Although the Energy Tax Act allocates considerably more dollars to efficient energy production, the homeowner energy conservation credits, along with the alternative motor vehicle credits (examined in our last column, Sept. 5-25, 2005, page 10), have made most of the headlines.While long-term predictions vary on whether the $500 lifetime (i.e., 2006 and 2007) residential energy property credit, the $2,000 credits for solar electricity and hot water, and the fuel-cell credit will be used by most homeowners or only a few, interest in them is high. In the age of Home Depot and ongoing relationships with home contractors, however, there is no doubt that, in time, enough situations will arise to test every issue and explore every fine point.
This column previews some of those situations.
Quick overview
In case you haven't heard, there are two categories of energy credits in the act that are directed toward homeowners: the residential energy property credit and a credit for solar and fuel-cell property.
The residential energy property credit under new Code Section 25C allows a $500 lifetime credit over 2006 and 2007 to homeowners in the form of a two-part credit:
* A 10 percent credit for any energy-efficient building envelope component (with an further credit limit of $200 for windows) and pigmented coated metal roofs; and,
* A 100 percent credit for "residential energy property expenditures," which is limited not only by the overall $500 credit amount, but also by $50 for any advanced main air circulating fan; $150 for any qualified natural gas, propane or oil furnace or hot water boiler; and $300 for any other items of energy-efficient building property (including certain energy-efficient heat pumps, water heaters and central air conditioners).
The solar and fuel-cell property credits under new Section 25D are 30 percent up to $2,000 for installations in 2006 and again in 2007 of qualified photovoltaic property; 30 percent, with another $2,000 limit, for installations in 2006 and again in 2007 of qualified solar water-heating property; and 30 percent, with a potentially unlimited cap, for qualified fuel-cell property expenditures.
Performance and quality standards
While a tax advisor or preparer is not expected to don the hat of an engineer or building inspector, advising clients in writing of their substantiation obligations under the credits might be appropriate. Part of that obligation is to be able to prove that the installed property meets a variety of performance and quality standards specified in the Tax Code and in anticipated Internal Revenue Service regulations.
Presumably, manufacturers and retailers of qualifying property will label their merchandise as such in order to encourage sales. Agreements between a homeowner and a contractor also might recite a contractual obligation of the contractor to use materials that will qualify for the credits.
Joint ownership
Whether a principal residence is owned by one taxpayer or jointly, only a single $500 limit (or $2,000 limit, in the case of the solar credits) will apply. If, within the 2006-2007 period during which the credits are effective, the taxpayer moves from one principal residence into another and has made qualifying improvements to each, double credits appear to be allowed under the statute.
Once again, the double credits must be shared between joint owners.
If, in a joint ownership situation, one of the owners is not making the home his principal residence (as may be the case in a pending divorce), the credit is allowed only if the owner who makes the house a principal residence pays for (or is deemed to pay for) the improvements. A similar division of the credit limitations is also required for joint owners who file separately.
Home office
Interplay of the home office deduction and the new credits falls into three categories:
* If the home office is a structure separate from the main home, improvements to that structure are not eligible for the personal residential energy property credits.
* If a home office is part of the main home, and home-office deductions do not claim that more than 20 percent of the home is occupied by the office, full credits may be taken for any energy improvements made anywhere in the home.
* If the home office takes up more than 20 percent of the home, reduced credits are required. New Tax Code Section 25D appears to require reduction of the expense and ceiling amounts at least in proportion to the percentage area used as the home office. However, if the energy improvements are specific only to the area occupied by a home office (for example, replacement windows in a room dedicated as an office), no credit is allowed.
Labor costs
Do-it-yourself installations are permitted for all qualifying property, although the dollar value of any sweat-equity is not eligible for any part of the credit. The cost of professional installations in addition does not qualify for the installation of envelope energy improvements. Labor costs are part of the credit computation, however, for residential-energy property under Sec. 25C, and for all solar and fuel-cell property allowed under Section 25D.
