Step 3: Redeeming the Tax Credit
Now that you have calculated the amount of tax credits earned, the final step is to establish exactly how much of the credit can be redeemed. The process for determining this is the same for the 10 percent and the 20 percent credit.
Tax credits are earned by the property owner of record as of the date that the building is placed-in-service. Consider a building owned in the name of Mr. John Smith. On the placed-in-service date, Mr. Smith is entitled to 100 percent of the tax credits. If a building is owned by a partnership or a limited liability company (LLC) with more than one owner, IRS regulations state that federal Historic Tax Credits are allocated to the owners of the partnership or limited liability company in accordance with their share of profits (delineated in the partnership agreement or LLC operating agreement). For example, if the partnership agreement or LLC operating agreement states that all profits are to be split evenly between two owners, each owner would be entitled to 50 percent of any tax credit earned by the LLC.
Once you have established that the credit is earned and the percentage to which each person is entitled, you can begin to explore the dollar amount that can be redeemed by each individual. This calculation is based on three complicated “tests” put forth by the IRS.
The first test involves determining if at -risk rules limit the amount of credits that can be redeemed. In general, the amount of credits a taxpayer can claim is limited to the amount the taxpayer has at-risk in the rehabilitation project.
The second test is to consider the impact of passive activity rules. In general, federal Historic Tax Credits are considered passive income and therefore can only offset taxes owed on passive income. Unfortunately, the majority of taxpayers pay taxes on income from non-passive sources such as wages and portfolio income. There are a few ways in which the impact of the passive activity rules may be mitigated:
- The real estate professional exemption. If an individual fits the IRS’s definition of a real estate professional, he or she may qualify for the real estate professional exemption. Real estate professionals are not limited in the amount of passive losses they can take in a given year.
- The “trade or business” condition. If the property is used in the property owners’ trade or business, taxes owed on active income may be offset by the tax credit.
- Deduction equivalent exception to the passive activity rules. This enables property owners with adjusted gross income (modified for this purpose) below $200,000 to offset taxes owed on a limited amount of active income.
In 2008, Congress eliminated the final test, which was to calculate the credit amount that may be redeemed under the IRS alternative minimum tax (AMT) rules.
If any of the above rules limit your ability to redeem credits in the year earned, the IRS allows credits to be carried forward for twenty years and/or back one year for redemption in previous or subsequent years. Redemption of tax credits in years other than the year in which the credits were earned is subject to the same rules and regulations outlined above.
For those who determine that any or all of the above rules may prevent them from utilizing a significant portion of an earned credit, or if the carry back/forward allowances are unattractive, the best option for some owners may be to ‘sell’ their credits to investors.
Be sure to visit the syndicating your credits section after you have explored your options for redeeming the credits.
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