Understanding Rehabilitation Tax Credits: What You Need to Know About Partnership Allocations
Anna Coldwell, CPA
In late 2013, the IRS released Revenue Procedure 2014-12, which established a safe harbor clarifying how the agency will treat allocations of rehabilitation tax credits among partners. The procedure lays out circumstances under which the IRS will not challenge a partnership’s allocation of credits to an investor/partner.
Safe Harbor Requirements
The safe harbor is available to two types of partnerships:
- A “developer partnership” owns and restores a qualified rehabilitation building or certified historic structure.
- A “master tenant partnership” leases a building from a developer partnership and elects to treat itself as having acquired the building for purposes of the rehabilitation tax credit.
The entities will generally be eligible for the safe harbor if they satisfy these requirements:
Minimum Partnership Interests — The principal in the partnership (the developer) must hold at least a 1% interest for the entire partnership term. The investor (the recipient of the tax credit) must hold at least a 5% interest for the taxable year in which the investor’s percentage share is the largest.
Bona Fide Equity Investment — The investor’s interest in the partnership must be a bona fide equity investment with a reasonably anticipated value commensurate with the investor’s overall interest in the partnership. An investor’s interest is a bona fide equity investment only if the reasonably anticipated value is contingent on the partnership’s net income — gain and loss — and it is not substantially fixed in amount. Plus, the investor must not be substantially protected from losses from partnership activities, and it must participate in the profits in a manner not limited to a preferred return.
Arrangements to Reduce Value of Partnership Interest — The value of the investor’s interest cannot be reduced through arrangements (for example, fees or lease terms) that do not reflect arm’s-length charges in other projects that do not qualify for credits. It also cannot be reduced by disproportionate rights to distributions or issuances of partnership interests for less than fair market value.
Minimum Contributions — Before a building is placed in service, the investor must contribute at least 20% of its total expected capital contributions. That minimum contribution must be maintained throughout the duration of the investment and generally may not be protected against loss through a guarantee or insurance arrangement with any person involved in the project.
Contingency Consideration — Before the building is placed in service, at least 75% of the investor’s total expected capital contributions must be fixed in amount. The investor should reasonably expect to meet its funding obligations as they arise.
Guarantees/Loans — The safe-harbor qualification procedure limits the types of guarantees that may be provided to the investor by parties involved in the project. (See the Sidebar ,“Is That Guarantee Permissible or Impermissible?”) Plus, the investor cannot get loans from the partnership or the principal, and the partnership and the principal cannot guarantee or insure any indebtedness the investor incurs to acquire its interest.
Purchase and Sale Rights — Neither the partnership nor the principal can have a call option or other right to buy or redeem the investor’s interest in the future. The investor may not have a right to require anyone involved in the project to buy or liquidate its interest at a future date at a price exceeding its fair market value.
Intent to Abandon — The investor must not have acquired its partnership interest with the intent of abandoning it after the qualified rehabilitation is complete. Such intention is presumed if the investor abandons its interest at any time.
Note that simply complying with these requirements will not ensure the validity of the tax credits. The credits must also derive from qualified rehabilitation expenditures and such allocations must possess “economic effect” as provided within the 704(b) regulations. The regulation generally requires credits to be allocated to the partners in the same ratio that the partners share the partnership’s taxable income for the year the property is placed in service, although future changes in income allocations are permitted.
Follow the Rules
Revenue Procedure 2014-12 is effective for allocations of rehabilitation tax credits made after December 29, 2013. If a building was placed in service before December 30, however, and the safe harbor requirements were met at that time, the IRS will not challenge the allocation.
As you can see, however, claiming rehabilitation tax credits is hardly simple. For more information, contact Anna Coldwell at [email protected] or call her at 312.670.7444.
Take Your Pick — There is More Than One Way to Execute a Like-Kind/Starker/Sec. 1031 Exchange
Michael Kovacs, CPA
Like-kind exchanges have been around for quite some time. They offer participants a way to dispose of property and subsequently acquire one or more other “like-kind” replacement properties as part of a non-recognition transaction. The simplest type of exchange is a simultaneous swap of one property for another. Deferred exchanges are more complex but allow for additional flexibility. Here is how they work.
Like-kind exchanges allow you to exchange business or investment property (the relinquished property) for business or investment property of a like kind (the replacement property) without recognizing any gain or loss until the disposition or liquidation of the replacement property occurs.
The provision also allows a deferred, or “forward,”exchange whereby the relinquished property is transferred before the acquisition of the “replacement property.” This deferred exchange, often called a Starker Exchange, is named for T.J. Starker, who convinced the courts that a delayed exchange in which he received no proceeds also qualified under the law. Subsequent to his case, Congress put in time limits to closing on the replacement property. Today the replacement property must be identified within 45 days of when the relinquished property is transferred. The replacement property also must be acquired within 180 days of the transfer or by the due date of the applicable tax return (including extensions) for the year in which the relinquished property is transferred, if sooner (the exchange period).
The same time limits apply to “reverse” exchanges. In a reverse exchange, the replacement property is acquired first and then “parked” with an exchange accommodation titleholder (the accommodator) before the relinquished property is transferred.
Unwrapping the Law
In a memo from the Office of Chief Counsel, the IRS considered a scenario in which a taxpayer structured two separate exchanges. In the first, a reverse exchange, the replacement property was acquired and parked with the accommodator and the taxpayer identified the relinquished property in a timely manner (within 45 days).
The relinquished property had a much higher value than the replacement property, so the taxpayer planned to engage in a second exchange — a deferred exchange — to defer the gain that remained after the relinquished property was exchanged for the replacement property.
A qualified intermediary (QI) (generally a title company) was retained to execute the transfers of the properties in both exchanges. The QI followed all guidelines to ensure the taxpayer was not in constructive receipt of any of the exchange funds during the two 180-day exchange periods.
The IRS memo concluded that, as long as the various guidelines are followed, the same relinquished property can be used in both forward and reverse exchanges — even though allowing this structure could result in up to 360 days between the day on which replacement property is parked at the beginning of the reverse exchange and the day the deferred exchange is completed.
It is important to note that a memo from the Office of Chief Counsel is specific to the particular facts that it addresses and has no precedential value. That said, it does provide a guideline for how to structure such a transaction.
Executing an Example
Imagine you decide to take advantage of property values and buy a property in California for $450,000 in January 2014. You park it with an accommodator so you can determine which property you would like to sell in order to reap the benefits of a reverse exchange.
Within 45 days, you identify a property in New Jersey. In July 2014 — within 180 days of parking the California “replacement” property — you sell the New Jersey “relinquished” property for $1 million, completing the reverse exchange.
You begin executing a deferred exchange within 45 days, identifying additional like-kind replacement properties to buy with the remaining $550,000 of proceeds from the relinquished New Jersey property. And you have 180 days from the close on the New Jersey property to close on one or more identified replacement properties.
So you do not have to close on those properties and complete the deferred exchange until January 2015 — nearly a year after you bought the California property.
To be certain, Sec. 1031 exchanges can be a great way to take advantage of a weak commercial real estate market. But it is not a cakewalk. To ensure you structure your next deal properly, or for any questions, contact Michael Kovacs at [email protected] or call him at 312.670.7444.