- A tip when prepping for an audit
- Calculating the tax equation
- Learning how to maintain good files
- A practical guide from the NAHB
If the Internal Revenue Service (IRS) targets your tax credit project for anaudit, you won’t get a free ride no matter what you do. But if you are prepared with all the necessary files and documentation of your actions, you should come out of it without too much damage. The first rule is to expect the worst, and try to cooperate as much as possible with the IRS auditor, according to speakers at a recent housing conference. The IRS may target tax credit project owners with the express purpose of raising more tax revenue.
“They are not there to get in and out quickly; they are there to find issues and generate reports that show you owe more money,” said William H. Simon, a consultant who previously worked for the revenue service.
According to speakers, IRS agents are spending most of their time focusing on a narrow range of issues, including the amount of the developer’s fee included in eligible basis. And so far, developers have avoided losing basis by structuring their deals using one entity for development and a separate legal entity to play the role of general partner.
In 2001, project owners also had to contend with several Technical Advice Memoranda (TAMs) issued by the IRS. These policy guidelines put very strict limits on what expenses can be counted in “eligible basis” for purposes of calculating a project’s tax credits. Among the items that must be excluded from basis were impact fees and costs attributable to landscaping and site improvement but not to the building itself.
A tip when prepping for an audit
According to F. Brook Voght of Miller & Chevalier, one key audit focus is to reduce “depreciable” and “eligible” tax basis by allocating more soft costs to land development and other nondepreciable items, such as syndication.
The IRS has also been known to look very closely at how to attribute portions of the development fee to activities that are not part of eligible basis, including land acquisition and financing. This is one reason why it’s extremely important for developers to keep very good records as to how they spend their time in case they are challenged. A second key focus is to reduce “depreciable” and “eligible” tax basis by treating deferred notes, primarily payable to developers, as too uncertain to count as a debt until the year these notes are actually due or paid.
There is also an IRS strategy “to disallow some payments between related-party entities (including developers’ fees), on the basis that, taken together, all the payments among such entities provide excessive compensation that only occurs because of the economic collusion of control,” Voght said. Deferred development fees could be excluded from basis if not properly accrued in the first year. There could also be problems if, between two related entities, the deferred fee is deducted by the payer but not taken into income by the payee. Matching income and deductions is not necessary for unrelated parties.
Calculating the tax equation
Also, if a project takes a deferred fee into basis, there must be an absolute obligation to pay it, and the recipient must pay taxes on it, said Anthony Freedman, an attorney with Hawkins, Delafield & Wood in Washington, D.C. He suggested paying interest on the deferred fee to help establish a legitimate obligation. Freedman said the IRS may challenge the reasonableness of developer fees, although he believes this action is not the revenue service’s legal right. “The IRS doesn’t get to decide if you make too much money. They only get to say what’s an ordinary and reasonable business expense,” he pointed out.
A developer’s best protection against such a challenge is the fact that state tax credit allocating agencies have underwritten their projects using standards that limit development fees, Freedman said. Voght warned, however, that state agency approval of a project’s costs does not dissuade IRS agents.
Additional advice for tax credit sponsors:
- Review all your project files before you are subject to an audit, examining them through the eyes of the IRS. “You’ll be amazed at what’s in the file that you don’t know is in the file,” Simon said. Be sure it contains valid documents that reflect how the deal was actually done, not obsolete papers that would confuse an IRS agent.
- Establish and implement a record retention policy. You must have a written policy on what records you retain, how long you retain them and what you discard. Do not strip a file in anticipation of an audit, since this could be construed as a deliberate and illegal attempt to hide information.
- When the IRS agent comes for an audit, do not meet him or her yourself. Let a professional who has audit experience deal with the agent.
- Don’t give the IRS agent free access to any document at any time. Control the flow of information, and keep a copy of every document you turn over so you always know what the agent is looking at. This strategy helps you anticipate problem areas where a response might be required.
- Try to satisfy the agent early in the process. The longer the agent stays, the more he or she needs to justify this time by finding problems.
Learning how to maintain good files
And one of the best tools for keeping up with all the confusing and complex IRS rules and regulations is computer software, much of which is specifically designed to help managers of low-income housing properties stay in compliance. At minimum a good software program should ensure that a site staff places qualified households, charges correct rents and follows the rules and procedures of low-income housing tax credit and related programs. But a less obvious benefit to computerizing property management files involves using software that encourages a property manager to keep consistent, legible and synchronized tenant records.
The IRS Audit Guide advises its agents: “The development of issues regarding a building’s qualification as a low-income project should begin with the inspection of tenant files,” according to Novogradac & Co., LLP. If files are legible, logical and well organized, the auditor is less likely to dig deeper after reviewing an initial batch of records. There are a number of typical problems that can lead to an audit, and poor handwriting often is a big culprit. In addition, many times, reports and documents are not in sync. For example, a unit can appear occupied on a certification but is listed as “vacant” on the rent-roll. And if no move-out date exists in the records, the state of occupancy was unclear.
Using software to perform all move-outs, move-ins and transfers prevents this problem. For example, a well-designed software program guides the operator through specific categories of income and assets, linked to the correct family member, and then calculates accurate totals. A computer program also associates income and utility allowance tables with units and households. A thorough computer program will also call attention to missing certifications, which are required to qualify households. And a computer that demands information be input helps prevents incomplete records.
Completeness and consistency, legibility and timeliness: these are the underlying benefits of keeping records with a well-designed software program. With the considerable monetary risks of falling out of compliance with programs such as the housing tax credit, owners and management companies should seriously consider the value of investing in good computerized “recapture insurance.”
A practical guide from the NAHB
For those looking for additional information on understanding and preparing for the tax credit audit process, the National Association of Home Builders (NAHB) has released A Guide to the IRS Audit Process and Your Housing Tax Credit Project. Written by Voght and Frederick H. Robinson, and written in collaboration with the NAHB’s Margaret McFarland, the publication attempts to guide taxpayers to the least harmful tax audit possible.
Chief among the recommendations are open levels of communication between the tax payer and agent, precise record keeping, and assertive participation by the taxpayer in the audit. The guide is divided into five sections:
- preparing for an audit;
- beginning the audit;
- the information-gathering process;
- identifying and dealing with issues during the audit; and
- resolving cases at the examination level.
To obtain a copy, call NAHB’s Housing Credit Group at (202) 822-0207.
Jim Kohn contributed to this story.