Q&A: Using State Rehabilitation Credits Part 2 of 3
Question: My state provides for rehabilitation credits using certificates. What do I need to be aware of in using these to help finance my redevelopment?
Answer: There are a number of tax and legal issues you will need to consider. An experienced lawyer will be able to help guide you through the legal implications. An introduction to the tax issues follows.
What Types of State Rehabilitation Credits are Available?
There are two types of methods that states use to provide tax credits as incentives to rehabilitate older properties. One method allows credits to be allocated to an owner of the property being rehabilitated and, by extension, to partners in a partnership owning the building. This we will call the “allocated credit,” and an example would be New York state’s program. This method was discussed in last month’s Journal of Tax Credits. The second method is to provide transferable certificates to the owner who can either use them or sell them to someone who can use them. We will call this the “certificated credit” and an example would be Massachusetts’ credit program. In this installment, we will discuss the certificated credit. Stay tuned for the final installment of this three-part series, which will discuss the role not-for-profits can play when it comes to state credits.
What is a Certificated Credit?
It is just that, it is a certificate that can be used to pay state tax liability. As will be discussed further, the certificate may be used by the owner or transferred (sold) to anyone with a state liability, subject to each state’s restrictions. The user of the certificate will then attach it to its state return when it files the certificate and claims the credits. So how does this work?
A developer will typically apply to its state for an allocation of state credits. Once the rehabilitation is complete, a cost certification will be submitted and the state will release the certificates. If the owner/developer has significant state liability, it will use the certificates to offset its state tax. More likely though, the owner/developer
will sell these certificates to a third party with state tax liability. Let’s consider the tax implications, and discuss two rulings that Massachusetts had requested from the Treasury Department in 2004 and 2011. These rulings, Chief Counsel Advice (CCA) 200445046 and more recently 201147024, requested treatment on a basket of state credits that Massachusetts offers, but we will focus on the rehabilitation credit.
In CCA 200445046, the IRS was asked to rule on whether the purchasers had made a “payment” toward their state taxes when they purchased the certificate and used it to reduce their state tax liability. The IRS’ ruling was in favor of the purchasers. What does that mean? That means when purchasing a certificate, the purchaser has purchased property and is then using that property to settle its tax liability. The ruling left some questions open, such as determining the basis in that property and how to account for the difference between the price paid for the certificate and the value of the credits applied against state tax. In CCA 201147024, the IRS attempted to answer these and other questions. Specifically in CCA 201147024, the IRS addressed five questions:
- When Massachusetts state credits are sold to a third party is the sale a taxable event?
- What is the basis to the original recipient (aka the allocatee)?
- Is the gain ordinary in nature (as opposed to a capital gain)?
- What is the basis to the purchaser?
- Should a gain be recognized by the purchaser on the discount and when should that gain be recognized?
The answers affirmed for what many of us had thought:
- The sale of the credit is a taxable event.
- The original recipient of the credit (the “allocatee”) has no basis in the certificate.
- The gain to the allocate is (generally) a capital gain.
- The purchaser’s basis is the amount it paid for the credit.
- The purchaser must recognize the gain ratably as the credit is applied to state taxes.
By way of an example, a developer (or allocatee) rehabilitates a structure eligible for a state credit of $100. The developer sells that for $95 to a purchaser. The allocatee has a $95 capital gain because it has no basis (see answer #2 above). The purchaser now has a basis of $95 (answer #4). When it applies the $100 against its state tax, it has a gain of $5. If this were a $20 credit usable over five years, (totaling $100), then the purchaser would have a gain of $1 each year for the five-year term of the credit (answer #5).
In this example, we price the credit at 95 percent of its face value, and we can price it that way because the $100 state tax expense deduction will still be available as a deduction on the federal tax return. Last month we discussed how an allocated credit reduces the federal tax deduction for state taxes paid. With a certificated credit there is no such loss of deductions and, therefore, the credit can be more “valuable” to a purchaser.
Next month we will discuss participation by not-for-profit entities and the issues and planning opportunities to be considered.
A transaction with both federal and state credits, and different investors for each of the credits, can complicate this matter further. As always, discuss these transactions with your tax advisor so these issues can be addressed accurately.
If you have additional questions about historic rehabilitation, please contact me at [email protected] or 617-330-1920 x116.