The IRS recently issued Rev. Rul. 2010-16, which discusses the application of the passive activity rules in typical new markets tax credit (NMTC) transactions, and Rev. Rul. 2010-17, which addresses NMTC investor use of recourse loans.
Just to review the basic NMTC transaction—in order to claim the NMTC, an investor must make a qualified equity investment (QEI) in a community development entity (CDE) that has received an allocation of NMTCs from the CDFI Fund. The CDE uses the investor’s cash investment to make a qualified low-income community investment (QLICI) in a qualified business (QALICB). The investor will receive an NMTC equal to 39% of its investment in the CDE over the next seven years. Typically, the investor will leverage its investment in the CDE from borrowed funds to increase the amount of the NMTC.
In an earlier ruling, the IRS concluded in Rev. Rul. 2003-20, that the NMTC rules do not prohibit an investor from using cash derived from a borrowing, including nonrecourse borrowing, to make a QEI in a CDE. Similarly, Rev. Rul. 2010-17 concludes that the amount of the QEI includes cash from a recourse loan. Unfortunately, Rev. Rul. 2010-17 does not contain any more specifics. For example, what types of property may be pledged to secure repayment of the recourse loan? We will have to wait and see if the IRS plans to issue any further guidance in this area.
Rev. Rul. 2010-16 addresses the issue of whether the passive activity rules are applicable upon the acquisition of an interest in a CDE. The passive activity rules limit the deductions and credits that certain taxpayers may claim including an individual, estate, or trust; any closely held C corporation; and any personal service corporation.
The ruling describes two scenarios, one in which an individual acquires a QEI in a CDE, and one in which a partnership acquires a QEI in a CDE and allocates the NMTC to its partners. In both situations, the acquisition is not in connection with either the individual’s or the partnership’s trade or business or in anticipation of a trade or business.
The ruling clarifies that whether the NMTC is disallowed under the passive activity rules does not depend on the investor’s interest or extent of participation in the CDE’s trade or business. The passive activity is tested at the investor level to determine whether the acquisition of a QEI in the CDE is in connection with an investor’s trade or business in which that investor does not materially participate.
The determination of what constitutes trade or business depends upon the facts and circumstances of each case. Generally, there are two requirements for an activity to constitute a trade or business: the activity must be conducted for income or profit, and the activity must be engaged in with some regularity and continuity. The ruling concludes that under the two scenarios, since the activity of acquiring the QEI was not in connection with the trade or business or in anticipation of a trade or business of the individual or partnership, the NMTC will not be a passive activity credit. The conclusions reached in Rev. Rul. 2010-16 may encourage more individuals to invest in the NMTC, especially if Congress amends the rules to allow the NMTC to offset the alternative minimum tax.