Congress often creates tax incentives, but it is up to the IRS and courts to determine their implementation and interpretation. The Sec. 179D tax deduction is an example of this.
The statute provides broad concepts but lacks substance, leading to the courts playing a crucial role in determining its implementation and interpretation. The details matter as the tax savings can be substantial.
The Johnson v. Commissioner, 160 T.C. No. 2 (2023), case is an example of this. It involves the allocation of Sec. 179D tax deductions for a building owned by the Federal government. The case addresses questions about when the building is placed in service and the amount of the deduction that can be allocated to the designer of the building.
Facts & Procedural History
The taxpayer is an engineering firm. It entered into a contract (maintenance contract) with the U.S. Department of Veterans Affairs (VA), a federal government entity, to provide maintenance services with respect to the HVAC systems at the Edward Hines, Jr. VA Hospital. The hospital had several buildings, including Building 200.
The taxpayer engaged a Sec. 179D study provider to conduct an “Energy Efficient Commercial Building Tax Deduction Study” for 2013. The study provider is in the business of certifying energy-efficient commercial buildings.
The study provider asked the taxpayer to have the VA sign an allocation letter that said this: “”the owner of the Building allocates the full federal income tax deduction available under Section 179D attributable to the HVAC and hot water systems to Edwards Engineering, Inc., for their work on the Building.” The Chief of Maintenance and Operations and a contracting officer’s representative for the hospital signed the letter for Building 200.
The study provider completed the study and determined that the taxpayer was allocated a deduction of $1,037,237. The Taxpayer claimed this deduction on its 2013 tax return, which was disallowed by the IRS on audit. The taxpayers, as the individual shareholders of the taxpayer, reported their share of the deduction on their income tax returns. Litigation ensued in the U.S. Tax Court.
About the Section 179D Deduction
Section 179D provides a tax deduction for energy-efficient commercial buildings. The tax deduction is designed to encourage the use of energy-efficient technologies in commercial buildings, which can help reduce greenhouse gas emissions and lower energy costs. The tax deduction applies to costs incurred for installing energy-saving systems in commercial buildings, such as lighting, heating, and cooling systems.
The tax deduction is based on the cost of energy-efficient property installed in a commercial building. The deduction amount is the lesser of the cost of the property or the maximum amount specified in the code (currently It is capped at $1.80 per square foot for new buildings and $0.60 per square foot for retrofitted buildings in which the equipment is installed). The calculation takes into account the amount of energy savings achieved by the property compared to a reference building that meets minimum energy efficiency standards.
This tax deduction generally does not benefit tax-exempt entities as they typically pay no tax. Congress recognized that tax-exempt entities, such as Federal, state, and local governments, own a sizeable portion of all commercial real estate. Thus, to extend the benefit of this tax deduction to those entities, Congress added a method to allocate this tax deduction to those responsible for designing the property. The owner of the property can allocate the deduction to the person primarily responsible for designing the property (the designer). The designer may include an architect, engineer, contractor, environmental consultant, or energy services provider who creates the technical specifications for the building. The allocation of the deduction must be in writing and contain certain information and signatures. The designer must obtain the written allocation before claiming the deduction, and retain it as part of the taxpayer’s records. The maximum amount of the deduction to be allocated is the cost incurred by the owner to place the energy-efficient property in service. The designer does not include the allocated amount as income, nor does the designer reduce future deductions by the amount of the allocation.
The requirements for this are set out in Notice 2008-40. This notice provides additional guidance on the process outlined in Notice 2006-52, which provides for a taxpayer to obtain certification for a property that meets energy efficiency requirements and lists software programs for calculating energy consumption. This notice also clarifies that references to Standard 90.1-2001 should be treated as references to ANSI/ASHRAE/IESNA Standard 90.1-2001, Energy Standard for Buildings Except Low-Rise Residential Buildings, as in effect on April 2, 2003, including addenda 90.1a-2003, 90.1b-2002, 90.1c-2002, 90.1d-2002, and 90.1k-2002.
What Year is the Sec. 179D Deduction Allowable
The IRS’s first argument was that Building 200 was not placed in service in 2013 and, as a result, there was no deduction allowable in 2014.
The court looked to the depreciation rules as Sec. 179D does not address this. It cited the general depreciation rule that property is deemed to have been placed in service at the time when it functionally could have been used, rather than when it was actually used. The IRS frequently challenges this issue on audit for depreciation, generally, even when Sec. 179D deductions are not at issue. You can read more about this type of placed-in-service dispute here.
Given this rule, the court ruled in favor of the taxpayer, finding that there was substantial evidence that the building was placed in service in 2013 based on an allocation letter, testimony from witnesses and employees, and the absence of evidence to rebut those claims.
What is the Amount of the Sec. 179D Deduction?
The IRS’s second argument related to the amount of the Sec. 179D deduction.
The taxpayer claimed a Sec. 179D deduction of $1,073,237 for 2013, which was equal to the product of $1.80 and the square footage of Building 200. The taxpayer argued that the cost of the property consisted of total expenditures made by the owner of the building, including amounts paid to other contractors for the HVAC upgrade work from 2010 to 2012.
The IRS argued that the cost of the property did not exceed $304,640, which was the amount the taxpayer billed to the owner of Building 200. It noted that the property the taxpayer installed in Building 200 cost the owner a total of $304,640 and the cost of the property does not exceed the maximum amount of deduction determined under Sec. 179D, so the amount of the Sec. 179D deduction in 2013 was $304,640.
The court held for the IRS on this issue and limited the Sec. 179D deduction to $304,640.
This case highlights the importance of the IRS and courts in determining how tax incentives, such as the Sec. 179D tax deductions are implemented. As evidenced by this court case, the tax savings can be substantial and the details matter in these cases.
The Sec. 179D tax deduction is available in the year that the building is in the state of readiness for its intended purpose but, when the tax deduction is taken by the primary designer rather than the owner, the deduction is limited to the equipment the designer installed. The designer cannot take a deduction for the work that other parties who assisted in the design installed. If you are a designer and have questions about allocations or allocation letters, this is an area where you should contact a tax attorney for advice.