Renewal Communities Revisited
Expansion Provides Retroactive Tax Savings

By Ann Burstein Cohen

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NOVEMBER 2006 - One provision of the American Jobs Creation Act of 2004 (AJCA) is little known but of significant importance to New York business owners and advisors. Section 222 of the AJCA allows for the expansion of the boundaries of many of the Renewal Communities (RC) established in 2002. Tax incentives for RCs were originally enacted through the Community Renewal Act of 2000. Qualifying businesses that invest in property, plant, and equipment (PPE) in a designated RC and employ RC residents are rewarded with increased IRC section 179 deductions, substantially accelerated depreciation on buildings, employment credits, and tax-free treatment for gains realized on the sale of a business or certain property of the business.

Of the 40 RCs established effective as of January 1, 2002, five are in New York: Buffalo/Lackawanna, Jamestown, Niagara Falls, Rochester, and Schenectady. New York ties with California for the distinction of having the most RCs. There are also RCs in the neighboring states of New Jersey (Newark and Camden) and Pennsylvania (Philadelphia). (For a list of all 40 RCs, see www.hud.gov/news/releasedocs/rcinitiative.cfm.) The legislation does not provide new or more-expansive tax benefits, nor does it create additional RCs, but it does modify the qualifying criteria so that preexisting RCs may be able to expand their boundaries, drawing in additional businesses eligible for the tax incentives and additional residents eligible for the employment credits.

Expansion of the Renewal Communities

Almost as soon as the RCs were established, many local officials encouraged their congressional representatives and senators to modify the provisions in two respects:

  • Base the determination of includible census tracts on 2000 census data rather than 1990 data; and
  • Allow employers operating in one RC to be eligible for employment credits with respect to employees residing in a neighboring RC.

These provisions were included in various bills between 2000 and 2004, but none passed. The AJCA does not provide for employment crossovers between RCs, but current RCs are now allowed to add additional census tracts based on 2000 census data, with a major qualifying factor of increased poverty, discussed below.

The original provisions of IRC section 1400E, “Designation of Renewal Communities,” required that communities (in most cases, portions of a city) nominated by the states and local governments demonstrate pervasive poverty, unemployment, and general distress. These criteria were defined by allowing the inclusion of only those census tracts with poverty rates of 20% or more and by requiring that the nominated community as a whole, taking all of the included census tracts into account, meet the following criteria [rural RCs are not subject to the full criteria, however; see IRC section 1400E(c)]:

  • An unemployment rate equal to 150% or more of the national unemployment rate;
  • At least 70% of the households earn income below 80% of the median household income of the entire local government jurisdiction;
  • A population between 4,000 and 200,000; and
  • A continuous boundary.

While the nomination process took place in 2001 and the communities were designated in 2002, IRC section 1400E required the use of 1990 census data. Because of continuing declines in certain economic measures, some RCs maintained that additional census tracts would have qualified had 2000 census data been used.

AJCA section 222 added subsection (g) to the original IRC section 1400E, allowing the nominating governments of the current RCs to submit requests to HUD to add additional census tracts to the RC on a retroactive basis, using 2000 census data, under three different sets of qualifying criteria. The actual language of the amendments notes that a significant qualifying condition applies for the inclusion of the new census tracts: they must exhibit increased poverty. If a census tract would otherwise qualify under the general criteria using 2000 data, but that high poverty rate had dropped even marginally between 1990 and 2000, the tract cannot be added.

While this increased poverty requirement has eliminated some otherwise eligible areas, section 1400E now allows the nominating government to request the addition of tracts that have no population according to the 2000 census or no poverty rate determined by the 2000 census if the area is one of general distress, if the tract is within the jurisdiction of the RC’s relevant local government, and if the continuous-boundary requirement is met. This provision allows the inclusion of areas that are essentially industrial or abandoned, with a limited or nonexistent population base.