While installers of envelope-type property have some leeway in what amount of a total contract price is allocated to material and what to labor, clearly there will be limits on the IRS's acceptance of such stated amounts as true costs.
Envelope property
The 2005 Energy Tax Incentives Act is not the first time a residential energy credit was passed. In fact, the Energy Act of 1978 allowed a broader range of energy-saving home improvements to qualify for its residential energy credit (albeit at a $300 level). The 2005 Energy Act's focus for the 10 percent credit is confined to energy improvements to the building's "envelope." Ceiling fans, set-back thermostats and energy-use monitors are not part of the new credit.
Certain expenses under the 2005 act also might appear counterintuitive to energy conservation. Skylights are a glaring example. The addition of a skylight where only insulated roof existed likely leads to an overall energy loss, yet the cost of new windows and skylights, in addition to energy-efficient replacements, qualifies for the credit. In all fairness to Congress, however, labor costs for installation in either case are not counted in computing the 10 percent credit amount.
Some types of property normally considered maintenance items are eligible for the envelope credit, as long as their useful life is at least five years. High-quality caulking and weather-stripping, for example, should therefore qualify. However, since labor is evidently not included for envelope improvements, remember that even a couple of hundred dollars of caulking material will only yield a $20 credit.
Finally, the taxpayer's reason for using qualifying energy property is irrelevant. Insulation and triple-paned windows purchased to keep out highway noise qualify as long as they also carry a qualifying energy-efficiency rating.
Principal residence
Vacation homeowners do not qualify for most of the new energy credits, since most of them carry the requirement that the home be the taxpayer's principal residence. The one exception applies to the 30 percent credit for qualified photovoltaic and solar water-heating properties, which only require installation in a residence of the taxpayer. The 30 percent credit for fuel cells, however, does require a principal residence.
Basis reduction
The basis-reduction rules for the credit should not prevent anyone from claiming it. The basis in the residence must be reduced not by the amount of the expense, but only the amount of the credit. For envelope energy improvements subject to the 10 percent credit, that's a real bargain.
In addition, gain on an eventual sale that is not covered by the principal residence homesale exclusion is taxed only at long-term capital gain rates, further reducing the real cost of having to reduce basis.
Solar generating equipment
The credit for solar equipment installed on a personal residence is subject to a $2,000 annual limit for each of the two categories of solar equipment: hot water and electricity. However, each installation can only occur once - when it is placed in service - so that a single project cannot be spread between 2006 and 2007 to manufacture $4,000 of credit.
Timing
Only property installed in 2006 or 2007 is eligible for the credit. While installation and not time of purchase is controlling, delaying installations until 2006 for purchases that already have been made will require clear proof of the installation date to withstand an audit.
Postponing installation to take advantage of the January 2006 start of the credits may itself be tricky. The "placed in service" rules that govern depreciation and the expensing deduction probably transfer neatly to this timing issue for the energy credit. Under these rules, "substantial" installation triggers when "placed in service" occurs.
Conclusions
As we move closer to Jan. 1, 2006, manufacturers and professional contractors likely will make most homeowners in America aware of the new energy tax credits. They will not make them aware of all the finer points, however, leaving that task to the tax advisor.
While the principal advice now for tax purposes is to hold off home energy improvements until January, the anticipated record-high price of fuel and natural gas during the next home heating season virtually guarantees that practitioners will be fielding many questions on the credits from both clients and acquaintances.
Correction to Sept. 5, 2005, column: In our column in the last issue, we stated that taxpayers leasing hybrid vehicles would also be eligible for the new hybrid vehicle credit. This was based on statutory language that the new alternative motor vehicle credits applied to vehicles that are acquired for use or lease by the taxpayer. The staff of the Joint Committee on Taxation has informed us that this statutory language is intended to make the credit available to the lessor, but not to the lessee.
As we had pointed out in that column, the lessee would have had some difficulty claiming the credit in any event, due to the typical lease term being shorter than the economic life of the vehicle and the potential application of recapture rules at the end of the lease term.
