Contractors performing work for public entities may be leaving significant tax savings on the table by not considering the Section 179D deduction for energy efficient buildings.
This relatively unknown provision of the tax law allows for a deduction of up to $1.80 per square foot if certain elements of the building’s design create energy savings that exceed specific standards established by a national trade group.
How does the deduction work?
The Section 179D deduction was first introduced by the Energy Policy Act of 2005 and was targeted at taxpayers investing in energy efficient properties. The deduction is claimed by the property’s owner in the year it is placed into service and is based on energy savings generated in three components of the building’s design: interior lighting, HVAC and building envelope.
Each component is allowed a deduction of 60 cents per square foot (for a total of $1.80/square foot for all three components) if they create energy savings that exceed the 2001 ASHRAE (American Society of Heating, Refrigeration, Air Conditioning and Engineering) standards by a predetermined amount. If greater than 50 percent of the overall energy savings can be achieved with just one or two of the three components, the entire $1.80/square foot may be taken.
These standards are almost 15 years old, and most current building designs exceed these standards with little trouble. To claim the 179D deduction though, the IRS requires an independent, licensed third-party engineering firm to certify the energy savings. Numerous engineering firms across the country can do this analysis. Your tax adviser should be able to refer you to a specialist and discuss the technical requirements further.
As an example of the tax saving benefit of the 179D deduction, assume a 50,000 square foot building is placed in service in 2014. The building creates energy savings that exceed the 2001 ASHRAE standards in each of the three required components: interior lighting, HVAC and building envelope.
The building owner can claim a deduction up to $1.80/square foot ($90,000 on a 50,000-square-foot building) and can do so by filing a Form 3115, Application for Change in Accounting Method, for qualified property placed in service in years 2006 through 2014, provided the property has not already been fully depreciated. (The first year the Section 179D deduction was available was 2006.)
How does it impact contractors?
Contractors enter the picture because public owners (e.g., public schools, state and local governments, and federal facilities) cannot use the deduction since they do not pay income taxes.
The IRS allows the public entity to allocate or assign the right to take the deduction to the contractors working on the project. The contractor must have a meaningful role in the energy savings design of one of the three components identified above and receive express authorization from the public entity to claim the deduction related to that project.
Many contractors are unaware these deductions are available, and they go unused on many projects. Contractors that perform a high concentration of their work for public entities stand to benefit the most.
A contractor might complete multiple projects for public entities during the year that meet the 179D deduction’s requirements. Assuming the contractor secures the rights to the deduction, each individual project can claim up to the full $1.80/sq. ft. deduction, without any limitation. Contractors wishing to begin taking advantage of this deduction should include the rights to the Section 179D deduction as a negotiating point with the owner before work starts.
For example, assume a contractor completes five separate 50,000 sq. ft. buildings that are placed in service during 2014 and is assigned the rights to all three 179D deductions on each. The contractor would be entitled to a $90,000 deduction for each building, adding up to a total deduction of $450,000. If the contractor is in the highest marginal tax bracket of 39 percent, a tax savings of approximately $175,000 would be realized. (Contractors who take the Section 199 deduction would see it decrease 10 percent, so only 90 percent of the tax savings would be realized.)
The IRS also allows companies to amend prior-year tax returns to claim the deduction in previous open years. Typically the previous three tax years are considered open. Contracts completed during the previous three years could be eligible, and the company should consider amending their previous years’ returns in order to claim the tax benefit.
As competitive forces continue to keep pressure on margins, contractors should be proactive in pursuing opportunities to realize tax savings related to their work. The Section 179D deduction can create significant tax savings, is often unused on public projects, and does not require a tremendous amount of additional effort to meet the requirements. – Steven Kohler, CPA, CCIFP, VonLehman & Company, Inc.