Geothermal Cost Segregation: What Counts Toward the ITC
A geothermal heat pump system earns a Section 48 credit of up to 30% of its eligible basis before any bonus adders. Eligible basis is the number nobody hands you. It has to be built, dollar by dollar, out of contracts that were never written with the credit in mind, and as of October 2026 the regulations still leave the hardest part of that build to general tax law.
That build is a cost segregation study. On a geothermal job it reaches past the ground loop and the heat pumps into wiring, piping, ductwork and soft costs priced in other contracts, and that’s where projects lose credit or create exposure.
Why isn’t the credit just 30% of the geothermal contract?
Because there usually isn’t a geothermal contract. On a new building the system is spread across trades: the bore field inside the mechanical subcontract or the site utilities line, the trenching inside earthwork, the circuits to the heat pumps inside the electrical contract, the design inside the architect’s fee. On one new-construction file we’re working now, not a single line in the contractor’s schedule of values, the line-item price list behind each pay application, says geothermal.
The law doesn’t name components either. The statute covers equipment that uses the ground or ground water to heat or cool a structure (Section 48(a)(3)(A)(vii)). The final regulations repeat that, add other underground fluids, and stop (Treas. Reg. §1.48-9(e)(8)). Treasury said in the preamble that it chose not to publish an exclusive list of components (89 FR 100618).
Everything past the definition comes from two tests. A component is functionally interdependent if the system can’t perform its intended function, heating or cooling the building with the ground, until that component is in service too (§1.48-9(f)(2)(ii)(B)). It’s an integral part if it’s used directly in that function and essential to its completeness (§1.48-9(f)(3)(i)). Those tests get applied to invoices, not to a clean drawing of the system.
Is the supplier’s quote a good starting number?
It’s the floor, and sometimes the wrong floor. A heat pump supplier’s invoice covers the units and maybe the pumps. It doesn’t carry the drilling, grout, loop pipe and headers, the installer’s labor, freight, startup, controls programming, electrical hookups, balancing or commissioning. Those live in other contracts. Meanwhile one mechanical equipment line can bundle the geothermal units with exhaust fans, unit heaters and a kitchen hood that have nothing to do with the ground.
The closest the regulations come to defining basis is a sentence in the retrofit rule: the cost of new components “includes all costs properly included in the depreciable basis” (§1.48-14(a)(1)). Labor follows the equipment it installs. So a study starts from the final pay application and every subcontract schedule of values, not the supplier’s price, and it reconciles back to what the owner actually paid.
On one completed public system, the largest dollar still to trace is electrical, not the bore field. An electrician priced the circuits to the heat pumps and loop pumps inside a lump sum that never mentions geothermal.
Which soft costs belong in eligible basis?
More than most owners claim, and the regulations won’t settle it for you. When commenters asked which costs get capitalized into basis, naming project management, design, engineering, permitting and contractor costs, Treasury answered that the question is beyond the scope of the regulations (89 FR 100637). That leaves it to general tax law: the capitalization rules in Sections 263(a) and 263A and the cost basis rule in Section 1012.
Everything the owner pays under the construction contract is part of that cost, including the general contractor’s site overhead (general conditions), fee, insurance and bonds, so each carries a geothermal share. Where Section 263A applies, property built for you under a contract is treated as property you produced, counting the costs you pay (§263A(g)(2)), and the regulations’ list of indirect costs to capitalize includes engineering and design, insurance and quality control (Treas. Reg. §1.263A-1(e)(3)). That reaches design fees, builder’s risk and commissioning. An owner claiming direct pay applies the same capitalization rules (Treas. Reg. §1.6417-2(c)(2)(ii)). The share has to come from a driver, not a feeling.
Design is where we see money left behind most often. An engineer’s fee split written months earlier for another purpose, treating geothermal as a small slice of mechanical, ends up in the file as the number. Nobody revisits it, and nothing in the credit file says why it’s right.
Do the heat pumps and ductwork count?
The heat pumps do. The piping and ductwork can, which puts the line further downstream than many engineers draw it. On one project the engineer of record had excluded the water source heat pumps from the geothermal scope because they aren’t uniquely geothermal: the same units could run on a loop served by a boiler and a cooler instead of the ground. That’s a reasonable engineering instinct and the wrong legal test.
The regulations’ own example of a geothermal heat pump unit is coils in the ground plus at least one heat pump used with them (§1.48-14(e)(4)(ii)). Putting the heat pumps back inside the boundary roughly doubled that project’s estimated credit.
The distribution side is where judgment lives. Treasury wrote that energy distribution equipment and components of a building’s heating and cooling system “may be integral” to geothermal heat pump property (89 FR 100603). May. A run that serves only the geothermal system comes in whole. Where a run also carries heat from a boiler, the dual use rule cuts its basis to the geothermal share (§1.48-14(b)). Where a component also serves a purpose other than heating or cooling with the ground, only its incremental cost comes in (§1.48-14(d)).
