Individuals and corporations alike can purchase tax credits to reduce federal and state tax liabilities and permanently lower their tax burdens — without participating in the activity related to the credit. However, determining which credits to purchase depends on the nuances of each individual or corporation and how they pay tax.
Below, gain insight into common federal tax credit investment opportunities available to you and your business and important factors to consider before purchasing a credit, including:
How do you choose the right federal tax credit?
Different credits benefit corporations, pass-through entities, and individuals — your personal circumstances will likely dictate which credits you should pursue.
Tax liability is also a major factor that dictates which credit makes the most sense for you. For example, you’ll benefit from different federal credits if your tax liability is predictable versus the result of a one-time event from a sale.
Timing is another consideration — some credits are delivered in one year versus over five, seven, or 10 years.
A step-by-step process for identifying which credit best fits your needs follows.
Step-by-step investment identification process
What should an individual taxpayer consider when investing in federal tax credits?
Purchasing tax credits as an individual is a little more complicated than purchasing as a corporation. You’ll need to be aware of some important tax considerations before getting started.
What are passive activity rules?
Passive activity rules are an important consideration for individual taxpayers; they determine how federal tax credits can be used.
The rules provide that credits can only be used to offset passive activity income — not active trade income, business income, W-2 wages or investment income, such as stock gains.
These rules may prevent some tax-credit investors from the ability to claim or utilize the credits. Investors aren’t actively involved in the underlying business activities generating credits and, as a result, they’re passive to the activity.
Accordingly, individual taxpayers can generally only participate in purchasing tax credits if they generate income from passive activities that can be offset by these credits.
What are at-risk rules?
Another important consideration for individuals is the at-risk rules. At-risk rules intend to prevent the use of tax deductions or in this case tax credits to the extent the taxpayer has no real economic investment at risk.
As they relate to investment tax credits, the at-risk rules limit the use of the credit by reducing the base of investment tax credit property by the amount of any nonqualified nonrecourse financing.
These rules are important to individual taxpayers because the credits can be reduced, denied, or recaptured in later years should the at-risk tests not be met throughout the investment period.
Are there any exceptions for individuals who invest in federal tax credits?
Yes. Two exceptions include the historic rehabilitation tax credit and material participation.
The historic rehabilitation tax credit
One common exception applies to real estate professionals investing in the historic rehabilitation tax credit.
If a taxpayer is a real estate professional, it may be possible to make a grouping election for the activities generating federal tax credits. The taxpayer may then be able to offset active trade or business income with federal tax credits.
Material participation
Material participation is an available exception for individuals who aren’t real estate professionals.
This applies if the taxpayer can establish that they’re actively involved in the activity or business — known as material participation — as opposed to receiving passive income. The material participation exception may also allow individuals to offset both ordinary income and passive income with tax credits.
Material participation can be established under numerous tests, but the 100-hour test is the most common.
This test proves that the individual participates in the activity for more than 100 hours during the taxable year, and the individual’s participation in the activity for the taxable year isn’t less than the participation in the activity of any other individual — including individuals who aren’t owners of interests in the activity — for such year.
What should a corporate taxpayer consider when investing in federal tax credits?
Considerations for individuals largely don’t apply to profitable corporations that have federal tax liability. Those factors do sometimes apply, however, if corporations are closely held or S corporations and are treated similarly to individuals.
Corporate taxpayers invest in tax credits for more reasons than the resulting reduced effective tax rate. For example, many companies do so to support their social responsibility initiatives, such as contributing to renewable energy or affordable housing.
By investing in projects that generate these types of credits, companies can help satisfy their investment goals without needing to operate the businesses.
Read more about renewable energy trends and the impact of social responsibility here.
Are there any exceptions for corporate taxpayers investing in federal tax credits?
Purchasing tax credits as a financial institution is more mainstream than with individuals. Many large banks have done so for years. Some regional and smaller banks are just starting or have yet to develop their strategy around purchasing credits.
With interest rates low, financial institutions should continue to evaluate how to best maximize returns from excess cash that can be used to reduce their tax liabilities as well as help meet certain investment requirements detailed below.
What should a financial institution consider when investing in federal tax credits?
For financial institutions, the Community Reinvestment Act (CRA) is an important driver of whether and how they may invest in tax credits.
The CRA requires financial institutions make investments in low- to moderate-income communities.
As a result, it’s common to see all sizes of financial institutions invested in low-income housing tax credit (LIHTC) or historic rehabilitation tax credit (HTC) investments to help satisfy their requirement.
What are the types of tax credit investments?
When selecting a tax credit investment, it’s important to consider whether you want to invest through a syndicator or directly with the project.
It’s also important to decide if you want to have diversification in a fund with multiple projects.
The credits below are general business credits and can be carried forward 20 years and back one year:
You’re also limited to reducing your federal tax liability by 75% with a general business credit.
Investment tax credits (ITC)
ITCs are commonly related to solar renewable energy projects eligible for an income tax credit equal to between 10%-30% of eligible costs, depending on when construction begins and when projects are placed in service.
