By Edmund G. Kauntz, Esq.
On July 21, IRS issued temporary regulations which provide long-awaited guidance regarding the income to be reported by the master tenant of a project claiming Federal historic tax credits (HTCs) when the project owner elects to pass-through the HTCs to the master tenant (Treasury Regulation Section 1.50-1T).
Owners engaging in a qualified rehabilitation of certain historic buildings are entitled to HTCs. Generally, when an owner of an eligible project claims HTCs, the owner must reduce its tax basis in the building by the amount of the claimed HTCs. However, if the owner enters into a master lease of the project to a master tenant and elects to pass-through the HTCs to the master tenant, the owner does not reduce its basis in the building. Instead, the master tenant claims the HTCs in the year of completion, but must take 100% of the HTCs into income ratably over the depreciation recovery period of the building (typically 39 years for non-residential rental property). This income is referred to as “Section 50(d) income” based on the Internal Revenue Code section which authorizes the pass-through of HTCs.
In a typical master lease structure, an HTC investor makes a capital contribution to the master tenant partnership or LLC in exchange for a 99% interest in the master tenant, and the HTC investor then becomes entitled to 99% of the HTCs. The master tenant subleases the building to the ultimate tenants. The HTC investor generally sells its interest in the master tenant after expiration of the 5-year HTC recapture period.
Prior to the issuance of the temporary regulations, it was unclear (i) whether HTC investors would receive an increase in their tax basis in the master tenant entity for the amount of Section 50(d) income they reported (generally leading to a capital loss on exit), and (ii) whether the HTC investors would be required to include in income the unreported balance of Section 50(d) income when they sold their interest in the master tenant.
For buildings placed in service on or after September 19, 2016, the temporary regulations provide that:
- The ultimate person claiming the HTC (i.e., the HTC investor) is treated as the master tenant in a master lease structure. Section 50(d) income is not a master tenant partnership item but rather an investor item. Therefore, HTC investors cannot increase their basis in the master tenant partnership or LLC as a result of reporting Section 50(d) income (which would have created an artificial loss on ultimate disposition of the master tenant partnership or LLC ownership interest).
- Except as provided in items 3 and 4 below, Section 50(d) income must be reported by the HTC investor ratably over the building’s depreciation recovery period. Section 50(d) income cannot be allocated to any other person (such as the transferee of the HTC investor’s ownership interest after year 5).
- Upon an HTC recapture event (e.g., disposition of the building, master lease termination, or disposition of the HTC investor’s ownership interest during the recapture period), the HTC investor must take into income the unreported balance of the Section 50(d) income (i.e., the unrecaptured HTCs).
- Upon disposition of the HTC investor’s ownership interest after the recapture period, the HTC investor can elect to accelerate the unreported balance of the Section 50(d) income into the year of disposition.
The effect of this guidance appears to make HTC master lease structures much less attractive, since the HTC investor (i) must report income (sooner or later) equal to 100% of the claimed HTCs, and (ii) does not get a basis increase equal to the Section 50(d) income to generate a loss on ultimate disposition of its ownership interest after the recapture period.
The traditional structure in which the HTC Investor acquires a partnership or LLC ownership interest in the building owner, the basis of the building is reduced by 100% of the HTCs, and no partner or member is required to report any Section 50(d) income, is now more attractive to HTC Investors. However, maximizing the HTCs will require the HTC investor to own 99% of the owner entity (similar to a low income housing tax credit structure) during the 5-year recapture period.