act, ABC Corp. is allowed a tax deduction of up to $18,000 given the square footage of its existing facility ($1.80 per square foot maximum deduction multiplied by 10,000 square feet). Because ABC Corp. upgraded its existing facility with energy-efficient property, it’s allowed to deduct the cost of that property from its overall taxable income for the current tax year.

Assuming the cost of its energy-efficient property is $10,000, and further assuming a marginal tax rate for ABC Corp. of 35 percent, ABC Corp.’s overall taxable income for the year is reduced by $3,500 and the net cost of the energy-efficient upgrade is $6,500 — the $10,000 initial cost less the tax savings of $3,500. Further, because ABC Corp. has only used $10,000 of the $18,000 deduction permitted by the Energy Policy Act, it’s allowed $8,000 in additional deductions for future costs incurred for energy-efficient property, assuming that Congress once again extends the commercial buildings tax deduction.

Absent the commercial buildings tax deduction, ABC Corp. would have capitalized the cost of the property and deducted that amount over several years. In contrast, under the terms of the Energy Policy Act, ABC Corp. accelerates the deduction into the current tax year, thereby allowing ABC Corp. to benefit from the time value of its money. It’s important to note, however, that if the cost of energy-efficient equipment exceeds the cost of normal equipment by an amount in excess of the time value of money benefit, then installing energy-efficient property is not a wise choice from a bottom-line perspective.

It should be noted that when a commercial buildings tax deduction is taken with respect to an energy-efficient property, the property’s basis is reduced by an amount equal to the deduction, resulting in lower depreciation deductions for the life of the property.

Are there certification requirements?

Yes. Before a taxpayer can claim the deduction, the building must be inspected and the taxpayer must obtain certification with respect to the energy savings of the energy-efficient property. Certification must be provided by engineers or contractors licensed within the jurisdiction in which the building is located. Accordingly, by retrofitting an existing facility or constructing a new facility with energy-efficient property, it’s possible to accelerate a tax deduction, thereby reducing a business’s overall taxable income and allowing it to benefit from the time value of its money.

DAVID GUEVARA, J.D., Ph.D., is an associate and member of Sommer Barnard PC’s Environmental Law and Litigation Practice Groups. Reach him at (317) 713-3500 or dguevara@sommerbarnard.com.