Congratulations. After months of construction with numerous change orders, you are now able to place your new hotel into service. Sure, you may have spent a little more than you originally budgeted, but you’re in a fantastic location and it’s an energy efficient building. So, in addition to enjoying lower operating costs, it should be no problem to quality for the Energy Policy Act (EPAct) 179D deduction of $1.80 per square foot.
NOT SO FAST!
“We have no problem acquiring the full EPAct deduction of $1.80 per square foot for our clients.”
When it comes to maximizing the 179D deduction for energy efficient improvements, we often hear this boast from overconfident building owners, brokers, CPAs and other advisors. The design for energy efficiency that’s required to meet local energy codes or meet tax criteria can be very different.
Sure, the Kentucky Derby winner always makes the race look easy. But it takes a heck of a lot of hard work, practice and well-coordinated teamwork to win even one championship—it’s far from automatic every year. Same goes for energy tax incentives.
Devil is in the details
So much depends on the type of building, the energy efficient equipment used, and the nature of use to qualify for the maximum benefit – it all begins with the design! When modeling a building for the 179D deduction, the results may surprise you.
When it comes to hotels, we tend to focus on HVAC and lighting to make sure they are efficient. Many hotel owners are confused about their energy bills. They wonder why their bills are so high when they’ve installed what they thought was the premium energy efficient HVAC system.
But what about the hot water system? With guests taking endless hot showers and staff doing tons of laundry every day, the type of hot water system a hotel installs can hugely impact whether or not it qualifies for EPAct. The hot water system can even have a more unfavorable impact on the annual operating costs.
Real world case study
Let’s look at Hotel A and Hotel B, both located in a moderate climate area.Both hotels are light-stay design and very similar. The energy bills for both hotels seem to be approximately the same, even though Hotel B is utilizing a highly efficient geothermal HVAC system for the common areas and PTHPs (Packaged Terminal Heat Pumps – all-in-one heating and cooling often referred to as PTAC units) in the guest rooms, while Hotel A is using standard-efficiency gas packaged units to serve the common areas and standard PTACs in the guest rooms.
|HOTEL A||HOTEL B|
|Location||Moderate climate||Moderate climate|
|Amenities||Indoor pool||Indoor pool|
|Dining||Breakfast only||Breakfast only|
|Business services||Meeting room/business space||Meeting room/business space|
|Heating||Standard package gas/electric and PTAC||Geothermal and PTHP|
Source: Bedford Cost Segregation 2020
Why isn’t the geothermal system saving more energy for Hotel B? Many other things can affect energy consumption in hotels, either positively or negatively. Occupancy rates, staff habits, maintenance and kitchen procedures all have a tremendous impact on energy. Our website has more case studies and resources about these topics https://www.bedfordteam.com/articles-and-publications/
Don’t be seduced by low-costs and bold promises
CAUTION: Always make sure your model is defensible. Unfortunately, some firms that claim to be experts in energy incentives, unknowingly (or intentionally) add incorrect inputs into their software model that skew the results of their studies for clients. Trust me, we’ve reviewed their reports.
Often a building owner is confused when it comes to selecting a provider. They’re hopeful after hearing promises like these: “We can guarantee the full deduction for almost all of our clients because of our proprietary software interface that has the ability to model shade trees and shrubbery, thus reducing cooling loads on the building. Other widely used modeling programs don’t have this feature.”
Again, when it comes to qualifying for energy incentives, decisions are often based on low pricing and empty promises. Suppose somebody cuts down the tree in the example above? I don’t think it’s entirely legal in the EPAct world for modeling. As stated in the requirements, the reference building must be identical to the actual building apart from the energy using systems and envelope improvements. That would mean the terrain would need to be identical, too. And all modeling must be done with IRS approved software.
First, let’s get our facts right
EPAct was created in 2005 to give tax incentives to encourage builders, architects and engineers who improve energy savings for new construction or remodel projects.