The restated RC must still meet the 200,000 population cap and the continuous-boundary requirement. Local governments have been reviewing census data to determine which tracts can be added. In some communities, the 200,000 population cap serves as a limiting factor and government officials must choose among census tracts in terms of desirability for business development and opportunities for employers to obtain job credits. Local governments have been applying to HUD for approval of these additions, and the expansion of many RCs has now been approved. Once approved, these tracts become part of the RC retroactive to January 1, 2002. This retroactive feature is particularly valuable because businesses will be able to amend earlier returns and claim tax refunds for 2002 through 2005.

Tax Incentives

RC tax incentives became available as of January 1, 2002, and will continue through December 31, 2009. Four potential tax incentives are available. Two of these, the enhanced IRC section 179 deduction and the capital gain exclusion, are available only to a qualified RC business (discussed below). The employment tax credit and the commercial revitalization deduction are available to any business operating in the RC that meets the criteria of the tax benefit and, in the case of the revitalization deduction, that applies for and is awarded an allocation of the deduction. Briefly, the tax incentives available to businesses operating in a RC are as follows.

Employment tax credit (IRC section 1400H). This is a credit equal to 15% of the first $10,000 of qualifying wages of each employee who resides in the RC and performs substantially all of his services for the employer in the RC. While the maximum annual credit is $1,500 per employee, this credit is available for each year the employee is eligible, allowing a possible $12,000 of credits per employee over eight years (2002–2009). Unlike other employment credits, any employee living and working in the RC qualifies the employer for the credit; the employee need not be part of a disadvantaged group. Furthermore, the employer need not have a permanent establishment in the RC as long the employee is working in the RC for at least 90 days.

While this provision is not unique to businesses located in an RC, a new employee may also qualify under the Work Opportunity Tax Credit (WOTC). If the employee qualifies for both the RC employment credit and the WOTC during the first year of employment, an employer cannot claim both credits with respect to the same wages. Different wage ceilings apply to the two credits, however, allowing an employer to leverage into a higher, integrated credit. The employer will normally maximize tax savings by applying the WOTC first, earning a $2,400 credit (40% of the first $6,000 of wages), and then applying the 15% RC employment credit rate to the $4,000 adjusted ceiling (the $10,000 statutory ceiling reduced by the $6,000 of wages applied to WOTC), generating a $600 RC employment credit. This integration of the two job credits will result in a combined first-year employment credit of $3,000. The RC employment credit can be claimed for the remaining years of employee eligibility through 2009. There are similar integration possibilities for employers of high-risk youth (ages 18 to 24) and summer youth (ages 16 and 17) living in the RC. Employees believed eligible for the WOTC, as well as high-risk youth and summer youth employees, must be certified by the relevant state agency. Certification of employees is not required for the RC employment credit, but the employer must maintain adequate records of the employees’ addresses. (The WOTC Credit, IRC section 51, has expired effective for wages earned after December 31, 2005. It has been extended in the past, but no action has been taken by Congress as of this writing.)

Commercial revitalization deduction (IRC section 1400I). Businesses can use an accelerated deduction of up to $10 million for a new nonresidential building or substantial rehabilitation of an existing nonresidential building in an RC. Certain mixed-use properties are also eligible. Allocation of a commercial revitalization deduction is awarded on a competitive basis by the designated state agency. In New York, the Empire State Development Corporation oversees these allocations, with applications accepted by and initially approved by the local jurisdiction. (See Exhibit 1 for contact information.)

Each RC is allowed to award a total of $12 million of commercial revitalization deductions each year. A maximum of $10 million can be awarded to any one project. Once the property is placed in service, the taxpayer elects to either immediately deduct 50% of its allocation in the year the property is placed in service or to amortize 100% of the allocation over 120 months. The balance of the property’s cost is depreciated in the normal manner. This is the only tax incentive for which the taxpayer must apply. The accelerated deduction is not an alternative minimum tax adjustment or preference, and in some circumstances the deduction will be subject to less restrictive limitations under the passive loss provisions of IRC section 469.

