Recent Real Estate Developments: Historic Tax Credits
Congress enacted Internal Revenue Code Section 47 in 1976 to provide tax credits for historic rehabilitation projects. This program was designed to encourage private investment in historic real estate properties. Several states have also enacted historic tax credit programs to provide state tax credits in addition to the federal tax credits.
Since inception of this program, more than 35,000 properties have been rehabilitated, comprising more than $50 billion of private investment to preserve and rehabilitate these properties.
Many of the business structures for historic tax credit projects involve either partnerships or LLCs, so investor partners making equity investments in these projects can benefit from the tax credits generated from these projects. In this article, partnerships, LLCs and related partners and members will all be referred to as “partnerships” and “partners.”
For an investor to receive federal historic credits, the investor usually must be a partner in the partnership rehabilitating the historic property prior to the property being placed into service. However, some states allow state historic preservation tax credits to be sold or transferred to nonpartners; some states also have partnership allocation provisions allowing partners to allocate tax credits “as the partners mutually agree,” meaning they do not have to follow the ownership percentages of the partnership.
If structured properly, most real estate developers and investors will not encounter tax issues when claiming the historic tax credits. However, in recent years the IRS has embarked on a national audit program to examine many historic tax credit projects.
In 2011, two historic tax credit cases illustrate how the IRS has challenged real estate developers and investors in historic properties. These examinations focused on several significant tax and partnership issues.
Key Issues Examined
- Economic substance issues
- The transactions must have a substantial business purpose and economic substance or they may be considered a sham by the IRS. The partnership should have a legitimate business purpose allowing for the historic structure’s rehabilitation. Partners must demonstrate the formation of the partnership was necessary to conduct the business enterprise of the parties and that the parties are clearly partners in the partnership.
- Being a “bona fide” partner
- The partnership must be structured so that the investor partner is a true equity partner, which may involve the payment of an annual cash preferred return on equity invested as well as having a realistic possibility of gaining an economic return in addition to the preferred return. It is also important that a partner have entrepreneurial risk of loss. If there is a guaranteed rate of return provided to investor partners, they may not be considered bona fide partners.
- In a historic tax credit partnership structure, it is generally understood the investor partner is expected to exit from the partnership after the five-year tax credit compliance period. Proper put and call option provisions in the partnership agreement, which dictate the terms for the exit of the investor partner, should include provisions that reward the investor partner for being a bona fide partner.
- If the partner is not considered a bona fide partner, the IRS may claim:
- The partnership arrangement between the investors and partnership are not bona fide. In this case, investor partners’ capital contributions may be treated as taxable income to the partnership rather than as capital contributions. The partner may be treated as a purchaser of the tax credits rather than as a partner, so it is important to reflect that the capital contribution of the partner is not merely for the purchase price of the tax credits but to cover partnership expenses, mitigate risk to the partnership and provide capital for operations of the partnership.
- Transactions between investors and partnerships may be considered disguised sales. When the investor partner contributes cash to the partnership and receives a distribution of tax credits within two years, the distribution of tax credits may be considered a sale rather than a distribution of tax credits to a partner.
These recent examinations are a reminder to real estate developers and investors that these complex real estate structures require careful planning. They should include experienced financial, legal and accounting advisors upon formation as well as throughout the five-year compliance period and eventual withdrawal of the investor partner.
If you have additional questions, please consult your BKD advisor.