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IRS Issues Long-Awaited Guidance Regarding Historic Rehabilitation Tax Credit Projects
More than a year after the U.S. Court of Appeals for the Third Circuit sent the historic tax credit world into a frenzy with its decision in Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012), the IRS issued much anticipated guidance in the form of Revenue Procedure 2014-12 (originally published December 30, 2013, and revised January 8, 2014) which, according to the IRS, is meant to provide “predictability” to investors in historic rehabilitation tax credit projects by establishing parameters for structuring such transactions. These parameters, if met, act as a “safe harbor” under which the IRS will not challenge the allocation of federal historic tax credits to investors. This long-awaited guidance should help rejuvenate the industry, as investors revisit transactions placed on hold following Historic Boardwalk and get back in the historic tax credit game.
Since 1976, the federal government has offered tax credits to property owners who rehabilitate older buildings. The credit is based on a percentage (generally 20%) of the costs incurred to rehabilitate the property. Owners who cannot use the tax credits themselves seek out investors to invest in the project as owners or long-term lessees, resulting in a win-win for both parties: the owner secures additional equity for the project on terms that are more favorable than conventional financing, and the investor receives the benefits of the tax credits, as well as other financial benefits. These arrangements generally went unchallenged until August 2012, when the Historic Boardwalk court invalidated the allocation of federal tax credits to an investor on the grounds that the investor was not a “bona fide partner”, because it lacked a meaningful stake in the project’s success or failure. For more information about the Historic Boardwalk case, as well as additional background on the federal historic tax credit program and how tax credit deals are structured, see our prior article, “Historic Boardwalk Case and IRS Memo Rock the World of Rehab Tax Credits”, found here.
The Revenue Procedure only applies to federal historic rehabilitation tax credits. It does not apply to other federal tax credit programs (e.g., energy, low income housing or new markets credits), nor does it apply to state credits. Furthermore, it only applies to projects placed in service on or after December 30, 2013. If the project was placed in service prior to that date and meets all of the requirements of the safe harbor, the Revenue Procedure provides that the IRS will not challenge the allocation of federal credits to the investor. Failure to satisfy all of the safe harbor’s requirements does not mean that the IRS will invalidate the allocation of credits, but the protection afforded by the safe harbor will not be available in the event of an IRS audit.
A summary and analysis of the entire Revenue Procedure is beyond the scope of this article, but some of the highlights are discussed below. The full text of the revised Revenue Procedure may be found here.
Minimum Ownership Interests
The Revenue Procedure provides that “principals” (i.e., developers) must have a minimum 1% interest in the operating company’s “income, gain, loss, deduction, and credit”. At no time may the investor’s interest in the operating company be less than 5% of its largest ownership interest at any time. Also, it is worth noting that the IRS has informally stated that these ownership interest requirements apply equally to the “master landlord” and “master tenant” entities in the event that the developer chooses to use a “master lease” structure.
Investor’s Bona Fide Equity Investment
Perhaps the most significant (but least helpful) provision of the Revenue Procedure is the requirement that the investor’s interest in the operating company constitute “a bona fide equity investment with a reasonably anticipated value commensurate with the Investor’s overall percentage interest in the [company], separate from any federal, state, and local tax deductions, allowances, credits, and other tax attributes to be allocated by the [company] to the Investor.” The guidance provides that “[a]n Investor’s [company] interest is a bona fide equity investment only if that reasonably anticipated value is contingent upon the [company’s] net income, gain, and loss, and is not substantially fixed in amount.” The Revenue Procedure goes on to impose other limitations, namely: the investor’s interest cannot be substantially protected from losses (see “Limitations on Guaranties” below); the investor cannot be limited to a preferred or “priority” 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 as compared to real estate development projects not involving historic tax credits; and the investor’s interest may not be reduced by disproportionate distribution rights in favor of other investors or the rights of others to acquire ownership interests in the operating company at a price that is less than fair market value.
