IRS guidance breathes life into historic rehab credits
Agency establishes new parameters for structuring such transactions
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, the Internal Revenue Service has issued much-anticipated guidance meant to provide “predictability” to investors in historic rehabilitation tax credit projects in the form of Revenue Procedure 2014-12.
The guidance establishes parameters for structuring such transactions, and, if met, act as a “safe harbor” under which the IRS will not challenge the allocation of federal historic tax credits to investors.
The Revenue Procedure only applies to federal historic rehabilitation tax credits and does not apply to other federal tax credit programs, nor does it apply to state credits. Furthermore, it only applies to projects placed in service on or after Dec. 30, 2013.
Some background: 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 percent) of the costs incurred to rehabilitate the property.
Owners who cannot use the tax credits themselves seek out tax credit investors to invest in the project as owners or long-term lessees. 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 on the Historic Boardwalk decision and federal historic tax credits in general, see Douglas R. Chamberlain’s article, “Court decision shakes the rehab tax credits world,” published in the Nov. 2-15, 2012, NHBR).
The Revenue Procedure provides that “principals” (i.e., developers) must have a minimum 1 percent interest in the operating company’s “income, gain, loss, deduction and credit.” At no time may the investor’s interest be less than 5 percent of its largest ownership interest at any time.
The investor’s interest also must 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 tax credits and other deductions, that is “contingent upon the [company’s] net income, gain and loss, and is not substantially fixed in amount.”
In addition, the investor’s interest cannot be substantially protected from losses; the investor cannot be limited to a preferred or “priority” return on its investment; the investor’s interest cannot be reduced by “unreasonable” fees, lease terms, or other arrangements; and the investor’s interest may not be reduced by disproportionate distribution rights in favor of other investors.
The investor also must contribute at least 20 percent of its investment prior to the project being placed in service. And at least 75 percent of the investor’s total capital contribution must be fixed by placement in service.
Limitations on guaranties
The Revenue Procedure also 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: 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).
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 lend any funds or guaranty any loans to the investor to permit it to acquire its interest.
In addition, the Revenue Procedure eliminates the developer’s “call option,” The investor’s “put option” is still permitted, but the “put price” is now capped at the fair market value of the investor’s interest at the time the option is exercised.
The bottom line: 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. Going forward, the industry will have to work out how to deal with unanswered questions.
Matthew J. Snyder, an associate at the Concord-based law firm Sulloway & Hollis, can be reached at 603-224-2341 or firstname.lastname@example.org. The author would like to thank Peter F. Imse and Douglas R. Chamberlain for their assistance with the preparation of this article.