Bar News - May 17, 2013
Real Property Law: Case and IRS Memo Rock Rehab Tax Credit World
By: Douglas R. Chamberlain
What do a theater in New Orleans, a mill building in Winooski, Vt., and a skyscraper in Omaha have in common? These once-dilapidated buildings have been restored to their former glory and given new purpose as apartments or office space.
A tax ruling disallowing investors in a real estate deal for the historic Boardwalk Hall in Atlantic City is roiling the world of historic building redevelopment.
Photo Credit: Paul Lowry via Flickr
For decades, the federal government has offered tax credits to encourage developers and investors to rehabilitate older and historic structures. Since the 1970s, thousands of buildings have been rejuvenated in this manner, and investors have reaped the benefits of hundreds of millions of dollars in tax credits.
Last August, however, a federal appeals court denied these credits to an investor in such a project, and in March, the IRS released an internal memorandum raising questions about a similar transaction. These developments have sent the historic tax credit community into a frenzy, sowing confusion and doubt within this long-established industry.
How It Works
The Internal Revenue Code provides a 20 percent tax credit for "qualified rehabilitation expenditures" (QREs) incurred when property owners rehab "certified historic structures" for nonresidential or residential rental uses. (A 10 percent credit is available for structures lacking certification that are at least 50 years old.)
In these cases, the property owner can also transfer the credit via a long-term lease to a "master tenant," who in turn subleases the premises to the actual users. The National Park Service weighs the structure’s historic significance, vets the rehab plans and reviews the completed project to confirm that it qualifies for the credit. However, all or part of the credit may be "recaptured," if the project is then disposed of within five years. A "disposition" can include any sale, exchange, transfer, gift or casualty, as well as a foreclosure.
Many times, developers are unable to take full advantage of the tax credits themselves and need outside capital to leverage bank financing, grants from city and state governments, and other funding sources. They therefore reach out to investors facing substantial tax liabilities, who can use the credits and provide the capital needed to complete the project.
Because federal tax credits cannot be sold outright by property owners, investors seeking these credits must become bona fide equity investors in the project. However, because the credits are available to long-term lessees, the investor can simply invest in the master tenant entity, typically owning 99 percent or more of that entity and thus receiving virtually all of the credits. The developer retains only a small equity share, but maintains operational control of the project.
The capital investment required generally ranges from 80-100 percent of the credits available to the investor, who often negotiates additional incentives, such as a priority return on its capital investment. However, once the five-year recapture period ends, the investor typically exits the scene, via an investor "put option," requiring the developer to purchase the investor’s interest, or a developer "call option," requiring the investor to sell its interest. Generally, the developer’s obligations under these option agreements and various other aspects of the deal are backed by personal guarantees of its principals.
The Historic Boardwalk Case
Until recently, the IRS has rarely challenged tax credit deals structured in this fashion.
Last year, in Historic Boardwalk Hall, LLC, et al. v. Commissioner, the federal Court of Appeals for the Third Circuit denied an allocation of federal tax credits to the investor, ruling that it was not a true partner in the project because it had no meaningful stake in its success or failure.
The investor was promised a 3 percent "preferred return" guaranteed by a New Jersey state agency, eliminating any true investment risk. The agency also guaranteed the investor would receive the economic benefit of the tax credits, even if they were ultimately disallowed by the IRS. No significant capital contributions were required until enough QREs had been incurred to generate tax credits equivalent to those contributions. And, there was little or no realistic possibility of upside potential for the investor, because the profitability projections developed by the project accountants were completely unrealistic.
The IRS Memorandum
The historic tax credit community suffered another blow when the IRS Office of Chief Counsel released Field Service Advice Memorandum 20124002F, calling into question the legitimacy of an investor’s partnership status in a project involving historic tax credits.
Although the Memorandum is dated August 30, 2012, it wasn’t circulated publicly until March of this year. In the Memorandum (which was largely written prior to the release of the Historic Boardwalk decision), the IRS applied a Boardwalk-type analysis to a similarly-structured historic tax credit transaction.
The IRS focused on the lack of "downside risk" and "upside potential" on the part of the investor, ultimately finding that it was "a partner in name only." While the Memorandum has no precedential value, it does seem to betray a fundamental hostility on the part of the IRS towards these transactions, as commonly structured.
The Historic Boardwalk decision and the IRS Memorandum have cast a shadow over the historic tax credit syndication industry.
While both the court and the IRS declined to establish any safe harbors or bright-line tests providing guidance in structuring future deals, it is clear that they want to see investors take a more meaningful stake in both the risks and rewards of being a partner in the project.
In response, some pending transactions have been recast to avoid some of the features that the court and the IRS found objectionable; for example, by limiting the scope of developer guarantees, requiring more substantial capital contributions earlier in the rehab process, or increasing potential upside returns for investors. Understandably, however, both developers and investors are loath to abandon the tried-and-true deal structures to which they have become accustomed.
It is unclear whether Historic Boardwalk represents an anomaly, based on the long-standing belief among lawyers that "bad facts make bad law," or the opening salvo in a broad-based IRS attack on these transactions, as further evidenced by the recent IRS Memorandum. In view of the lingering malaise in the real estate sector, it would be unfortunate should the latter prove to be the case.
The tax credit syndication market plays a vital role in financing historic preservation and other real estate developments. Pending further guidance from the IRS or the courts, the industry faces an uncertain outlook, at least in the short term. Those interested in the future of historic preservation, and rehabilitation tax credits specifically, will continue to follow these developments with great interest and concern.
Editor’s note: Peter F. Imse and Matthew J. Snyder assisted with the preparation of this article, a version of which appeared in the Nov. 2, 2012, edition of the NH Business Review.
Douglas R. Chamberlain is a senior member of Sulloway & Hollis of Concord. A NH Bar member since 1976, Doug’s practice includes corporate, health care and employee benefits matters, in addition to historic tax credit transactions.