A five-year compliance period begins when the solar project is placed in service. The credit is delivered in the tax year when the project’s placed into service.
Credits can be carried back one year and forward 20 years. Credits can be recaptured if ownership of the project changes or if the project ceases to operate. The credits at risk of recapture reduce 20% of the original credit amount on each anniversary of the placed in-service date.
Monetization is typically structured via the partnership-flip structure.
The partnership-flip structure
The partnership-flip structure is the most common tax-equity structure for solar projects.
Generally, investors in ITCs become members of a pass-through entity — partnership or limited liability company — where they’re the 99.99% owner of the project entity during the five-year compliance period related to recapture. They’re then allocated the tax credits, income, loss, and a preferred return in accordance with their interest.
After the compliance period, the ownership interest flips, and the investor exercises a right under the operating agreement to put their interest in the partnership for its fair market value.
This price usually ranges from 3% to 5% of the investment. Preferred returns can range from 1.5% to 3%. It isn’t uncommon for a syndicator to share in some of or all the preferred return cash flow.
Purchase prices and management fees
As a result of these tax attributes, the purchase price for ITCs can range from $1.07 to $1.20 for each dollar of credit. The investor could generate a capital loss or gain at exit, depending on the structure chosen.
When purchasing ITCs through a fund, the syndicator will often agree on an asset management fee, which may include sharing the preferred returns with the investor.
Equity returns
Generally, ITC investments under the partnership-flip structure yield between 15%-20% return on equity. The size of the fund and underlying projects and creditworthiness of the power offtake will impact pricing.
Historic rehabilitation tax credit
The HTC is an income tax credit equal to 20% of qualified rehabilitation expenditures applicable to income producing buildings that are listed on the national historic registry.
The credit is claimed over a five-year period, 4% each year starting with the year the building is placed in service for a total of 20% over five years. Credits are earned evenly over the compliance period and can be carried back one year and forward 20 years.
Credits can be recaptured if ownership of the property changes or if the property ceases to historically significant during the compliance period.
It takes longer to earn a return from investing in HTC versus ITC. This is because the HTC is a five-year credit — as opposed to the ITC being a one-year credit — however, over time taxpayers can save more with HTC versus with ITC.
In general, there are two different ways to invest in an HTC:
Whether you have reliable capital gains or not will largely drive which option is better suited for you.
Single tier
In a single-tier structure, a developer entity holds the historic property and engages in rehabilitation expenditures.
Prior to being placed in service, an investor joins the partnership as a 99.9% owner with the general partner. The investor is allocated the tax credits, income, loss, depreciation, and other tax attributes based on the partnership agreement.
After five years, which is the recapture and compliance period, the investor sells their interest back to the general partner at an agreed upon put price, ranging from 3% to 5% of investment.
The investment amount will generally recognize gain as a result of the basis reduction equal to the amount of the credit and depreciation.
Master lease
In a master-lease structure, there’s a landlord entity, or lessor, that holds the historic property and engages in the rehabilitation expenditures. Generally, the developer owns this entity.
A second entity, the master tenant, or lessee will lease and operate the property. The lessee will accept the investor as the 99.9% owner, like the single-tier structure above, prior to the property being placed in service. The lessor will then make an election to pass through the HTC to the lessee.
Under this structure, the lessee is only allocated the credit, while the lessor retains the other tax attributes. There’s no basis reduction in this structure, but the lessee will recognize income over the depreciable life of the asset — presumably 39 years for real property.
Under IRC Section 50(d), this amount is equal to the amount of excess depreciation resulting from no-basis reduction.
Because basis isn’t reduced and the lessee isn’t allocated other tax attributes, this will likely result in a capital loss as exit when the lessee divests of its interest at the end of the compliance period.
State HTC programs
Many states also have HTC programs and projects that qualify for the federal HTC that likely can also qualify for state HTCs. Additionally, most state HTC programs provide for their credits to be bifurcated from the federal tax credit investor.
In these instances, the project sells the state credits to another party, either as a certificate or through special allocation in a state tax credit fund. State HTCs can also be guaranteed against recapture if the state statute has recapture provisions.
Generally, HTC investment generates between 10%-15% return on equity, whereas internal rate of returns (IRRs) can vary significantly based on when the investment is made.
Low-income housing tax credit (LIHTC)
The LIHTC is a 10-year federal income tax credit equal to 4% or 9% of construction costs. The amount depends on what other federal subsidies are received related to the project, starting with the year the project is placed in service and leased.
The compliance period for LIHTC is 15 years.
Ways to invest in an LIHTC
Banks and insurance companies tend to be the most active investors in LIHTC. Similar to the HTC structures above, investors in LIHTC projects can invest in one of two ways:
State LIHTC programs
Many states have LIHTC programs, and projects that qualify for federal LIHTC likely can also qualify for state LIHTCs. Additionally, most state LIHTC programs allow their credits to be bifurcated from the federal tax credit investor.
