Proposed regulations under section 47, REG-124327-19, filed on May 21, 2020 with the federal register, provides guidance on the requirement added in the Tax Cuts and Jobs Act (TCJA) relating to the allocation of the rehabilitation tax credit over a five year period. Those proposed regulations also provide guidance on the interaction between the new proposed section 47 rules and the rules under section 50.
The proposed regulation preamble states, with respect to the law in effect prior to the proposed regulations, that practitioners had questioned whether the rehabilitation credit is determined in the year the property is placed in service and is then allocated ratably over the 5-year period, or whether five separate rehabilitation credits are determined during each year of the 5-year period. The new proposed regulations provide that the rehabilitation credit is properly determined in the year the subject property is placed in service but is then allocated ratably over the 5-year period, thereby rejecting the determination of five separate rehabilitation credits. The proposed regulations provide that taxpayers claiming the rehabilitation credit under section 47 with respect to credit expenditures paid or incurred after December 31, 2017, generally will have the same federal income tax consequences from the rules under section 50 for recapture, basis adjustment, and leased property as taxpayers claiming the rehabilitation credit under pre-TCJA law.
The proposed regulations give several examples of its application. In one example, the property is disposed of in the third year of it being placed in service but before the expiration of the 5 year allocation period. The example illustrates that there can be a tax credit allocation in a taxable year when the taxpayer no longer owns the property.
The proposed regulations also contain a partnership example where the partnership is the lessee and the election is made to treat the partnership as acquiring the property. That results in a gross income inclusion by the partners which, under final regulation §1.50-1(b)(3), is not treated as a partnership gross income item includable by the partnership and then allocated to the partners. Rather, the gross income inclusion occurs as if each ultimate credit recipient-partner directly owned its respective share of the credit as if no partnership existed. The final section 1.50-1 regulation preamble had stated that “The Treasury Department and the IRS believe that Basye is inapplicable to the determination that the notional income created under section 50(d)(5) is not an item of partnership income computed under section 703. Unlike the income at issue in Basye, the income created under section 50(d)(5) is not “earned” by the partnership. It has no economic effect as it is merely a notional item created to mimic the effect of the basis adjustment under former section 48(q) with respect to a lessee. Further, treating it as a partnership income item would generate an inappropriate basis increase to the partners under section 705 that would allow them to take a non-economic loss.”
If a partnership actually owns the credit property and allocates the credit to its partners, there would be a capital account effect that would not take into account the 5-year allocation of the credit. That issue is not addressed in the proposed section 47 regulations issued May 21. The current final regulations are somewhat convoluted in this case, but they go something like this:
- Reg. §1.704-1(b)(4)(ii) states the general rule that allocations of tax credits are not reflected in the capital accounts of the partners except to the extent that adjustments to the adjusted tax basis of partnership section 38 property are reflected in the partners’ capital accounts elsewhere in the section 704 regulations.
- Reg. §1.704-1(b)(2)(iv)(j) states that when there is a reduction in the adjusted tax basis of partnership section 38 property there is a downward basis adjustment to the partners’ shares of that partnership property.
- These rules pre-date the rules under section 50(d) but the intent is clear to reduce all of (1) the tax basis of the partnership property, (2) the basis of each partner’s partnership interest and (3) the section 704(b) capital accounts of the partners when the partnership directly owns the subject property.
- The allocation of tax basis is made under the still outstanding rules of reg. §1.46-3(f). Under reg. §1.46-3(f)(2)(i), the tax basis of the partnership property is generally allocated based on how the general profits (non-separately stated income) of the partnership is allocated to the partners. Special allocations of partnership tax basis where all economic attributes of that tax basis are consistently allocated are generally respected under reg. §1.46-3(f)(2)(ii).
It is clear that the proposed section 47 regulations apply to partnership owned property and that a full tax basis reduction occurs in the year the property is placed in service by the partnership even though the credit is allocated over a five-year period.
What is not stated in the proposed section 47 regulations is whether the partners are allocated 20 percent of the credit each year although all of the credit basis is reduced in the first year when the property is placed in service or whether, after the first year, the remaining four years over which the credit is spread is taken into account and applied solely at the partner level over those remaining years, consistent with the section 1.50-1 regulations.
Further, there is no guidance on whether there would be a reporting obligation by the partnership to its partners on schedule K-1 that advises the partners on how to report the credit (reduce tax basis all in the first year but take the credit into account over five years). Presumably, if the partnership interest is sold in the interim, the remaining credit should travel with the partnership interest and not remain with the now former partner.
What now to do with the case where the partnership is the lessee. The sole example on this in the proposed section 47 regulations indicates that the gross income inclusion by the partners occur directly at the partner level over a 39 year period. Presumably, although it is not directly addressed, the credit is determined by the partnership in the year that the partnership enters into the lease of the property but is spread ratably over the five year period.
As noted earlier, the final section 1.50-1 regulations state that there is no outside tax basis adjustment under section 705(a) for the notional gross income inclusion that occurs at the partner level as if there was no partnership. The operation of these new rules should be addressed in revised section 1.704-1 regulations which are now out of date.
It is entirely possible that the rules in the final section 1.50-1 regulations relating to the gross income inclusion when the partnership is the lessee are invalid because the notional gross income is indeed a partnership item. One could clearly argue that rules similar to those under reg. §1.705-2 should have been issued in lieu of the arguable proposition that the notional income is not a partnership item. At that point, the tax accounting rule in reg. §1.704-1(b)(2)(iv)(n) would control and that rule mandates that the book treatment of the item in computing capital accounts follows the tax treatment of the item, thus forcing a positive capital account adjustment when there is no economic corollary.