This is the first crucial hurdle the project faces once construction begins. The so-called “10% test” to carry over the tax credits is an all-or-nothing test. If a project has not incurred 10% of its “reasonably expected basis” before December 31 of the year in which tax credits are allocated AND/OR if the incurred costs and the tax credit allocation do not run to the same legal entity, the tax credits cannot be carried at the end of the year. The project will have lost its tax credit allocation irretrievably, and has no credits.
The only way to salvage tax credits for the project is to apply for, and receive, a new tax credit allocation in the new year. This is possible only if the project is still in construction. Syndicators tend to be VERY conservative regarding the 10% test. The importance of meeting this test cannot be overemphasize!
Here is the tax credit process that is involved:
• The sponsor has applied for, and received, tax credits according to the allocating agency’s schedule, pursuant to its QAP.
• The project has received a reservation of tax credits. This may be for the project or for individual buildings in the project.
• Within 5 days of receiving the allocation, a decision was made to either lock in the tax credit rate for the allocation month, or by default to allow the tax credit rate to float until project completion. Many states require a lock-in at the time the credits are allocated. Most investors tend to prefer lock-ins, too, to reduce financing risk.
• The partnership has incurred costs greater than 10% of the project’s “reasonably expected basis” (the “10% test”) by December 31 of the reservation year in which the Carryover Allocation was received. The Carryover Allocation provides time to get the project into service – two years from the end of the allocation year.
• The costs that go into a project’s “reasonably expected basis” and the incurred costs by the partnership to meet the 10% test have been reviewed carefully, to confirm that incurred costs satisfy IRS requirements. Many states and local tax allocating authorities require the partnership’s CPA firm to certify the 10% figure prior to the IRS’s date of December 31.
• Ways to meet the 10% test:
Purchase land and/or building. These costs count toward the 10%.
Incur pre-development costs – appraisal, environmental study, legal fees, etc.
Earn a small portion (usually no more than 20%) of the developer’s fee.
Fund or pre-fund construction costs prior to year-end. The contractors’ costs may be included. But the contractor’s pre-purchased construction inventory does not. There may be ways to structure around this. Specific IRS rules apply.
Note: meeting the 10% test can involve very technical interpretations. Get assistance from an attorney and an accountant who are experienced in tax credit transactions.