Section 179D of the Act outlines the tax deductions available for commercial buildings. It’s a tremendous help to businesses that install energy saving alternatives, like lighting retrofits…if you do everything correctly. The maximum tax deduction is $1.80 per square foot of the upgraded space: $.60 per square foot for interior lighting, $.60 for building envelope improvements and $.60 for HVAC system upgrades.
To qualify for the full deduction of $1.80 per square foot, energy and power costs need to be reduced by a full 50 percent. It is NOT that easy to achieve a 50 percent or higher reduction in energy usage against an ASHRAE standard reference building, unless the new building is expressly designed for maximum energy efficiency employing high tech systems that are usually more expensive. Using the tax incentive to fund the extra cost can prove to significantly reduce operating costs well into the future.
What’s the risk of relying on a model that is not defensible?
Generally, the tax deduction reduces the basis of 39-year assets and is taken in the current year. The deduction can range from $0.30 to $1.80 per square foot for the area that qualifies, but the deduction is never greater than the investment costs. If the study is challenged or disallowed by the IRS, the taxpayer must add back to income the difference between the deduction they took and what they should have taken under regular depreciation rules. The penalties for underpayment (or late payment) may be more significant than the tax itself. The IRS has issued guidance outlining the criteria that must be addressed in the certification. IRS Notice 2006-52 was the original guidance issued to establish the process for certification.
Many owners believe their building is energy efficient if it achieves LEED certification. However, this still does not guarantee it will qualify for the entire $1.80 per square foot deduction based on energy efficiency. There are varying degrees of LEED certification, and the LEED certifications can include many categories unrelated to energy consumption.
Our firm has modeled all types, sizes and designs of buildings for EPAct since the legislation was introduced. Experience shows that modeling a building for energy efficiency is a complex process, even on user friendly software such as eQUEST. Expertise is needed to understand the complex equipment specifications and building systems to maximize the benefit.
$1.80/sf: More easily said than done
Sure, you can achieve the requisite savings for the full EPAct deduction on many building types, but it does take a focused design on energy efficiency. In many cases, even efficient design still falls short and only a partial deduction can be attained.
Simple lighting upgrades and retrofits to older buildings just won’t do it for the full $1.80 PSF deduction. Replacing a 12 SEER air conditioner with a 16 SEER won’t do it. Adding to existing insulation or replacing windows won’t do it, either. Even a combination of all the above will not usually result in the maximum required 50 percent savings on an older building or even new construction, simply because of the requirements we have to follow when modeling the reference building. We might get close, but close only gets you a partial deduction. The good news is that with a little planning, you may be able to move from a partial deduction to a full deduction.
Let’s be clear about one thing: We are not trying to discourage building owners from pursuing EPAct certification. We just want to set realistic expectations. If you are considering making energy upgrades to an existing building, or if you’re constructing a new efficient facility, make the upgrades to assure you will increase your bottom line with lower operating costs. And don’t forget to claim some utility rebates. It’s free money. And if you find you can qualify for the EPAct deduction, that’s even better.
But before you do, I would caution you to shop around before deciding on a provider to help you certify the deductions. When it comes to energy efficiency, there’s usually a whole lot more to it than meets the eye. Pricing and capabilities vary widely. It would be wise to first contact an independent firm for some unbiased opinions, instead of simply going along with what your HVAC vendor or electrical contractor wants to sell you.
And remember, ASHRAE energy standards just aren’t that easy to beat by a large margin.
Maximizing the 179D deduction is all about design. Not all energy efficient improvements qualify, and the project must be certified by a properly licensed engineer or contractor in the jurisdiction in which the building is located. Additionally, there may be other incentives or strategies available that can further enhance benefits for the same project, resulting in a greater ROI and reduced payback period. Take the time to do it right and hire the right professional to help you.
Karen J. Koch, CPA, MT, is a partner of Bedford Cost Segregation in Louisville, Kentucky. She is a recognized professional in tax treatment of fixed assets for commercial real estate, tax incentives for energy efficient buildings and research and development tax credits. Patti Hagewood is the Director of Energy Services for Bedford Cost Segregation. With more than 30 years of experience in the energy engineering business, she has conducted more than 6,000 energy audits and has numerous certifications, including LED Lighting and Auto Cad.