12.04.2011 The Developers’ Perspective: Disguised Sales of State Historic Tax Credits
Developers Left with Uncertainty
The IRS did not audit the lower tier developers (“Developers”) of the Virginia Tax Credit projects (“Projects”), and the Fourth Circuit did not analyze Developers’ relationship with the Funds. Developers are left with apprehension because parallels can be drawn between the Investors’ taxable investment in the Funds and the Funds’ investment in the lower-tier Projects. For example, Funds do not expect to receive more than negligible allocations of income or loss from the Projects. The Funds have limited entrepreneurial risk because they are not contractually obligated to contribute the bulk of their investment to the Developers until a Project is complete and has received Part III certification from the Virginia Department of Historic Resources confirming that the Project is complete. Furthermore, the Funds are entitled to refunds of all or part of their capital contributions in the event that there is a subsequent disallowance of all or a portion of the Virginia Tax Credits allocated to them.
Capital Gains Versus Ordinary Income, Basis and Holding Period
In Temple v. Commissioner, 136 T.C. 15 (2011), the U.S. Tax Court analyzes a husband and wife’s sale of transferable Colorado state tax credits to a third party. The Temples obtained the tax credits in return for placing a conservation easement on their land. The Colorado statute allowed Colorado taxpayers to engage in outright sales of the tax credits. The Temples did not dispute that their sale of the tax credits was a taxable transaction. The Temples argued that the tax credits were a capital asset resulting in capital gain and not ordinary income, that they had basis in the tax credits that reduced their gain, and that they had a long-term holding period in the tax credits that entitled them to favorable long-term capital gains tax rates on their gain from the sale of the tax credits rather than short-term capital gains taxed at higher ordinary income tax rates.
The Tax Court ruled that the Temples’ state tax credits were capital assets, the sale of which resulted in capital gains and not ordinary income. In the Court’s analysis, the Court observed that the tax credits are not listed in the eight types of assets excluded from the definition of capital assets under Code §1221. The tax credits are not a contract right, the sale of which produces ordinary income, because Colorado does not bind itself contractually with taxpayers such as the Temples in connection with the credits. Finally, the tax credits do not represent taxpayers’ right to receive ordinary income from Colorado, only their right to reduce their state tax liabilities, something that does not give rise to ordinary income.
In addition, the Tax Court ruled that the Temples had no tax basis in the tax credits. On their tax return, the Temples claimed a basis in the tax credits equal to the professional fees that they incurred in connection with granting the conservation easement and obtaining the tax credits. Before the Tax Court, the Temples also argued that some portion of their basis in the land was allocable to the credits. The Tax Court rejected both of the Temples’ arguments. The Tax Court noted that professional fees incurred “in connection with the determination, collection, or refund of any tax” are an itemized deduction under Code §212(3) and are not capitalized into cost basis of tax credits. Furthermore, the Tax Court reasoned that cost basis is what taxpayers pay to acquire an asset. In contrast, the Temples did not purchase tax credits from Colorado but were granted tax credits after complying with a statute. Finally, the Tax Court noted that the tax credits did not represent a right that the Temples possessed in their land and sold to a third party because the Temples sold tax credits, not rights in their land.
The Tax Court ruled that the Temples did not have a long-term holding period in the tax credits that would support long-term capital gain treatment. The Temples argued that they had held the land on which they granted the conservation easement for more than one year, and that their holding period in the land carried over to their holding period in the tax credits. The Tax Court observed that the Temples right to the tax credits did not arise until after the charitable donation of the conservation easement. While the easement represented part of the Temples’ property rights in their land, the tax credits were never part of their property rights in their land, and the holding period did not carry over from the land to the tax credits. The Temples’ holding period in the tax credits began when Colorado granted the tax credits to them and ended when they sold the tax credits, a period of not more than one-year. Consequently, the Temples had short-term capital gains taxed at the higher ordinary income tax rates.
Applicability of Temple v. Commissioner to Developers of Virginia Tax Credit Projects
A court following the precedent of Temple and Virginia Historic Tax Credit Fund 2001, LP is likely to rule that Developers do not have any basis in Virginia Tax Credits. Developers do not purchase Virginia Tax Credits from Virginia but are awarded credits by the state, likely precluding Developers from having a cost basis in Virginia Tax Credits under the reasoning of Temple. Developers’ professional fees to secure Virginia Tax Credits can be deductible expenses or capitalized into the Projects’ bases, but under the reasoning of Temple, professional fees should not produce basis in Virginia Tax Credits. Furthermore, Virginia Tax Credits are a separate property right in the hands of the Developers and not a right that they possess in the Projects. Thus, under the reasoning of Temple, it would be inappropriate to allocate basis from the Projects to Virginia Tax Credits.
Developers’ holding period for Virginia Tax Credits would be short-term under the reasoning of Temple. Developers allocate Virginia Tax Credits to the Funds in the same year that the state awards such credits. Under the reasoning of Temple, Developers’ holding period of the Projects would not carry over to their holding period in Virginia Tax Credits. Under Virginia’s historic rehabilitation tax credit statute, there does not appear to be any means to allow the Developers to “hold” Virginia Tax Credits for more than one-year prior to allocating them to the Funds to permit long-term capital gain treatment at favorable tax rates.
Virginia Taxation of Developers’ Gain
Developers that report federal taxable income from the deemed sale of Virginia Tax Credits should also report an equal amount of Virginia taxable income. In 2007, the Virginia Tax Commissioner released Ruling 07-82 (May 25, 2007)(the “Ruling”) discussing an internal IRS memorandum, AM 2007-002 (the “IRS Memo”). The IRS Memo analyzed the tax consequences of the transactions between Investors and Funds that had obtained state tax credits under facts similar to Virginia Historic Tax Credit Fund 2001, LP. The IRS Memo proposed reclassifying the transactions as resulting in taxable income for federal income tax purposes.
The Ruling is informative about Virginia income tax treatment of federal taxable income that Developers or Funds recognize from deemed sales of Virginia Tax Credits. The Tax Commissioner notes that Virginia income tax returns start with federal adjusted gross income for Virginia individual income tax or federal taxable income for Virginia corporate income tax. Thus, Virginia taxable income includes any federal taxable income, including federal taxable income resulting from the deemed sale of Virginia Tax Credits.
We will continue to evaluate and monitor developments with Virginia Historic Tax Credit Fund 2001, LP and Temple and the issues that they present.
For more information about this topic, please contact Conrad Garcia at 804.420.6910 or or any member of the Williams Mullen Tax Law Team.
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