Ask where the engineer drew the line. If the geothermal scope in the drawings or the fee proposal stops at the loop header or the mechanical room wall, the heat pumps and part of the distribution may be sitting outside the credit. It's the first boundary we check on a study.
Which geothermal components qualify for the credit?
The ground loop and the heat pumps come in whole, along with the circuits that feed them. The building and any backup heat stay out, and nearly everything in between gets split or allocated.
| Component | Typical treatment | What decides it |
|---|---|---|
| Bore field, grout, U-loops, headers, manifold | In | §48(a)(3)(A)(vii); §1.48-9(f)(2)(ii)(B) |
| Heat pumps and loop circulating pumps | In | §1.48-14(e)(4)(ii); §1.48-9(f)(2)(ii)(B) |
| Hydronic piping, ductwork, terminal units | In if integral; split where shared | §1.48-9(f)(3)(i); §1.48-14(b), (d); 89 FR 100603 |
| Dedicated circuits to heat pumps and pumps | In | §1.48-9(f)(3)(i) |
| Shared switchgear, feeders and panels | Split, demand load as the driver | §1.48-9(f)(3)(i); §1.48-14(d) |
| General conditions, fee, insurance, bonds, design | Allocated or assigned | §§263(a), 263A, 1012; §1.6417-2(c)(2)(ii) |
| Backup boiler or electric resistance heat | Out, and it triggers the dual use test | §1.48-14(b) |
| Domestic hot water | Out, incremental cost at most | 89 FR 100602-03; §1.48-14(d) |
| Building structure, mechanical room, roof | Out | §1.48-9(f)(3)(v) |
| Fencing, paving and landscaping over the field | Out | §1.48-9(f)(3)(i), (iii), (iv) |
A gas boiler or electric reheat feeding the same distribution makes that distribution dual use property. It qualifies only if no more than half its energy comes from the boiler or reheat, and basis is cut to the qualifying share. If that share falls below 50% in any later year of the five year recapture period, the credit is recaptured (§1.48-14(b)(2)).
Equipment that only makes domestic hot water, such as a desuperheater, is out. A heat pump that serves both the building and domestic water comes in only for its cost above equipment that would serve the domestic water alone (§1.48-14(d)).
Can a depreciation cost segregation study set the credit?
Not on its own, and mixing the two costs credit. A depreciation study files pipes and ducts with the building, because the structural components definition in the old investment credit regulation, which cost segregation still uses, covers all components of a central heating or air conditioning system, including pipes and ducts (Treas. Reg. §1.48-1(e)(2)). That decides recovery periods. It doesn’t decide the credit, because the Section 48 definition of geothermal heat pump property has no structural component exclusion. The regulation excludes buildings (§1.48-9(f)(3)(v)), and the preamble says building heating and cooling components can be geothermal property (89 FR 100603).
A taxable owner needs both answers, one for depreciation and one for the credit, now that the 2025 tax law ended the five-year recovery class for energy property whose construction begins after 2024 (Public Law 119-21, §70509). Depreciable basis also drops by half the credit (Section 50(c)(3)). A tax-exempt owner claiming the credit as a direct payment needs only the second, and it’s the whole credit.
What happens if the basis is wrong?
Overstate it and the IRS has a playbook. It’s the Cost Segregation Audit Techniques Guide, IRS Publication 5653, written for depreciation studies, and its cost questions carry straight over. It tells examiners to reconcile a study to the final pay applications, to question a standard percentage of electrical cost that isn’t backed by a load study, and to ask for the computations with the formulas intact. A percentage someone typed into a spreadsheet doesn’t survive that conversation. For an owner taking the credit as a direct payment, an excessive payment comes back as additional tax, plus a 20% addition that only reasonable cause excuses (Section 6417(d)(6)).
Understate it and nobody calls. Every dollar left in a general mechanical line, every design fee nobody allocated, is credit the owner never sees.
If the project is still under construction, the easiest time to build the study is now. Change orders still have descriptions, and the people who know what’s inside each line still answer email. After closeout, the same file takes far more digging.
Have a geothermal project under construction or recently placed in service? GreenFile Advisory builds eligible basis studies, the cost segregation that sorts every pay application line, subcontract and design invoice into in, split or out, and ties each dollar to a document an examiner can follow. Request a scoping review. The contract and the latest pay application are enough for us to tell you what the study will need.
Have a project and a deadline?
GreenFile Advisory handles the tax side of Section 48 and Section 6417 direct pay: eligibility confirmation, eligible basis studies, IRS pre-filing registration, and the Form 990-T with the elective pay election. Tax filing and substantiation only, so we are not competing with your installer or your financing.
This article is general information, not tax advice, and it reflects IRS guidance as of October 26, 2026. Deadlines and eligibility depend on your organization's tax year and entity type. Please confirm your own facts with a qualified tax professional before relying on anything here.