Bar News - May 21, 2014
Real Property Law: IRS Issues Guidance on Historic Rehab Tax Credit Projects
By: Matthew J. Snyder
More than a year after a Court of Appeals rocked the historic tax credit world with its decision in Historic Boardwalk Hall LLC v. Commissioner, the IRS recently issued guidance intended to provide “predictability” to investors in historic tax credit projects by establishing structural parameters for such transactions.
If met, these parameters act as a “safe harbor,” and the IRS will not challenge the allocation of federal historic tax credits to investors. This safe harbor only applies to federal historic tax credits. It does not apply to other federal tax credit programs (or to state credits), and only applies to projects “placed in service” on or after Dec. 30, 2013.
Since 1976, the federal government has offered tax credits to property owners who rehabilitate historic buildings. The credit is based on a percentage (generally 20 percent) of the costs incurred to rehabilitate the property. Owners who cannot use the tax credits themselves seek others to invest in the project as part-owners or long-term lessees. Investors receive the tax credits and other financial benefits as a result of their investment.
These arrangements generally went unchallenged until August 2012, when the Historic Boardwalk court invalidated the allocation of federal tax credits to an investor, ruling that the investor was not a “bona fide partner” because it lacked a meaningful stake in the project’s success or failure.
The Safe Harbor
Here are some of the highlights of the Revenue Procedure and safe harbor provision.
Minimum Ownership Interests: “Principals” (i.e., developers) must have a minimum 1 percent interest in the “income, gain, loss, deduction, and credits” of the entity owning or leasing the project. As long as the tax credit investor retains any interest in the project, that interest can never be less than 5 percent of its largest ownership interest.
Investor’s Bona Fide Equity Investment: The investor’s interest must constitute “a bona fide equity investment with a… value commensurate with the investor’s overall percentage interest…,” separate from any tax credits and other deductions, that is “contingent upon… net income, gain, and loss, and is not substantially fixed in amount.”
Also, the investor’s interest cannot be substantially protected from losses; the investor cannot be limited to a “preferred” return on its investment; the investor’s interest cannot be reduced by “unreasonable” fees (e.g., developer fees, incentive management fees, and property management fees), lease terms, or other arrangements; and that interest may not be reduced by disproportionate distribution rights in favor of other investors.
Investor Minimum Contribution: The investor must contribute at least 20 percent of its investment before the project is placed in service, and at least 75 percent of the investor’s total capital contribution must be fixed (that is, not subject to conditions or contingencies) by that time.
Limitations on Guaranties: In historic tax credit transactions, the principals or other parties related to the developer will typically issue guaranties to the tax credit investor.
A hot topic since Historic Boardwalk, the Revenue Procedure distinguishes between “permissible” and “impermissible” guaranties. Permissible guaranties include: guaranties to perform acts necessary to claim the historic tax credits; guaranties to avoid acts or omissions that would cause the project to fail to qualify for the credits, or cause a recapture of the credits; completion guaranties; operating deficit guaranties; environmental indemnities; and financial covenants.
Permissible guaranties must also be “unfunded”, which means that the guarantor cannot set aside money or property to fund the guaranty (with limited exceptions), and cannot agree to any minimum net worth covenants.
Impermissible guaranties include: outright guaranties that the investor will receive the historic tax credits, the cash equivalent of the credits, or the repayment of any portion of its capital contribution due to its inability to claim the credits based on an IRS challenge. Guaranties that the investor will receive distributions or consideration in exchange for its investment (other than the fair market value of its interest) are also barred. Principals cannot agree to pay the investor’s costs or to indemnify the investor if the IRS challenges the investor’s claim of the credits. Finally, principals cannot loan any funds or guaranty any loans to permit the investor to acquire its interest.
Sale Rights: Under the safe harbor, principal “Call Options” – the right to acquire the investor’s interest at a predetermined time and price – are no longer allowed. The investor “Put Option” – the right to require the principal to purchase the investor’s interest – is still permitted, but the “Put Price” is now capped at the fair market value of that interest at the time the option is exercised.
Revenue Procedure 2014-12 and its safe harbor are a step in the right direction for developers and investors alike, as the historic tax credit industry looks to rebound from the Historic Boardwalk decision.
While completed projects generally aren’t being revisited (and those placed in service before 2014 aren’t eligible for safe harbor treatment in any case), the industry consensus is that pending and future deals should be structured to comply with the safe harbor requirements, if possible.
However, the terms of the safe harbor raise many issues that remain unresolved, including the scope of permissible and impermissible guaranties, how to define “reasonable” fee arrangements with the developer and third parties involved in the project, how to set an appropriate rent schedule (where a long-term lease is involved) that reflects an arm’s length transaction irrespective of any tax credit considerations, and what impact the safe harbor has on “twinned” transactions involving historic and other federal tax credit programs. Hopefully future IRS guidance will shed light on these and other issues.
Matthew J. Snyder is an associate at Sulloway & Hollis whose practice includes corporate, real estate, and labor and employment law, in addition to historic rehabilitation tax credit transactions. Douglas R. Chamberlain and Peter F. Imse assisted with the preparation of this article, a version of which appeared in the March 21, 2014, edition of New Hampshire Business Review.