IRS Provides Safe Harbor for Allocation of Historic Rehabilitative Tax Credits
The Internal Revenue Service recently published much-anticipated guidance on the structuring of historic rehabilitation tax credit (“HTC”) transactions. The guidance, Revenue Procedure 2014-12 (first published December 30, 2013, revision published January 9, 2014), provides a narrow safe harbor for the allocation of rehabilitation tax credits among partners in HTC partnerships.
By way of background, section 47 of the Internal Revenue Code allows rehabilitation tax credits to certain owners and lessees of qualified historic buildings for up to 20 percent of qualified expenditures related to rehabilitation of the building. HTC transactions typically involve the partnership of one or more developers that manage the rehabilitation and one or more investors that aim to procure the credits from the rehabilitation. One of the key considerations in the transaction is whether the investor is a true partner in the HTC partnership for tax purposes.
Revenue Procedure 2014-12 comes in the wake of the Third Circuit Court of Appeal’s decision in Historic Boardwalk Hall, LLC, v. Commissioner, 694 F.3d 425 (3d Cir. 2012). In Historic Boardwalk, the Third Circuit upheld the Internal Revenue Service Commissioner’s denial of rehabilitation credits allocated to an investor under an HTC partnership agreement. The Court held that the investor was not a “bona fide partner” in the partnership that incurred qualifying rehabilitation expenditures. The court explained that, because the developer partner guaranteed the investor partner’s allocation of HTCs and provided only a preferred return, the investor partner lacked a meaningful stake in the success or failure of the partnership. Accordingly, the investor partner was not a bona fide partner and was not entitled to the HTCs.
Uncertainty ensued after the Historic Boardwalk decision, stifling investment in HTC projects until the IRS provided clearer guidance. The safe harbor Revenue Procedure 2014-12 provides, albeit narrow, should provide tax equity investors with comfort to resume HTC transactions. If the HTC partnership meets the requirements of the safe harbor, the IRS will not challenge the allocation of rehabilitation credits to the partners.
Revenue Procedure 2014-12 provides two examples of possible HTC partnership structures: (1) a “flip” partnership, also known as a developer partnership, and (2) a master tenant partnership. A developer partnership is a partnership that owns and rehabilitates the building. A master tenant partnership is a partnership that leases the building from the developer partnership and receives an allocation of the HTCs.
Revenue Procedure 2014-12 sets out a number of requirements and limitations for a partnership structure to qualify for the safe harbor including the following:
Principal’s Minimum Partnership Interest. A partner in an HTC partnership must have at least a one percent interest in each material item of partnership income, gain, loss, deduction and credit at all times during the existence of the partnership. NOTE: Previously, it was common for a developer/manager to take only a 0.01 percent interest to maximize the amount of HTCs the investor received.
Investor’s Minimum Partnership Interest. An investor in the HTC partnership must have, at all times it holds an interest in the partnership, a minimum interest in each material item of partnership income, gain, loss, deduction and credit equal to at least five percent in such item (adjusted for sales, redemptions, or dilution of its interest).
Investor’s Bona Fide Equity Investment. An investor’s partnership interest must constitute a “bona fide equity investment.” It must have value commensurate with the investor’s percentage interest in the partnership, separate from the tax credits allocated to the investor. The value of the interest must be contingent on the partnership’s income, gain, and loss, and cannot be fixed. NOTE: To meet the safe harbor, investors will need to consider a participating preferred interest, rather than a fixed preferred return.
Prohibited Reductions of an Investor’s Interest. Fees, lease terms, and other arrangements cannot reduce the value of the investor’s partnership interest unless otherwise reasonable as compared to fees, lease terms, or other arrangements for a real estate development project that does not qualify for rehabilitative credits. NOTE: This is to prevent the developer/manager from “stripping out” all of the cash flow of the HTC partnership through aggressive deferred developer fees and subleases.
Investor’s Minimum Unconditional Contribution. Before the rehabilitated building is placed into service, an investor must contribute a minimum unconditional amount to the partnership of at least 20 percent of that investor’s total expected capital contributions and must maintain that contribution throughout its ownership of its interest in the partnership. With limited exceptions, no person involved in the transaction may directly or indirectly guaranty or protect the minimum contribution against loss. Contributions of promissory notes and similar future obligations do not count toward the investor’s minimum unconditional contribution.
Contingent Consideration. At least 75 percent of the investor’s total expected capital contributions must be fixed, in amount, before the building is placed into service. NOTE: To satisfy the safe harbor, the investor will no longer be able to defer more than 25 percent of its capital contribution beyond the project’s placed-in-service date.
Guarantees. No person involved in the transaction may directly or indirectly guarantee or otherwise insure an investor’s ability to claim HTCs, the cash equivalent of HTCs, or the repayment of the investor’s contribution due to inability to claim HTCs. In addition, no person may guarantee an investor partnership distributions or consideration in exchange for its partnership interest, other than the fair market value of that interest. Further, no person may pay or indemnify the investor for its costs related to challenges from the IRS to the investor’s claims on HTCs. Guarantees are allowed, however, to ensure the developer/manager’s performance of any act necessary to claim the rehabilitative and to avoid recapture, as well as completion guarantees, operating deficit guarantees, environmental indemnities, and certain financial covenants. NOTE: The safe harbor does not prohibit some certain unfunded operating guarantees, nor does it prohibit the purchase of insurance to protect against certain HTC risks.
Loans. Neither the developer partnership, master tenant partnership, nor the principal of either, may lend an investor funds to acquire any part of the investor’s interest in the partnership or otherwise insure any indebtedness incurred or created in connection with the investor’s acquisition of the its partnership interest.
Purchase and Sale Rights. Neither the developer/manager, nor the HTC partnership, can have call rights to purchase or redeem an investor’s interest at a future date. An investor may, however, have a contractual put right to sell its interest in the partnership at a future date, but the purchase price must be capped at fair market value at the time of exercise. NOTE: Developers/managers of HTC partnerships will likely be reluctant to forego the ability to call the interests after the HTC term.
- No Abandonment. An investor cannot join an HTC partnership with the intent of abandoning its interest once the partnership completes the rehabilitation and generates the credits. If an investor does abandon its interest in the partnership, there is a rebuttable presumption that the investor joined with the intention of abandoning its interest, therefore disqualifying it from safe harbor protection.
Revenue Procedure 2014-12 provides a path for developers and investors to use in structuring HTC transactions. The Procedure requirements limit or prohibit some previously common aspects of HTC transactions. The impact of these limitations on HTC credit pricing and transaction structure remain to be seen.
As the safe harbor requirements above exemplify, tax credit syndications are complex and must be carefully planned and executed. Baird Holm’s Real Estate and Corporate & Business Transaction attorneys regularly represent developers, real estate companies, investment entities, and landowners with a wide variety of projects designed to generate state and federal tax credits, including, historic, low-income, new market, energy production, and investment tax credits. Baird Holm also drafted and is lobbying for LB 191, Nebraska HTC legislation. Please do not hesitate to contact us if you have any questions or want more information.