Capital Review Group: Grasping the Tax Opportunities for Apartment Building Owners

Capital Review Group: Grasping the Tax Opportunities for Apartment Building Owners

Thanks to §179 of the Energy Policy Act (EPAct), new and existing apartment buildings not only can recognize significant reductions in energy costs, but may also qualify for substantial tax deductions for energy-efficient construction and renovations.

To make the most of the apartment building's income potential, it is essential to understand the tax strategies that result in increased cash flow and can actually provide funding for renovations, improvements and energy efficiency upgrades. Grasping the tax opportunities that are currently available allows owners to develop a comprehensive plan for improvements that makes financial sense and allows them to maintain a community that is energy efficient for years to come.

Apartment owners looking at a "big picture" scenario of saving money through energy efficiency must consider the cost of making the necessary improvements to the community. Retrofit improvements can be performed through efficient lighting, HVAC or upgrades to the building envelope to save money on energy costs. All involve capital expense. The ROI on new, energy-efficient systems may take longer, but the equipment will perform more reliably while providing better living conditions and lowering energy costs in the interim. Most building owners will assume that funding for energy efficient upgrades have to result from dipping into their equity in the property or from an outside funding source such as a bank loan. The good news is that building owners can take advantage of targeted tax and energy strategies that may significantly increase operating cash flow and generate a substantial ROI, as well as funding energy efficiency projects through a considerably lowered tax burden.

Reclassification of Assets

For new buildings, review of the real property assets may identify tangible personal property reducing the class lives to five, seven and 15 years for taxation purposes, which decreases current income tax obligations. Personal property assets include a building's non-structural elements, exterior land improvements and indirect construction costs. Exterior features such as paving, fencing, sidewalks and lighting are also eligible. When these assets' lives are shortened, depreciation expense is accelerated and tax payments are decreased, which frees up cash for other uses.

For example, reclassification on an apartment building allows for a traditionally 27.5-year property (written off over 27.5 years) to be reclassified to either a five-year, seven-year or 15-year property based on a detailed, engineering-based analysis of the blueprints and asset usages. Certain parts of the building actually may be depreciated much faster based on IRS guidelines. The IRS has issued an Audit Technique Guide (ATG) for IRS field agents and this guide spells out the process of a properly conducted cost segregation analysis.

In addition, this year owners may claim 50 percent bonus depreciation on qualifying assets (generally new assets with a class life of 20 years or less). Congress is considering the possibility of raising that to 100 percent again for 2012 (as it was in 2011). However, as of now, traditional depreciation is expected to return in 2013 with no special incentives.

To illustrate the potential impact of reclassifying assets for the owner, consider this example: Based on the cost of the apartment building and the improvements that were done, a building owner was able to reclassify 29 percent of the building assets to short-lived assets and saved approximately $700,000 in taxes during a five-year period.

To illustrate the potential impact of reclassifying assets for the owner of several apartment buildings, one owner responded, "Our objective in reclassification of assets was to depreciate the assets over a shorter period of time and reap the tax benefit in shorter period of time. We were able to take depreciation from the standard 27.5 years down to five, seven or 15 years for various assets for cash savings over a shorter period of time."

The ideal time to begin this strategy is during the planning phase of building a new property, remodeling or expanding an existing building. At this time, project-related costs that qualify for a shorter depreciable life can be identified, enabling the owner to derive greater benefit from the planning process.

For capital construction projects and newly acquired buildings, an accurate assignment of costs will allow a taxpayer to "front load" cost recovery and cash flow, maximizing them in the immediate years following the construction or purchase. However, the benefits of this strategy may be retroactive, including buildings that have been purchased, constructed, expanded or remodeled since 1987. This allows taxpayers to bring forward previously unrecognized depreciation, which can significantly increase cash flow in the current year.

§179D of the Energy Policy Act of 2005

Another potential tax benefit for apartment building owners goes hand in hand with energy efficient building projects and improvements. §179D of the Energy Policy Act of 2005 provides guidelines for building owners of properties standing at least four stories tall, who may be eligible for tax deductions for implementing energy efficiency components in commercial buildings. These deductions are applicable to buildings that were either built or retrofitted after Dec. 31, 2005, and must be certified by a qualified third party.

§179D includes full and partial tax deductions for investments in energy efficient commercial buildings that are designed to increase the efficiency of energy-consuming functions. The deduction available is up to $.60 per square foot for lighting, HVAC and building envelope, creating potential for $1.80 per square foot if all three components qualify.

Enlisting the aid of qualified professionals to coordinate your green/efficient building improvements not only may pinpoint the most effective improvements to make initially, but also may result in a cohesive plan to ensure that owners receive the maximum energy savings and tax benefit from their capital expenditure.

If the apartment community operates through a central plant or chiller, HVAC system upgrades may qualify for the §179D deduction. Professional expertise is especially valuable in this case, because the building that is to be improved with the new HVAC system must be modeled by a qualified individual using IRS prescribed software, and blueprints/plans and specifications for the new system also need to be provided.

For the HVAC system to qualify for the $.60 per square foot deduction, it must save at least 16 2/3 percent in energy costs over the minimum requirements established by ASHRAE 90.1-2001. Based on the specific needs and characteristics of the property, as well as the variety of HVAC and control systems available in the marketplace today, it makes sense to model any and all possible systems to find the most cost effective solution for the property. Third-party certification is part of the study and is required for the system to qualify.

Apartment building owners can consider energy-efficient lighting systems in apartment units, stairways and hallways, offices, common areas, laundry rooms, operations/mechanical rooms and parking garages. Replacing traditional incandescent lighting with fixture/ballast and controls MAY reduce lighting levels enough to qualify for the deduction.  Replacing compact fluorescents (CFLs), LEDs or low-wattage incandescents as an "Energy Efficiency Measure" may result in prescriptive rebates from the owner's utility company. 

When upgrading apartment units with energy efficient bulbs, the building owner and residents will need to work together to realize savings. By teaming up, both parties gain from improved energy efficiency.

The building envelope on new apartment building construction may qualify for the partial §179D deduction with proper incorporation of well-insulated, building envelope components and energy-efficient windows. Existing buildings may be retrofitted with air barrier systems, green roof or cool roof systems, insulation and sealant systems, insulated exterior cladding and deck coating and window glazing or tinting and may qualify for the deduction after modeling and third party certification.

With §179D deductions and future energy cost savings as incentives, making qualifying improvements to apartment buildings offers taxpayers powerful strategies to fund energy projects or increase cash flow. In addition, the issuance of Revenue Procedure 2011-14 will allow some taxpayers to claim the §179D deduction all the way back to Jan. 1, 2006, without filing one single amended income tax return. This means that a taxpayer could potentially claim deductions from 2006-2010 (or 2011) all on one return and significantly reduce their tax burden, if not eliminate it altogether.

As an example, a 90,000 square foot building under this IRS ruling could provide a potential allowable deduction of $162,000 at $1.80 per square foot for entire building (envelope, HVAC, water heater, and lighting). These tax incentives may be applied to projects as far back as Dec. 31, 2005, and incentives expire at the end of 2013.

The opportunities for tax savings and enhanced planning are available with the right knowledge and planning. Putting these effective tax and energy strategies to work makes smart business sense for apartment building owners and can make the difference in today's challenging economy.


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