The Massachusetts Brownfields Tax Credit program, created in 1998 to help spur the cleanup and redevelopment of contaminated commercial and industrial properties throughout the state, has been an exceptionally successful program. Hundreds of property owners who are “Eligible Persons” – which the law defines as parties who did not cause or contribute to the contamination nor who owned or operated the property at the time of the contamination – have benefited from the ability to recover up to half of their qualifying costs once they have reached a Permanent Solution in accordance with the DEP’s cleanup standards. Owners of these properties – all of which are located in Economically Distressed Areas or EDAs – are located in every congressional district across Massachusetts.
2006 Reforms
Two key provisions were added in 2006 that expanded the Brownfields Tax Credit program to more entities and made the program even more valuable. At that time, not-for-profit organizations first became eligible for the tax credits; previously only individuals, partnerships, LLCs, trusts, sole proprietors, and corporations were able to receive credits. Many non-profits perform cleanups: community development corporations (CDCs), colleges and universities, charitable organizations, and others. Prior to the 2006 program changes, such organizations did not qualify for the tax credits and therefore could not benefit from the program.
The other change instituted in 2006 made the tax credits transferable. Because the credits are not refundable, by allowing the credits to be sold, this provision enabled both non-profits (and other entities) to turn their credits into cash. A robust market now exists for the purchase and sale of these credits, adding liquidity and spreading the benefits to allow more redevelopment and spurring more site cleanups.
Tax Implications of Sale and Use of Credits
Following the move to allow the sale of brownfields credits, the tax status regarding the purchase, sale, and use of the credits was unclear. Little or no formal guidance existed from the Internal Revenue Service (IRS) or the Massachusetts Department of Revenue (DOR). Sellers often received conflicting advice from accountants, tax professionals, and even from the DOR itself regarding the proper tax treatment of the receipt and/or sale of the Brownfield credits.
An IRS guidance memorandum published in 2011 resolved the uncertainty. Buyers, sellers, and users of credits should be aware of these procedures and properly report all transactions to minimize audit risk. Since all credit transfers are done through the MassDOR, a complete database exists of all credit sellers and the price realized through the sale. Failure to declare income generated from the sale and use of these credits may subject parties to audit risk.
IRS Guidance
The IRS issued an Internal Legal Memorandum in November 2011 (ILM 201147024) that clarified the tax treatment of Massachusetts Brownfields Tax Credits as well as other transferable state credits including the film tax credit, the historic rehabilitation credit, the low income housing tax credit (LIHTC), and the medical device tax credit. In summary, the memorandum described the following principles:
- These credits generally are considered capital assets to the original recipient, with no cost basis
- The sale of the tax credit is a taxable event
- A discounted purchase of a tax credit generates a capital gain when the tax credit is used
These conclusions have varying ramifications to recipients, sellers, and buyers of credits as discussed below.
Tax Credit Recipients
To a taxpayer or non-profit entity that qualifies, applies for, and is granted a tax credit, the award of the credit itself does not constitute income. Rather, it is simply treated as a reduction in taxes owed, and no gain is produced for federal tax purposes. Users of tax credits generally are subject to a 50% limitation, that is, the maximum credit allowed in any year is half of the tax liability
If, however, the credits are sold to another taxpayer, a capital gain would be recognized. Since the original recipient (seller) has no “cost basis” in the credit, all proceeds received from the sale would be considered a capital gain in the year payment is received. The gain would be short-term or long-term depending on the holding period. It is not clear whether the holding period begins with the receipt of the credit, the date of the application for the credit, or the date the credit was generated.
For example, suppose a cleanup generated a credit of $50,000 and the recipient used $10,000 against its own taxes and sold the remaining $40,000 at $0.75 per credit, resulting in a cash receipt of $30,000. The $10,000 applied against its own tax liability would have no income implications but the sale would generate a $30,000 capital gain, taxable to the seller.
Original recipients who use credits in satisfaction of Massachusetts income taxes decrease their state income taxes paid, which will reduce any deduction that may be available on the federal return.
Tax Credit Resellers
Resellers of credits – those who buy credits and resell them to users – would recognize a gain on the difference between the purchase and sale price. This is similar to other capital assets where the profit on the transaction becomes a gain.
Tax Credit Buyers
A buyer of credits who then uses the credits to reduce its taxes is considered to have a gain equal to the difference between the discounted purchase price and the amount of taxes offset (i.e., the face value of the credit used). The gain is recognized in the year the credits are used. For example, imagine a buyer who purchases a $100,000 credit for $80,000, then uses $20,000 of credit against his taxes each year for five years (the credits have a “shelf life” of six years and can be carried forward, but not back). This would generate an annual taxable gain of $4,000 ($20,000 of credits used each year, which had a basis of $16,000).
A key aspect for a purchaser of Brownfield Tax Credits is that the purchase price can be deducted for federal income tax purposes[1]. Extending the example above, suppose the buyer had a tax liability to the Commonwealth of Massachusetts of $40,000 per year. The credits can be used to satisfy half that liability ($20,000) and the other $20,000 would be paid in cash each year towards its tax liability. In this example, the buyer could deduct $36,000 on Form 1040 Schedule A as state taxes paid – the $20,000 paid in cash and the $16,000 spent to buy the credits. The itemized deduction for state taxes paid, of course, is less valuable since the cap on state and local taxes (SALT) was instituted.
The Bottom Line
The bottom line is that anyone who is eligible for a Massachusetts Brownfields Tax Credit should investigate the program and apply for an award if they meet the basic criteria. If you performed a cleanup for which you were not responsible for the contamination (it was pre-existing or caused by someone else); your project is located in an Economically Distressed Area (EDA), which includes most cities and towns in the state; you have completed the cleanup or are currently in Remedy Operating Status; and the site is used for commercial purposes – then you may be eligible for a credit.
Once received, the most tax-advantaged option is to apply the credits received against one’s own taxes. If the credit exceeds the available tax appetite, a sale of all or a portion of the credits can generate cash. The proceeds must be declared as taxable income. Buyers of credits can benefit from the discount to face value at which the credits are purchased, although the savings from the discount itself is considered a taxable gain and must be recognized when the credits are used.
Make sure that the procurement, sale, and use of these tax credits are done properly in order to maximize your benefits and minimize your audit risks. As with many aspects of life, it often pays to seek expert advice when dealing with arcane procedures and government programs.
[1] See Rev. Rul. 86-117, 1986-2 C.B. 157.