Real Estate Tax Credit Limited Partnership

What is it?

Real estate tax credit limited partnerships are limited partnerships organized, primarily, to take advantage of certain tax credits associated with investment in real estate–specifically, the low-income housing credit and the qualified rehabilitation expenditures credit. Because limited partnerships are flow-through entities, partners can claim their share of the tax credit on their individual tax returns (subject to any limitations that may apply). In addition to tax credits, real estate limited partnership investors are entitled to their share of partnership income and may be entitled to take deductions for depreciation, mortgage interest, and real property taxes.

Caution: Different rules apply to certain master limited partnerships (MLPs). If an MLP is taxed as a corporation, the partners are usually unable to take partnership deductions, credits, and income on their own tax returns.

As with any limited partnership, a real estate tax credit limited partnership is comprised of at least one general partner (who manages the business and assumes liability for it) and at least one limited partner (who provides capital, enjoys limited liability, and forgoes an active management role). Shares in a limited partnership are typically bought through a securities broker-dealer or financial planner. Private limited partnerships generally require at least a $20,000 investment. Offerings frequently involve suitability rules requiring that investors meet minimum net worth, income, and tax bracket criteria. MLP shares, by comparison, are typically marketed in much smaller amounts.

Low-income housing credit

The low-income housing credit is a specific type of general business tax credit that pertains to low-income housing units bought, built, or rehabilitated after 1986. The housing project must have a certain percentage of units occupied by low-income tenants. The amount of the credit equals the qualified basis of the building times an applicable percentage prescribed by the IRS for the month placed in service or elected in agreement with the housing credit agency. The credit is taken over a 10-year period. This period usually starts with the tax year the buildings are placed in service. However, the person claiming the credit can, in some circumstances, elect to start the period the next tax year.

Credit rates will differ depending on whether the project is or isn’t federally subsidized. The owner of the qualified buildings must enter into a binding contract with the housing credit agency, agreeing to maintain the units as low-income housing for at least 30 years to receive credit authorization. The units, moreover, must also maintain actual low-income status for at least 15 years. Otherwise, a portion of the already taken credit may have to be recaptured.

Qualified rehabilitation expenditures credit

The credit for qualified rehabilitation expenses offers tax credits at two different percentages, depending upon the type of building involved. An investor can take a credit of 20 percent of qualified rehabilitation expenditures regarding certified historic structures and 10 percent for qualified rehabilitated buildings first placed in service before 1936. (Although you can claim the 20 percent historic rehabilitation credit for either residential or nonresidential buildings, you can claim the 10 percent credit only for nonresidential buildings.) A qualified rehabilitation expenditure involves rehabilitation activities such as reconstruction or constructing an addition or improvement. It doesn’t involve new construction, the cost of acquiring the building, or rehabilitation of any portions of the building that are used for tax-exempt purposes. The apportionment of this credit among partners of a limited partnership reflects the ratio by which they would divide up any partnership profits.

Tip: Since rehabilitation expenditures qualify for a credit, as opposed to a deduction, you can directly reduce the amount of tax owed by the amount of your qualified rehabilitation expenditures. In contrast, deductions only allow you to reduce your taxable income. They don’t offset dollar for dollar the amount of tax owed.

Strengths and tradeoffs

There are several advantages to investing in real estate tax credit limited partnerships. These include professional management, limited liability, and the fact that profits are taxed only once. In addition, financial benefits such as income, gain, losses, and deductions may be passed through to the partners (subject to limitations). The main advantage, however, is that tax credits may be passed through.

There are also a number of drawbacks to investing in real estate tax credit limited partnerships. First of all, the at-risk rules and certain passive loss limitation rules apply. Also, illiquidity of shares, the high price of shares, expensive brokerage and management fees, lack of participation in management, and (potential) risk of losing principal are drawbacks.

Tax considerations

As with most limited partnerships, tax benefits flow through to individual partners. From the information provided on Schedule K-1, each limited partner reports on an individual income tax return his (or her) distributive share of the partnership’s taxable income or loss, and separately stated items of partnership income, gain, loss, deductions, and credits. However, certain loss limitation rules apply. For instance, a limited partner’s passive losses may be deducted only against his or her passive gains; they cannot be used to offset earned income or investment income.

In addition, the amount of your passive credits for a given year generally must exceed the tax attributable to your net passive income. Passive activity credits that are not allowed in the current year are carried forward until they are allowed against the tax on either net passive income or the special allowance, if applicable. A special allowance of $25,000 applies to limited partners who invest in low-income housing credits and rehabilitation credits. This lets an investor take advantage of the appropriate tax credit even when there is no net passive income in a given year.

For more information about the special allowance and calculation of the passive activity credit, consult a tax expert.

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