In these situations, a project sells the state LIHTC to another party, either annually as they’re earned or in a multiyear strip generally through a state-tax syndication fund. State LIHTCs can be guaranteed against recapture by the seller or by a state tax syndicator.
New market tax credits (NMTC) program
The NMTC program is a seven-year federal income tax credit. It’s equal to 5% of the equity investment in the first three years and 6% for the following four years — for a total credit amount of 39%.
To qualify for the credit, a taxpayer must make a qualifying investment in a qualified community development entity that:
In general, NMTC investments can produce:
Due to receipt of certain tax attributes, such as losses and credits, capital gain is recognized upon exit. When exiting a NMTC structure, the investor typically recognizes a capital gain versus a capital loss that’s seen with the master lease structure and HTC investments.
The enhanced IRR is due to an option to leverage the buy-in over multiple years.
Are there risks when purchasing federal tax credits?
One of the most important considerations when purchasing a federal credit is risk.
Investors should watch for the following risks:
Guarantee of return
A guarantee of return is a common way to mitigate risk with state tax credit transactions where you aren’t required to be a partner for federal and state income tax purposes. Whereas when purchasing federal credits, a guarantee of return likely wouldn’t allow an investor to qualify as a true partner, which is required for an investor to qualify for tax credits for federal income tax purposes.
The Historic Boardwalk Hall, LLC v. Commissioner case, which was denied cert by the Supreme Court case in 2013, helped define what being a true partner means and prompted the IRS to establish safe harbors guidance for how to structure tax credit investments.
As a result of this decision, most tax credit investments are largely structured the same to comply with safe harbors; to qualify for tax credits, an investor must be a true partner that’s at risk and have a portion of their returns come from something other than the tax credit.
The only structure that can offer a true guarantee is an NMTC, which is outlined above. This is only allowed in certain situations, such as if a financial institution is resyndicating a NMTC, is a nonmember manager of the NMTC fund, and can guarantee the credits or returns.
These are highly complex transactions, but they’re achievable if they’re carefully planned.
Tax credit recapture
When investing in federal tax credits, the investor must be a respected partner and bear some risk from business operations.
As such, short of certain NMTC investments, there can be no guarantee from risk of recapture.
Forbearance agreements
In practice, especially in HTC or real estate transactions, forbearance agreements can and do exist wherein the lenders agree to forgo or limit foreclosure rights on the properties during the five-year recapture period.
These agreements are as close to a guarantee as federal tax credit investments can provide.
There are also other forms of guarantee around construction and other items that can help limit the risk of receiving tax credits.
Tax opinion on the validity of credits and structure
Once you’re in a tax credit structure, your return is made up of multiple parts:
This division can complicate your filing process and lead to reporting errors.
Regardless of whether you invest through a syndicator or directly with a project, it’s key to always receive a tax opinion on the validity of the credits and structure; certain types of investments might not pass the scrutiny of an IRS exam.
For example, taxpayers should carefully consider whether to invest in syndicated conservation easements and structures involving a syndicated charitable deduction or net operating loss.
Listed transaction
Some transactions are deemed abusive by the IRS and must be reported to the IRS as a listed transaction.
None of the tax credit opportunities discussed above are considered listed transactions with the IRS — they’re all viable tax credit investment opportunities if they’re structured properly.
That said, it’s important to analyze all available opportunities and consult an external tax advisor if you’re unsure about next steps. As is often the case, if it seems too good to be true, it probably is.
How do one- and five-year returns differ?
Not all credits are created equal. Some have statutory delivery periods over time, and others deliver the credits and other tax attributes all in the year the project is placed into service.
Examples in which a credit would be delivered in one year versus over five years follow. Because the returns differ for each credit type, your investment strategy might alter based on your tax liability, cash position, and other investment opportunities.
One-year model example
A large renewable energy fund generates federal ITC from a series of solar investments the fund makes.
In the below model, the investor pays $1.07 for the credits and receives credits and losses from depreciation and operating losses. The syndicator is taking their asset management fee from the preferred return based on the performance of the solar assets.
At exit, a capital gain occurs when the fund puts its interest in the project entity. The IRR is fairly strong, coming in at approximately 31% after tax, but the after-tax return on investment is lower, coming in at 4.7%.
An investor in this structure would earn 72% of their total return in five months. The calculated returns included in this model are linear, so the IRR or return on investment would ultimately be the same no matter the size of investment.
Five-year model
In the below model, the investor pays $0.85 cents for the credits and limited losses from the structure. The syndicator takes their asset management fee from the preferred return based on the performance of the project, which in this case is federal historic tax credit eligible.
At exit, a capital gain occurs when the fund puts its interest in the project entity. The IRR is lower than with the one-year investment, at approximately 8% after tax, but the after-tax return on investment is higher, at 15%.
An investor in this structure wouldn’t reach their breakeven point until the fourth year. The calculated returns included in this model are also linear, so the IRR or return on investment would ultimately be the same no matter the size of investment.
Assurance, tax, and consulting offered through Moss Adams LLP. Investment advisory services offered through Moss Adams Wealth Advisors LLC.
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