While the Revenue Procedure does provide some guidelines as to how to ensure that the investor’s interest is a “bona fide equity investment”, these guidelines also create additional questions, such as determining what are “reasonable fees” payable to the developer and/or third parties involved in the transaction. Clearly, however, the IRS wants to ensure that the investor is a “bona fide partner” in the operating company, along the lines of a typical real estate investor.
Investor Minimum Contribution
The Revenue Procedure requires that the tax credit investor contribute at least 20% of its investment prior to the project being placed in service. This minimum amount must be maintained throughout the duration of the investor’s membership in the operating company. Also, at least 75% of the investor’s total capital contribution must be fixed (that is, not subject to conditions or contingencies) by the time the project is placed in service.
Not surprisingly, investors have typically limited the amount of their early capital contributions, instead preferring to wait until project completion, or shortly thereafter, at which time they know that the project is truly viable. Now, although investors will still be permitted to make a relatively nominal capital contribution during construction, they must contribute at least 20% of their investment before project completion.
Limitations on Guaranties
In historic tax credit transactions, the principals of the developer or other related parties will typically issue guaranties to the tax credit investor. The Revenue Procedure’s guidance with respect to such developer guaranties is perhaps the second most significant aspect of the safe harbor, although the IRS’s stance on this issue is not entirely surprising considering the facts of 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 the exception of operating reserves capped at 12 months of reasonably projected operating expenses), and the tax credit investor cannot demand any minimum net worth covenants from the guarantors.
Impermissible guaranties include: 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; and guaranties that the investor will receive distributions or consideration in exchange for its investment (other than the fair market value of its interest upon exercise of its “Put Option”-see “Sale Rights” below). The Revenue Procedure also prohibits agreements to pay the investor’s costs or to indemnify the investor if the IRS challenges the investor’s claim of the credits, however the investor may obtain insurance to cover its risk.
Finally, the Revenue Procedure provides that the developer cannot loan any funds to the tax credit investor in order to acquire its membership interest, and cannot guaranty any loan to the investor to permit it to acquire its interest.
Another highlight of the Revenue Procedure is the elimination of the developer’s “Call Option”, the right to acquire the investor’s interest in the operating company at a predetermined time and price. The Revenue Procedure still permits the tax credit investor’s Put Option, but now caps the “Put Price” at the fair market value of the investor’s interest in the operating company at the time the investor exercises its Put Option. (Note that, on its face, the Revenue Procedure does not prohibit sales at less than fair market value, although it is unclear whether the IRS would look favorably upon such terms.) When calculating fair market value, an appraiser can only take into account arms-length agreements and transactions that are not unreasonable as compared to similar agreements and transactions not involving historic tax credits.
The IRS has informally indicated that their reason for eliminating the Call Option is to give the investor the opportunity to remain a member of the operating company should it choose to do so after it has received the benefits of the tax credits and the recapture period has expired-bolstering the investor’s “bona fide partner” status.
The Revenue Procedure is 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. Of all the new questions the safe harbor creates, a big one is: “Now what?” Thus far the industry consensus seems to be that projects already placed in service should not be revisited, but that pending and future deals should be structured to comply with the Revenue Procedure if at all possible. However, the industry has differing opinions as to what to do about projects that are under construction but have not yet been placed in service. Some developers and investors seem keen to reopen these deals, while others are unwilling to do so (perhaps to avoid the added costs), or are only willing to make minimal changes to their existing documents, choosing instead to take their chances in the event of an IRS audit.
Sulloway & Hollis has represented an historic tax credit investor in dozens of transactions involving projects throughout the U.S., including helping to restructure both previously closed and pending transactions to comply with the Revenue Procedure. The author would like to thank Peter F. Imse and Douglas R. Chamberlain for their assistance with the preparation of this article, a version of which was published in the March 21-April 3, 2014 edition of the New Hampshire Business Review and the May 21, 2014 issue of the New Hampshire Bar News. For information on the firm’s practice in this area, please contact Douglas R. Chamberlain or Peter F. Imse, Chair of the firm’s Real Estate, Development and Environmental Practice Group.