Temp Regs for IRC 50(d)—Income Inclusion
Do you rent your office space or home from someone else? Do you get to enjoy the benefits of any of these investment property credits without owning property, thanks to an arrangement with the property owner:
- Rehabilitation credit
- Energy credit
- Qualifying advanced coal project credit
- Qualifying gasification project credit
- Qualifying advanced energy project credit
- Qualifying therapeutic discovery credit
Sometimes, a lessor will let a lessee claim credits like these as their own – something commonly referred to as a pass-through investment credit arrangement. And it’s been a great arrangement for many entities for a long time. If an owner can’t take advantage of a credit, it’s a great way to be able to let someone else benefit from the tax savings. It’s also an incentive that the lessor can offer to prospective tenants, helping to monetize a credit that would otherwise go to waste.
But it’s not quite as simple as that. The cost to a lessee of claiming these credits is that the lessee must recognize income over a period of time. The recognized amount is generally the amount of the credit received. However, in the case of the energy credit, only 50% of the amount must be recognized as income, providing an added incentive for going green. Since a tax credit provides dollar-for-dollar tax savings, a lessee will generally still come out substantially ahead for having claimed the credit. The new Treas. Reg. § 1.50-1T specifically addresses how the income gets reported.
If the lessee in an investment credit arrangement is any kind of a flow-through entity, such as a partnership or an S-corporation, the questions are: Does the income get reported at the entity level, or does is flow down and get reported on the tax returns of partners and shareholders? And, what happens when the property no longer qualifies as an investment credit property? How do you report the recapture value? The new temporary regulation aims to answer these questions.
The temporary regulation the U.S. Department of Treasury released on July 21, 2016, clarifies income inclusion rules for lessees of investment credit property. Simply put, if a property owner of investment credit property chooses to elect to treat the lessee as having acquired the property, then the lessee’s gross income will be affected.
In addition, the new temporary regulation coordinates the income inclusion rules with the recapture rules of Internal Revenue Code (“IRC”) § 50(a). Treas. Reg. § 1.50-1T applies to investment credit property placed in service on or after September 19, 2016, and before July 19, 2019.
What Qualifies as Investment Credit Property?
Investment credit property is any depreciable or amortizable property that qualifies for one or more of the following credits: rehabilitation credit, energy credit, qualifying advanced coal project credit, qualifying gasification project credit, qualifying advanced energy project credit, and qualifying therapeutic discovery credit. This kind of property used to be called “section 38 property”. Section 50(a)(5)(A) replaces this term with “investment credit property”.
The general purpose of this new temporary regulation that supports IRC § 50(d)(5) is to provide rules that are similar to energy credit rules that once existed under IRC § 48(d)(5), which was repealed by the Revenue Reconciliation Act of 1990. Under former IRC § 48(d)(1), the government used to permit a lessor to elect to treat section 38 property as having been acquired by the lessee at fair market value. The credit associated with that property would also pass through to the lessee. Section 50(a)(5)(A) replaced the term “section 38 property” with “investment credit property”. So now, the new temporary regulation applies when a lessor elects to treat a lessee as having acquired the lessor’s investment credit property, creating a lease pass-through arrangement (i.e., the property and its credits have literally passed through to the lessee).
The general applicability of IRC § 50(d)(5) should be distinguished from the investment credit arrangement under IRC § 50(c), which applies when a lessor (or owner) does not elect to treat the lessee as having acquired the investment credit property. In this single-tier investment credit arrangement, the tax code requires the lessor to reduce his or her tax basis in property by the amount of the credit. In contrast, under the IRC § 50(d)(5) scenario, the lessee is required to recognize gross income proportionally over the shortest recovery period. The income is recognized in an amount equal to the investment credit claimed under IRC § 46 or 50% of the amount of any energy credit that can be claimed under IRC § 48.
Special Rule for Partnerships and S-Corporations
Treas. Reg. § 1.50-1T(b)(3) provides clarification that prior regulations did not address: Who is required to recognize the income under IRC § 50(d), as it applies to partnerships and S-corporations?
The answer provided by Treas. Reg. § 1.50-1T(b)(3) is: Whoever is the ultimate credit claimant. The ultimate credit claimant is any partner or S-corporation shareholder who files (or would file) IRS Form 3468, “Investment Credit”, with their annual federal tax return. As such, the ultimate credit claimant is treated as the lessee in the lease pass-through arrangement under IRC § 50(d), not the partnership or S-corporation. Given this, IRC § 50(d) income is not included in gross income at the partnership or S-corporation level. This distinction is important because of the effect it can have on other items on the filer’s income tax return.
If the investment credit property is disposed of or ceases to be an investment credit property within five years, the lessee needs to recapture all or part of the credit under IRC § 50(a). The amount to be recaptured depends on the length of time the property was held and is treated as an additional tax.
Treas. Reg. § 1.50-1T(c) provides that if recapture of an investment credit is required, a corresponding adjustment to income is also required. This adjustment is dependent on the amount of unrecaptured credit and the amount of the prior income inclusion. It can either increase or decrease income.
The amount to be included in or deducted from income is determined by comparing the amount of unrecaptured credit to the amount that has previously been included in the lessee’s income because the credit was claimed. In the case of the IRC § 48 energy credit, the comparison is between 50% of the unrecaptured credit and the amount that has previously been included in the lessee’s income.
Generally, if the unrecaptured credit or 50% of the unrecaptured energy credit exceeds the prior income inclusions, the lessee’s or ultimate credit claimant’s gross income is increased by whatever that excess credit amount is over the amount of prior income inclusions.
On the other hand, if the income inclusion exceeds the unrecaptured credit or 50% of the unrecaptured energy credit prior to recapture, the lessee’s or ultimate credit claimant’s gross income is reduced by the amount of unrecaptured credit that’s in excess of the total prior income inclusions.
Beyond clarifying who receives the income allocations, the temporary regulation also explains specific rules for energy credits, elections to accelerate income inclusion outside the recapture period, and the timing of such rules as they may apply when the property is disposed of or is no longer used as an investment credit property.
Bonus strategy: In addition to these new guidelines, some taxpayers will be able to take advantage of Rev. Proc. 2014-12, which provides a safe harbor for certain investors of historic structures when computing the investment credit.
Still have questions about how this new Treasury regulation will ultimately affect you? Need help determining whether any of your properties qualify for these credits or any other property credits? Contact Cherry Bekaert’s Credits/Accounting Methods team to start the conversation. Or reach out to a local member of our client service team so they can answer questions and guide you through the calculations.