Court decision shakes the rehab tax credits world

Historic Boardwalk decision casts a shadow over the syndication industry

For decades, the federal government has offered tax credits to encourage developers and investors to rehabilitate older and historic structures. Thousands of buildings throughout the nation have been rejuvenated in this manner, and investors have reaped the benefits of hundreds of millions of dollars in tax credits.

However, in a closely watched case, a federal appeals court recently denied these credits to an investor in such a project, sowing confusion and doubt within the long-established rehab tax credit market.

The Internal Revenue Code provides a 20 percent tax credit for “qualified rehabilitation expenditures” (QREs) incurred by property owners rehabbing “certified historic structures” for nonresidential or residential rental uses. 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 “recaptured” if the project is disposed of within five years thereafter.

In many cases, 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 reach out to investors facing substantial tax liabilities, who can use the credits and provide the capital needed to complete the project.

Since federal tax credits can’t be sold outright by property owners, investors seeking these credits must become bona fide equity investors in the project. However, since 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 to 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” that requires the developer to purchase the investor’s interest, or a developer “call option,” which requires 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.

Historic Boardwalk

Until recently, the IRS has rarely challenged tax credit deals structured in this fashion. However, in Historic Boardwalk Hall LLC, et al. v. Commissioner, the Third Circuit Court of Appeals 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. Nor were any significant capital contributions required until enough QREs had been incurred to generate tax credits equivalent to those contributions.

Finally, 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 Historic Boardwalk decision has cast a shadow over the historic tax credit syndication industry. While the court declined to establish any safe harbors or bright-line tests providing guidance in structuring future deals, some pending transactions have been recast to avoid some of the features that the court 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’s unclear whether the case represents an anomaly, based on an exceptionally unfavorable fact pattern, or the opening salvo in a broad-based IRS attack on these transactions.

In view of the current longstanding 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 National Park Service 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.

Douglas R. Chamberlain, a senior member of the Concord-based law firm Sulloway & Hollis, can be reached at 603-224-2341 or

Categories: Legal Advice