Enhanced section 179 deduction (IRC section 1400J). For 2006, the maximum IRC section 179 deduction of $108,000 has been raised to $143,000, an increase of $35,000. The AJCA extended the increased section 179 deduction for all taxpayers that was originally enacted in the Jobs and Growth Tax Relief Reconciliation Act of 2003. Unless extended again, the regular section 179 deduction will revert to $25,000, adjusted for the cost of living, as of January 1, 2008. The RC benefit of $35,000 will be in addition to that amount. The benefit also provides a more generous phase-out range, only 50% of the normal rate, once the investment ceiling has been reached. This benefit is available only to a qualified RC business.

Capital gain exclusion (IRC section 1400F). This provision allows an exclusion from income for gains on the sale of the following:

  • Stock in a qualified RC business;
  • A partnership interest in a qualified RC business; or
  • Qualifying community business property—essentially, tangible section 1231 property used in the RC by a qualified RC business. Realizing this exclusion requires that the property be held for a five-year period. While the RC tax benefits are set to expire after December 31, 2009, the exclusion may be realized later as long as the holding period has begun by that date.

Several limitations apply to the acquisition of the stock, partnership interest, or business property in order to qualify for the exclusion upon disposition. Key among the acquisition limitations for the stock or partnership interest is the requirement that the ownership interest be acquired solely for cash at its original issuance, in the case of stock, or directly from the partnership, in the case of a partnership interest. Additionally, the acquisition must occur after December 31, 2001, and before January 1, 2010, and the business must be a qualified RC business at the time of issuance (or in the process of becoming organized as such) and remain qualified during substantially all of the taxpayer’s holding period. In the case of business property, the taxpayer must purchase the property [as defined in IRC section 179(d)(2)] after December 31, 2001, and before January 1, 2010; its original use in the RC must begin with the taxpayer; and substantially all of the use of the property must be in an RC business during substantially all of the taxpayer’s holding period. While the exclusion will not apply to property acquired before January 1, 2002, substantial improvements to real estate (or the related land) made after that date may qualify. The exclusion will not apply to any appreciation accrued after December 31, 2014. An added benefit of this exclusion is that, unlike the IRC section 1202 small business exclusion, there is no alternative minimum tax preference.

Certain lines of business are totally excluded from enjoying any of the four RC tax benefits. These disqualified business activities include liquor stores, tanning salons, massage parlors, hot-tub facilities, racetrack/gambling facilities, golf courses, country clubs, and certain large farms. As noted above, two benefits, the enhanced IRC section 179 deduction and the capital gain exclusion, are available only to qualified RC businesses.

Briefly, to be a qualified RC business according to IRC section 1400G, the business must meet the following tests:

  • Active conduct of a qualified business within the RC;
  • At least 50% of gross income is derived from its active trade or business;
  • A substantial portion of the use of the business’ tangible property is in the RC;
  • A substantial portion of the use of the business’ intangible property is in the active conduct of this business;
  • A substantial portion of employees’ services are performed in the RC;
  • At least 35% of employees are residents of the RC; and
  • Less than 5% of the unadjusted bases of property are collectibles or nonqualified financial property (e.g., investments).

The active conduct of a trade or business does not include renting residential real property; it does include nonresidential real property only if more than half of the rentals are to RC businesses. These criteria tend to favor very locally based businesses, and they tend to eliminate service businesses unless those services are focused in the RC. The testing is not required on a consolidated or controlled group basis, so legally separate but related entities do not need to be aggregated for testing. Businesses operating multiple branches should consider setting up a branch operating in the RC as a separate legal entity.

