For the first time in quite a while (more than ten years), the IRS made some changes to the Historic Tax Credit regulations. The change is a bit obscure, but it provides a reminder of the issues that can arise when an HTC rehabilitation involves two owners, and the first one dies. One of the fundamental historic tax credit (HTC) rules is the “substantial rehabilitation” test. In order to qualify for any tax credit, this rule requires that the taxpayer spend at least as much on the rehab as his basis at the start of some two year period. Sometimes, the property gets transferred while the rehabilitation is underway, but not yet completed. In this case, the regulations provide a “step into the shoes” rule that allows the successor owner to compute its credit including the transferor’s expenditures. So, imagine a transferor has a $1 million property and it does $900,000 of rehab work before transferring the project to the recipient. At first look, it appears that the transferee will have a $1.9 million basis, and have to start to rehab the property all over again, incurring at least $1.9 million of new rehabilitation costs. But the HTC rules solve this problem. Provided the rehabilitation hasn’t been placed in service, the new owner can generally “step into the shoes” of the transferor and qualify the project for tax credits with just $100,000 of additional work.
A similar issue can arise when a rehabilitation is commenced by someone who dies before the work is placed in service. Our analysis begins with a Code section that is important in estate planning. When property is transferred by a decedent, Section 1014 has long provided the rules for how basis is determined by the recipient, generally setting it at fair market value. So, imagine a decedent has a $1 million property and does $900,000 of rehab work and then dies, when the property has a fair market value of $1.9 million. Once again, the rehab has nearly passed the substantial rehab test, and the recipient would expect to step into the shoes of the decedent and qualify for credits with $100,000 of additional work. However, under Section 1014, the recipient’s basis would automatically jump to fair market value, or $1.9 million, again messing up calculation of the substantial rehabilitation test. Fortunately, the IRS identified this problem and provided, in regulations, that the decedent’s expenditures are backed out for the purpose of computing the recipient’s starting basis. As a result, the recipient once again tests the rehabilitation against the $1 million that the decedent was using, and the problem is avoided. The saving rule in the regulations specifically applies where “a transferee’s basis [is] determined under Section 1014.”
But, that’s not the obscure part. In 2009, the Internal Revenue Code was amended to provide a reduced estate tax. But that wasn’t the end of computing tax liability. Instead of paying an estate tax, if the new law applied, then the recipient got a “carryover basis.” That’s another way of saying that the recipient took the decedent’s basis in the property. The idea was that estate didn’t have to pay an estate tax on the value of the property, but now the recipient of the property would eventually pay an income tax if and when the property was sold. Effectively, this would make up for the estate tax that had been avoided by the 2009 law. To implement this carryover basis rule, Congress adopted new Section 1022.
Once again, the tax rules for estates could affect the computation of the substantial rehabilitation test. Go back to my illustration, with the decedent who started with a $1 million property and did $900,000 of rehab work. When he died, he had a basis in the project of the total of these two numbers, $1.9 million. Accordingly, with the Section 1022 carryover basis rule, the recipient would have a starting basis of $1.9 million, thereby necessitating a lot more rehab work to qualify for the HTC. Once again, a special rule would be needed to determine the recipient’s starting basis for purpose of this analysis.
Here comes the obscure part. You probably don’t remember, but these new estate rules had a very short life. They (including Section 1022) were repealed at the end of 2012. Indeed, after the transition rules that applied to that repeal are applied, new Section 1022 only applied to estates of people who died in one calendar year, i.e., 2010.
So, to recap, we have this group of people and projects -- certain individuals who (A) undertook HTC projects, but (B) died during the rehab, and (C) whose estates/transferees used the carryover basis rules of now-repealed Section 1022, where (D) the person died in 2010. In the case of that group of people and projects, the reference in the HTC regulations to Section 1014 was inaccurate. For that one year, Section 1022 could apply.
Accordingly, for the group that meets the four requirements I described, the HTC regulations were amended to add “or Section 1022” to the step into the shoes test.
Like I said, it’s a bit obscure. By the way, don’t think that this demonstrates that the IRS has some special regard for the HTC. The Treasury Decision addressing Section 1022 is actually 9 pages long, and it includes somewhat similar changes to 20 or 30 different provisions of the regulations. The HTC was simply carried along with the tide.
One last note -- As you may have heard, the White House and the Congress are reserving the right to reconsider any regulation adopted in the past several months. I doubt that this will affect these regulations, but you never know. By being adopted a few days before the inauguration, they did just slip in under the wire for the President’s executive order that requires 2 regulations to be repealed for every new one added.