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?
• What Should an Individual Taxpayer Consider When Investing in Federal Tax Credits?
• What Should a Corporate Taxpayer Consider When Investing in Federal Tax Credits?
• What Should a Financial Institution Consider When Investing in Federal Tax Credits?
• What Are Types of Tax Credit Investments?
• Are There Risks When Purchasing Federal Tax Credits?
• How Do One- and Five-Year Returns Differ?

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.

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.

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:

• Single-tier structure, which results in capital gain at exit
• Master-lease structure, which results in a capital loss at exit

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:

• Directly, with a developer entity through a single-tier structure
• Indirectly, though going through a syndicator that pools together multiple projects into a fund or partnership with admitted investors

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:

• Has already been allocated NMTC
• Makes a qualifying investment in eligible low-income communities and qualifying active businesses in those communities

In general, NMTC investments can produce:

• Above 20% IRRs
• 12%–14% return on investment

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.

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 an 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:

• Income and losses of the project
• Depreciation of the property
• Tax credits
• Preferred returns
• Recognition of capital gains or losses upon exit

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.

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.

We’re Here to Help

These types of investments can be complicated, so it’s important to work with an experienced tax credit professional to fulfill benefit from these opportunities.

As with any investment, there are risks to tax credit investment—planning around these risks is doable but requires careful planning.

If done correctly, you can safely reduce your federal tax liability while diversifying your investment portfolio.

As an independent party to these types of investment transactions, we can help you determine the right fit for you or your business. Our network of developers and syndicators provide us with various opportunities for investments. As a CPA firm, we’re also positioned to advise on the many tax implications and considerations related to these investments.

For more information on purchasing tax credits and to view available inventory, please contact your Moss Adams professional.