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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 rehabilitation 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 rehabilitation 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:

  1. The real estate professional exemption. If an individual fits the IRS's definition of a real estate propfessional, he or she may qualify for the real estate professional exemption. This enables the taxpayer to apply the tax credit to non-passive income.

  2. The "trade or business" condition. If the property is used in the property owners' trade or business, taxes owed on non-passive income may be offset by the tax credit.

  3. 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 non-passive income.

The final test is to calculate the credit amount that may be redeemed under the IRS alternative minimum tax (AMT) rules. This is the ultimate arbiter of how much you can redeem and supercedes all other tests, even if the amount redeemable under the passive activity rules is greater.

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.

Syndicating the Credit

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, a final option for some owners may be to 'sell' their credits to investors. In reality, this is not a "sale" of credits; instead, ownership of the building would need to be held by a partnership or a limited liability company and one or more investors would be admitted to the partnership or LLC, agreeing to provide equity to the project in exchange for an allocation of an interest in profits, losses, cash and federal credits earned by the partnership or limited liability company. The investor would redeem the credits allocated to it against its federal income tax liabilty. Often these investors are banks, publicly held corporations, and other institutional investors or equity funds that have banks, publicly held corporations and other institutional investors, because these entities are not subject to passive loss rules. Explore syndicating your credits.

For more information on the historic tax credit marketplace, visit our Community Investment Funds web page.

Explore your options for redeeming the credit