Question: Can an investor continue to claim new markets tax credits (NMTCs) if sufficient basis doesn’t exist in their investment in a community development entity (CDE)?

Answer: As we near the two-year mark of the COVID-19 pandemic in the United States, many businesses continue to struggle to stay afloat as temporary economic relief programs expire. Qualified active low-income community businesses (QALICBs) in the NMTC program are no exception, especially considering that these businesses are located in areas that have otherwise lacked access to capital. As a result, many QALICBs could experience bankruptcy, causing qualified low-income community investments (QLICIs) to become partially or wholly worthless.

If a QLICI becomes worthless due to a settlement, foreclosure or bankruptcy, this triggers a realization of a tax loss to the CDE under Internal Revenue Code (IRC) Section 165 or Section 166. These losses are then allocated to the owner of the qualified equity investment (QEI) at the end of the taxable year. The loss will reduce the owner’s basis in the QEI at the end of the taxable year under IRC Section 705.

Language of IRC Section 45D and Applicable Regulations

IRC Section 45D(a)(1) provides that:

For purposes of Section 38, in the case of a taxpayer who holds a qualified equity investment on a credit allowance date of such investment which occurs during the taxable year, the new markets tax credit determined under this section for such taxable year is an amount equal to the application percentage of the amount paid to the qualified community development entity for such investment in its original use.

Furthermore, IRC Section 45D(h) provides:

The basis of any qualified equity investment shall be reduced by the amount of any credit determined under this section with respect to such investment. This subsection shall not apply for purposes of sections 1202, 1400B and 1400F.

There is nothing in the statute that considers, in determining the amount of the tax credit allowable under Subsection (a), the amount of basis available for the reduction required by Subsection (h). They are two separate provisions. There is no language within IRC Section 45D indicating that the tax credit should be redetermined in the event that there is insufficient basis for reduction under IRC Section 45D(h). Therefore, there is no support within the language of IRC Section 45D for a disallowance of a tax credit amount determined under IRC Section 45D(a) because other tax events have eliminated the basis that would be required to be reduced under IRC Section 45D(h).

The NMTC program was meant to incentivize community development through the use of tax credits that attract private investment to distressed communities. One of the important components of this concept is the rule that the credit is allowed to be taken even if the investment is not returned, as promulgated in Treasury Regulation (Treas. Reg.) Section 1.45D-1(d)(2), which states that unreturned investments are considered continually invested. Treas. Reg. Section 1.45D-1(e)(4) also provides that “bankruptcy of the CDE is not a recapture event”. Because of the language in the statute, the tax credit investor may take the position that they can continue to claim the credits on the remaining credit allowance dates upon the bankruptcy of a QALICB as long as the CDE continues to meet the substantially all requirements of Treasury Regulations Section 1.45D-1(c)(1)(ii) even if their basis in the CDE has been reduced to zero.

IRC Section 704(d) addresses how partnerships should address the consequences of inadequate basis with respect to losses.  This section states that a partner’s distributive share of partnership loss shall only be allowed to the extent of the adjusted basis of such partner’s interest in the partnership at the end of the partnership year in which such loss occurred.  Any excess losses are suspended until such time that basis is sufficient.  However, there is no provision in the Internal Revenue Code that provides what happens in the event there is insufficient basis for the required reduction from tax credits.  While it is not directly discussed in the NMTC regulations, one position is that the excess basis reduction could be treated as a suspended, non-deductible loss. However, if the taxpayer claims the credit and suspends the basis reduction, this could reduce or eliminate the taxable nature of the credit.

Approaches to Preserve the Taxable Nature of the Credit

Should the Internal Revenue Service (IRS) feel that a proposal is needed to preserve the taxable nature of the credit in the event that there is insufficient basis to absorb the required reduction, there are some potential approaches that could address this issue.

Income-Based Approach

Should the IRS determine that adjustment is needed to preserve the taxable nature of the credit, one approach would be to keep the basis reduction as per the current regulations and require the recognition of income to the extent that a required basis reduction in the QEI exceeds the holder’s basis in the interest. This approach would match the tax effect of the basis reduction to the taxpayer taking the credit.

Possible Approaches Related to the Timing of the Basis Adjustment

Other approaches to the issue of preserving the taxable nature of the credit relate to the timing of the basis adjustment, however, each of these approaches have potential issues that could be raised.

Require Immediate Basis Adjustment

The regulations could be amended to require an immediate basis adjustment on the first credit allowance date for the full amount of the NMTCs that will be allowable over the entire compliance period. However, there are problems with this approach in the event that there is a syndication or transfer that occurs after the first credit allowance date. Accelerated basis reductions by the seller would lead to a mismatch between the buyer taking the credits and the seller who bore the burden of the full basis reduction.

Preserve Basis in the QEI for Later Reduction

Another approach could be to require a basis reduction in the QEI at each credit allowance date, as provided in the current regulations, but to provide that a minimum amount of tax basis is treated as already reduced solely for the purpose of determining a partner’s basis under IRC Section 705 and the suspension of excess losses under IRC Section 704(d) (as discussed above) to the CDE. Under this approach, there could be no loss allocations or distributions from the CDE that reduce the basis below the remaining credit amount. Any losses that would otherwise reduce basis below the remaining credit amount would be suspended under IRC Section 704(d), and any distributions that would otherwise be offset by such basis are treated as income under IRC Section 731. However, under this scenario, there are also issues that could arise if a sale of the investment occurs.

In this example, assume that the basis in the QEI has already been reduced to the remaining credit amount and the tax credit investor decides to sell. Since there is no longer a QLICI but only a stream of future credits, the buyer would generally only be willing to pay the present value of the remaining credit stream. If this were to occur, at some point, the buyer would not have sufficient basis to offset the remaining credits, which could lead to a similar problem about claiming credits beyond the buyer’s basis in the investment.

Conclusion

It appears that the intent of the NMTC program would support that an NMTC investor may continue to claim credits even if they do not have sufficient basis in their investment If this position is taken, any excess reduction would be treated as suspended, non-deductible loss under IRC Section 704(d). This position appears to be supported by Treasury Regulations 1.45D-1 regarding unreturned investments being considered continually invested, and the explicit language that bankruptcy of a CDE is not a recapture event, along with the silence in the Regulations regarding whether the credit amount needs to be re-determined if insufficient basis in the investment exists.

If the IRS were to determine that an adjustment needs to be made to preserve the taxable nature of the credit, there are possible approaches that could address this issue, however, each of these approaches has limitations in the event that the NMTC investments are syndicated or sold.

Each NMTC transaction is unique and comes with its own potential issues. Should you be involved with a transaction that experiences a settlement, foreclosure or bankruptcy, reach out to a Novogradac NMTC expert to ensure you are complying with current tax law and NMTC incentive compliance.