The U.S. Department of the Treasury (Treasury) recently issued temporary and proposed regulations under Section 50 of the Internal Revenue Code (IRC) that reduce the overall tax benefit of certain third-party investment tax credit lease structures. (See Treasury Regulations 1.50-1 and 1.50-1T.) While these regulations do not alter the amount of the available credits, they prevent investors in third-party lessees from effectively circumventing the impact of taxable income recognized under IRC Section 50(d) by claiming a tax basis increase for this income. The regulations are effective for investment tax credit property placed in service on or after Sept. 19, 2016. In addition, Treasury suggested in the preamble to these new regulations that prior transactions treated inconsistently with the new rules could be subject to IRS challenge.
Historically, Congress has offered incentives for various types of investments in the form of investment tax credits. Two common types of such credits include the rehabilitation tax credits for older buildings (including certified historic structures) and certain renewable energy properties. These credits offer a dollar-for-dollar reduction in the investor’s tax liability, and the investor is also able to benefit from the tax depreciation recognized over the property’s useful life. However, in order to eliminate the double-benefit of receiving both a tax credit and a depreciation deduction, IRC Section 50(c) requires the owner of the investment property to reduce the depreciable basis of the property by the amount of the tax credit (the basis reduction is limited to 50 percent of the tax credit for certain renewable energy property).
Company A rehabilitates a certified historic structure and incurs $1 million of qualified rehabilitation expenditures. Company A receives a $200,000 tax credit (20 percent) for the rehabilitation, but must reduce its depreciable basis in the building by the amount of the credit. Thus, the basis for claiming depreciation deductions on the building is $800,000.
This same rule applies whether Company A owns the building directly or invests in a partnership that owns the building. In the latter case, IRC Section 50(c)(5) requires Company A to reduce the tax basis in its partnership interest by the same basis reduction the partnership applies to its tax basis in the building.
Consequently, for U.S. generally accepted accounting principles (GAAP) purposes, the tax impact of the basis reduction is recorded as a deferred tax liability because the tax basis of the building is reduced compared to the GAAP book value.
Special rules apply when the investment credit property is leased to a third party. In that situation, Treasury Regulation 1.48-4 generally avails the property owner (lessor) of an election to pass the tax credit on to the lessee. When this election is made, the lessee is entitled to claim the tax credits and the owner/lessor is not required to apply the basis reduction.
In order to prevent the lessee from enjoying a double-tax benefit (the tax credits and a full deduction for the lease rental payments), IRC Section 50(d) requires the lessee to recognize phantom taxable income equal to the amount of the tax credit over a period matching the owner’s depreciable life of the investment property. This phantom taxable income mimics the effect that the basis reduction would have yielded had the pass-through election not been made.
Assume the same facts as in Example 1, except that instead of owning the building, Company A leases the building from Company B and an election is made by Company B to pass the investment tax credit on to Company A. Company A would claim the $200,000 tax credit, Company B would not apply a basis reduction to its depreciable basis in the building, and Company A would recognize $200,000 of phantom taxable income under IRC Section 50(d) over the depreciable life of the building.
In situations in which the lessee is a partnership, the tax credits are passed through to partners who then claim them at the partner level. However, prior to the recent issuance of the regulations, uncertainty existed about the impact on partner tax basis resulting from the phantom income recognized under IRC Section 50(d). Many taxpayers took the position that this phantom income was an item of partnership income, rather than partner income, and therefore resulted in an increase to the partner’s basis in the partnership under IRC Section 705. This treatment effectively would circumvent the impact of the phantom income over the term of the partner’s investment in the partnership.
Assume the same facts as in Example 2, except that the lessee is a partnership in which Company A is a partner. Company A still would receive the tax credits as a pass-through from the partnership. If Company A treats the phantom income recognized under IRC Section 50(d) as an item of partnership income, that income is recognized by Company A as taxable income, but Company A also would increase its tax basis in the partnership by the amount of this income. This increase would avail Company A of the tax benefit of a reduced gain or increased loss upon the termination of its interest in the partnership.
Under the position described in Example 3, the taxpayer essentially could avoid the economic impact of the basis reduction that would have applied if it had been the owner of the building. For GAAP purposes, the taxpayer likely would record a tax benefit for the full tax credit, given that no economic benefit is lost to the basis reduction, which is a much more lucrative outcome.
Proposed Regulations Under Sections 1.50 and 1.50-1T
The recent issuance of both proposed and temporary regulations addresses the perceived inequity resulting from claiming a tax basis increase in a partnership interest from phantom income under IRC Section 50(d). The regulations clarify that the phantom income is an item of partner income, rather than partnership income, thereby eliminating any basis increase resulting from this income.
Assume the same facts as in Example 3. Under the regulations, Company A still would recognize the same amount of tax credits and phantom income. However, Company A would not be able to claim a tax basis increase in its partnership interest for the amount of phantom income recognized. Consequently, when Company A terminates its interest in the partnership, the phantom income recognized will have no impact on the resulting gain or loss from this termination.
Under the regulations, the taxpayer cannot circumvent the tax impact of the IRC Section 50(d) income through a tax basis increase in its partnership interest. Consequently, for GAAP purposes, the taxpayer likely would record a net tax benefit for its tax credit (the full tax credit, offset by the deferred tax liability to recognize the IRC Section 50(d) phantom income in future years with no basis increase). This benefit effectively places the taxpayer in the same economic position as if it owned the building directly.
The regulations apply to investment tax credit property placed into service on or after Sept. 19, 2016. However, in the preamble to the regulations, Treasury notes that no inference is intended concerning the proper treatment of prior transactions and that treating the IRC Section 50(d) phantom income as a tax basis increase to a partnership interest would be inconsistent with congressional intent. Consequently, taxpayers who have taken this position on prior transactions might be at risk for IRS audit exposure.
The recently issued regulations eliminate the ability to effectively circumvent the tax effect of the IRC Section 50(d) phantom income through a tax basis increase in the investor’s partnership interest. These regulations apply to investment tax credit property placed into service on or after the effective date, but they also raise concern for older transactions. Taxpayers should evaluate the structure of these investments to give the tax consequences adequate consideration.