Implications of the RC Expansion

The impact of the RC expansion will vary greatly by community. For example, the pre-AJCA Buffalo/Lackawanna RC had a population of approximately 69,000 in the original 22 census tracts, but the addition of the 37 new 2000 census tracts brings it very close to the 200,000 cap. The law change will also allow the inclusion of some desirable waterfront property not previously included because it did not have a measurable population. Schenectady, with three original census tracts in its RC, has added 12 new tracts.

Four of the New York RCs have been able to add substantial numbers of new census tracts; Jamestown’s application is pending. Businesses located in cities that include RCs, and their advisors, will want to learn the exact location of these new tracts. Specific census tracts, once approved, are posted on the HUD RC website. An address locator is available, and a tract’s status is shown. According to one HUD representative, the posting of census tracts will take place once approved, but because of necessary software rewrites and negotiations with vendors, the updated address locator will take time. An interested business owner or representative should contact the local RC office. See Exhibit 1 for the HUD census tract address locator and local contacts for obtaining more information about specific RCs.

Businesses located in a preexisting RC. For businesses already located in a pre-existing RC, some employees may reside in the added tracts, entitling the businesses to additional tax credits of up to $1,500 per employee, not only for 2005–2009 but also retroactive to 2002, if those employees were employed during those earlier years and resided in the additional tracts. This claim will require researching payroll and human resource records, including employees who may no longer work for the company. Businesses and advisors must be sensitive to deadlines under the statute of limitations.

The additional employment credits are the most obvious feature of the expanded RC for businesses already located in a preexisting RC. A less-obvious benefit for these businesses is that more of them may now meet the requirements for a qualified RC business, which will entitle them to the benefits of the increased IRC section 179 deduction and future capital gain exclusion. This is particularly true if the main disqualifying feature was the requirement that 35% of the employees reside in the RC. If a service business now meets this employee test, the expanded boundary may allow it to meet the requirement that substantially all of its employees’ services are provided within the expanded RC. Again, the added tracts are effective retroactively to January 1, 2002. Businesses that had substantial property additions in these earlier years, exceeding the general $100,000 ceiling of section 179 (as adjusted for inflation for the relevant year), or that were affected by the phase-out range, will want to check their earlier payroll and human resource records. Furthermore, if the business now meets the requirements for those earlier years, taking into account the added tracts, then the five-year holding period for future exclusion of gain on the sale of stock, a partnership interest, or real estate will have already started running.

Businesses located in the added census tracts. For businesses located in the newly added census tracts, benefits will also become available retroactively to January 1, 2002. Whether it is a qualified RC business or not, a company may currently or previously have employed individuals living in the expanded RC and be eligible to claim the retroactive employment tax credits of up to $4,500 per employee (for the three years 2002, 2003, and 2004), in addition to the employment credits for 2005 and future years. Again, businesses will need to check payroll, human resource, and other business records to determine eligibility for employment credits.

These records will also require analysis to determine whether the business meets the criteria for classification as a qualified RC business. If a company qualifies, the five-year holding period for exclusion of gain will start running on January 1, 2002, or when the business started, if later. In addition, if a company qualifies and if large investments were made in IRC section 179 property during these earlier years, it should consider filing an amended return. Revenue Procedure 2006-16 provides that qualifying taxpayers can retroactively make the IRC section 179 election or revoke an earlier election by filing an amended return for the year the qualifying assets were placed in service and for all subsequent affected years, provided that the relevant year is open under the IRC section 6501(a) statute of limitations. The Revenue Procedure also refers to the election procedures of Treasury Regulations section 1.179-5(c)(2) and (3), which allow election or revocation through amendment without the consent of the IRS Commissioner.

Unallocated commercial revitalization deductions. Not all RCs have fully awarded their $12 million annual commercial revitalization deductions. Exhibit 2 lists unallocated commercial revitalization deductions (CRD) by New York RCs. Since the passage of AJCA, RC administrators have been wondering whether these unallocated amounts from earlier years would become available and, if so, in what manner.

