The Energy Tax Aspects of Chillers
Chillers are one of the more expensive building equipment items, ranging from tens of thousands of dollars to millions of dollars at large facilities. Chillers are industrial refrigerating systems that are an integral part of commercial HVAC systems. They are most frequently utilized in office buildings, industrial buildings, hotels, hospitals, apartment buildings and other large buildings. Due to the high cost of chillers, many companies deferred chiller purchases during the recent economic downturn. As a result of EPAct, these companies should carefully consider their chiller tax planning opportunities and act before the December 2013 EPAct expiration date on EPAct eligible chiller projects. There are multiple opportunities, including EPAct, for favorable tax treatment depending on whether the chiller is being purchased for a new building or an existing building, and the type of building. A smart tax planning decision can only be made after analyzing each tax deduction opportunity.
The Tax Deduction Opportunities
The EPAct 179D Tax Deduction
Pursuant to Energy Policy Act (EPAct) Section 179D, building owners or tenants making qualifying energy-reducing investments can obtain immediate tax deductions of up to $1.80 per square foot.
If the building project doesn't qualify for the maximum $1.80 per square foot immediate tax deduction, there are tax deductions of up to $0.60 per square foot for each of the three major building subsystems: lighting, HVAC (heating, ventilating, and air conditioning), and the building envelope. The building envelope is every item on the building’s exterior perimeter that touches the outside world including roof, walls, insulation, doors, windows and foundation.
The Business Expense Deduction
Pursuant to Internal Revenue Code Section 162, a building owner or tenant can deduct all ordinary and necessary expenses paid or incurred during the taxable year in carrying on their business. It is important to note that the chiller repair expense is only available if the chiller project meets multiple tests all of which need be documented. For example the fact that the old unit has completed its life cycle and energy performance values, should be supported by quantitative metrics. Also, the property repair expense cannot be claimed for a capital improvement that substantially adds to the value or useful life of a building. Capital improvements are depreciated as building assets under normal building tax depreciation rules. In determining the difference between an ordinary business expense and a capital improvement there has always been a line based on facts and circumstances; however, the court in FedEx Corp. v. United States set out a useful criteria in making this decision, which are:
- The industry custom,
- A comparison of the economic useful lives of the part and the whole,
- Whether the larger and smaller units of property can function without each other, and
- Whether maintenance on the smaller property can occur while affixed to the larger property .
In a recent private ruling obtained by Energy Tax Savers, Inc., the IRS ruled that a $1,000,000 replacement chiller can qualify for section 162 repair treatment .
Chiller Tax Deduction Analysis
With new buildings the tax deduction opportunity is with Section 179D. A $0.60 per square foot EPAct HVAC tax deduction is typically available with the following fact patterns:
1. High efficiency chillers installed as component elements of very efficient systems,
2. Chillers included with thermal storage systems,
3. Rental Apartment buildings or Hotels,
4. Buildings less than 150,000 square feet,
5. Hybrid fuel chillers, and
6. Central Chiller Plants serving buildings less than 150,000 square feet
For larger buildings, in order to obtain the maximum HVAC EPAct deduction while installing a chiller, the owner needs to combine the chiller with an efficient HVAC system. An example of this is a thermal storage system, which when installed with a new high efficiency chiller and package unit will often reduce energy cost to where the maximum EPAct HVAC deduction is a possibility, particularly in jurisdictions with time of day electricity pricing differences . Large EPAct deductions are also typically available for an apartment building that installs a chiller because the energy standards for apartment buildings are based on devices that are less efficient than chillers .
A building less than 150,000 square feet is the typical building where a chiller can be installed on its own, reduce energy use below the required levels, and thus trigger immediate EPAct HVAC tax deductions. Chillers can also be powered in ways other than by electrical energy. These hybrid fuel chillers use other forms of energy, such as natural gas or low-grade waste heat, and in the right situation can reduce energy cost more so than an electric chiller.
A final opportunity for large HVAC EPAct tax deductions from installation of a chiller is for a central chiller plant that serves multiple buildings less than 150,000 square feet. In this situation every building supported by the central chiller plant can be in line for large HVAC tax savings.
The $0.60 per square foot maximum HVAC deduction is achieved when total building energy use is reduced by 16.67% or more . The following chart shows the possible immediate EPAct tax deductions at various square footages for a new building:
To obtain the $0.60 to $1.80 per square foot EPAct tax deductions, the required energy cost reduction must be documented by an IRS approved energy simulation model. The ever popular United States Green Building Council’s Leadership in Energy and Environmental Design (USGBC’s LEED) certification program also requires building energy modeling. Moreover, recognizing the increasing importance of building energy efficiency measures, the recently revamped LEED system places much more emphasis on granting LEED qualifying points for energy efficiency measures. The only way to accurately right size HVAC to the building envelope and other building systems is to model the building. As a result of improvements in CAD systems and modeling interfaces, along with the huge increase in professionally trained software modelers, soon every new building will be modeled as matter of course .
Existing building chiller projects may be eligible for the $1.80 179D immediate tax deduction described above or a properly documented unit of property repair expense deduction. A smaller building will want to choose the property repair expense deduction, because chillers are typically very expensive, and that deduction is not based on the square footage of the building, whereas the EPAct deduction is. An example of this is a 140,000 square foot building that installs a $300,000 chiller. The $0.60/sq.ft. EPAct HVAC tax deduction would be $84,000, but the repair expense deduction would be $300,000.
However, in many situations where the existing building chiller installation would qualify for the EPAct deduction, the installation would probably arise to a capital improvement and thus would not be eligible for the property repair expense deduction. The most common chiller replacement where repair expense is applicable will be a so called one-for-one similar kind of chiller replacement. It is crucial to have a chiller study thoroughly documenting repair expense eligibility since the IRS is going to start with a presumption that the chiller should be capitalized. A good chiller tax study should incorporate about 10 documentation factors that make it easy for the auditor to verify repair expense eligibility. The chiller study should be prepared by tax experts intimately familiar with building energy and chiller technology . If a building energy simulation model exists and the EPAct and repair expense deduction amounts are similar it may make sense to use the model as documentation rather than expending the effort required for a separate study.
If a chiller project qualifies for either tax deduction but the taxpayer is contemplating a future investment that will only qualify for EPAct, then it would make more sense to first use the repair expense tax deduction. This is evidenced by the following example: Presume the taxpayer replaces an existing chiller on a 120,000 square foot building at cost net of rebate for $72,000 and is eligible for either a $72,000 EPAct tax deduction (120,000 x $0.60/sq.ft.) or a $72,000 repair expense deduction. If the same taxpayer is contemplating an LED lighting project by 2013 it may make more sense to first select the $72,000 repair expense and potentially obtain a $1.80 per square foot EPAct deduction upon the completion of the future LED project. With this approach the taxpayer has maximized the universe of tax opportunities.
Chillers are very expensive building equipment items; however, installing them presents large tax deduction opportunities. When advising on tax planning for a chiller deduction, it is important to look at the type of building, and whether it is an existing building being retrofitted or if the building is new. It is also important to take potential future energy efficiency projects into account when making the decision of which deduction to take. As seen above, if the correct decisions are made, the tax savings can be quite large.