Questions have been raised as to whether unallocated amounts would be available only to businesses located in the add-on census tracts and only for projects that would have been eligible in those earlier years, or whether they could be added on to future-year allocations. These questions are answered by Revenue Procedure 2006-16, which details the manner in which the local governmental granting agency can award previously unallocated 2002–2005 commercial revitalization deductions, the buildings eligible for consideration, and the election procedure to be followed by a taxpayer awarded a retroactive allocation.

Basically, the unallocated amounts can be allocated only to buildings located in the new census tracts that would have otherwise qualified had the census tract been approved with the original group in 2002. Revenue Procedure 2006-16 incorporates the substance of Revenue Procedure 2003-38, allowing allocations to buildings placed in service by the end of the relevant year (“placed-in-service” allocation) or to planned buildings not placed in service by the end of the relevant year, provided that the buildings are placed in service by the end of the second calendar year following the year of deemed allocation and provided that more than 10% of the reasonably expected basis of the project is invested as of June 30 of the year following the year of deemed allocation (“carryover” allocation). (Paragraph 3.04 of Revenue Procedure 2006-16 provides a detailed discussion of the carryover allocation requirements. The 10% requirement is based on a “project” basis as opposed to a building basis.)

Local governmental agencies face a rapidly approaching deadline for retroactively allocating the unallocated CRDs. This deadline is the later of nine months after HUD approves the expanded area or November 27, 2006. Given the limited time allowed to the granting agencies to make the allocation, and the time required to review the application and bring it before the relevant decision-making body, interested taxpayers with eligible properties in the new census tracts must submit applications quickly. Taxpayers must apply to the relevant granting agency in the manner provided in Revenue Procedure 2003-38. If a taxpayer is granted a retroactive allocation, the taxpayer will choose between the 50% immediate expensing and the 10-year amortization by following one of two methods prescribed by Revenue Procedure 2006-16:

  • A taxpayer can file an amended return for the year the building is placed in service and all subsequent affected years, provided the placed-in-service year is still open. The amended returns should include at the top the statement “Filed Pursuant to Revenue Procedure 2006-16.” Elections made in this manner will be deemed to have the IRS Commissioner’s consent for the change in accounting method.
  • A taxpayer can obtain the consent of the IRS Commissioner in accordance with IRC section 446(e) by filing Form 3115, Application for Change in Accounting Method. Form 3115 should be filed with the taxpayer’s return for the tax year including the date on which the governing agency makes the retroactive allocation, or with the tax return for the first succeeding tax year. The taxpayer must follow the automatic change in method of accounting provisions of Revenue Procedure 2002-9. The designated change number that should be noted on line 1a of Form 3115 is “97.”

Revenue Procedure 2006-16 clarified that previous allocations of CRDs to buildings that subsequently “failed” the requirements cannot be put back into the unallocated pool. It also clarified that unallocated amounts cannot be carried forward to subsequent years or shared with other RCs.

Unlike the employment credits, the CRDs only accelerate a deduction; depending upon the the taxpayer, they may offer the opportunity to benefit from deductions in higher-tax-rate years. If the only benefit is the time-value of money, it may not be worth the additional expense of putting together an application from old data and amending multiple tax returns or applying for a change in accounting method.

While the RCs themselves may be expanding in size, with some of them tripling, each RC, regardless of size, will still have only $12 million of commercial revitalization deductions to award each year. Therefore, Jamestown, with its two census tracts expected to expand to four census tracts, has the same $12 million as Buffalo/Lackawanna, with its new total of 61 tracts. Given this flat dollar allowance per RC, smaller businesses will have a better chance at securing an allocation in a smaller RC.


Ann Burstein Cohen, CPA, is an associate professor of accounting at the University at Buffalo, State University of New York, Buffalo, N.Y. A more complete discussion of Renewal Community tax incentives and tax-planning opportunities is available in her article “Renewal Communities: Tax Benefits for Distressed Areas,” The CPA Journal, March 2004, www.cpajournal.com.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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