New IRS guidance changes structuring of historic rehabilitation tax credits

In Historic Boardwalk Hall v. Commissioner (110 AFTR 2d 2012-5710), the IRS successfully argued that the structure did not constitute a partnership and therefore the investor was not entitled to a share in the section 47 historic tax credit (HTC) allocation. Due to such an IRS victory, developers of HTC projects have requested IRS guidance on whether (1) an investor partner is a bona fide partner in a partnership and (2) partner allocations of HTC will be respected.

On Dec. 30, 2013, the IRS issued Revenue Procedure 2014-12, which is intended to provide partnerships and partners with more predictability about the allocation of HTCs where a partnership rehabilitates certified historic structures and other qualified rehabilitated buildings. The IRS won’t challenge a partnership’s allocations of validly claimed HTCs if the partnership and its partners satisfy all of the requirements of the safe harbor.

Scope

The revenue procedure applies only with respect to allocations of HTCs from qualified rehabilitation expenditures. It does not apply to federal credits other than the section 47 rehabilitation credit, and it does not apply to state credits. Many HTC projects will have other federal, state, or matching state HTC credits. With the issuance of this guidance, the IRS will not provide private letter rulings to individual taxpayers regarding the allocation of HTC.

Safe harbor requirements

To qualify for the safe harbor, the partnership and partners must meet all of the following requirements:

1. Principal’s partnership interest. The principal must have a minimum 1 percent interest in each material item of partnership income, gain, loss, deduction, and credit at all times.
2. Investor’s partnership interest.
   1. Minimum partnership interest. The investor’s minimum percentage interest in each material item of partnership item of income, gain, loss, deduction, and credit must be at least 5 percent of the investor's maximum percentage interest in each such item. For example, if an investor is allocated 99 percent of partnership items for years one to five, the investor’s percentage interest for year-six termination must be at least 4.95 percent (i.e., 5 percent of 99 percent).
   2. Bona fide equity investment. An investor’s partnership interest is a bona fide equity investment only if its anticipated value is contingent upon the partnership’s net income, gain, and loss, and is not substantially fixed. Additionally, the investor must not be substantially protected from losses from the partnership’s activities. Finally, the investor must participate in the partnership’s profits in a manner that is not limited to a preferred return on capital.
   3. Arrangements to reduce value. The value of the investor’s interest may not be reduced through fees (e.g., developer, management, and incentive fees), lease terms, or other arrangements that are unreasonable compared to fees, lease terms, or other arrangements for a real estate development project that does not qualify for HTCs. Further, the value may not be reduced by disproportionate rights to distributions or by issuances of interests in the partnership (or rights to acquire interests in the partnership) for less than fair market value. (Under this section of the revenue procedure, many investors in HTC will require the project to provide a written opinion of whether the developer fee is not unreasonable.)
3. Investor’s minimum unconditional contribution. The investor must contribute a minimum unconditional amount to the partnership before the date the building is placed in service, equal to 20 percent of the investor’s total expected capital contribution. The investor must maintain the minimum contribution throughout the duration of its ownership, and the minimum contribution cannot be protected against loss through any arrangement, directly or indirectly, by any person involved with the rehabilitation (except for permissible guarantees, see below). Contribution of promissory notes or other obligations for which the investor is the maker are not permitted to satisfy the minimum contribution. See also allocation of credits below.
4. Contingent consideration. At least 75 percent of the investor’s total expected capital contribution must be fixed in amount before the date the building is placed in service.
5. Guarantees and loans.
   1. Permissible guarantees. Certain unfunded guarantees are permitted, including completion guarantees, operating deficit guarantees, environmental indemnities, and financial covenants.
   2. Impermissible guarantees. No person involved in any part of the transaction may directly or indirectly guarantee or otherwise insure the investor’s ability to claim the HTC, the cash equivalent of the credits, or the repayment of any portion of the investor’s contribution due to inability to claim the credits if the IRS challenges all or part of the transaction.
   3. Loans. Neither the partnership nor the principal may lend any investor the funds to acquire any part of the investor’s interest in the partnership or guarantee or otherwise insure any indebtedness incurred or created in connection with the investor’s acquisition of its partnership interest.
6. Purchase and sale rights. Neither the principal nor the partnership may have a call option or other agreement to purchase or redeem the investor’s interest at a future date.  The investor may not have a contractual right or other agreement to require any person involved in any part of the transaction to purchase or liquidate the investor’s interest in the partnership at a future date at a price that is more than its FMV (determined at the time of exercise of the contractual right to sell).
7. Restriction on abandonment. An investor may not acquire an interest in a partnership with the intention of abandoning the interest after the partnership completes the qualified rehabilitation (typically after the recapture period has lapsed). If the investor abandons its interest in the partnership at any time, the investor will be presumed to have acquired its interest with the intent to abandon unless the facts and circumstances establish otherwise.
8. Allocation of credits. The HTC can be allocated in accordance with the partner’s share of partnership profits (reg. section 1.46-3(f)(2)(i)) unless a special allocation meets partner’s interest in the partnership) or the substantial economic effect test. In other words, each partner’s share of the investment credit is determined in accordance with the general profits ratio unless a special allocation is provided by the partnership agreement for all related income, gain, loss, and deductions with respect to any item of partnership investment credit property. Further, any such special allocation provision will have to meet the substantial economic effect rules under § 704(b) in order to respected. Under the general HTC rules (not discussed in this revenue procedure), a HTC requires a reduction in the depreciable basis of property and also triggers a corresponding basis reduction in a partner’s capital account. If a partner lacks sufficient capital, risk exists the HTC may be allocated to others. Allocation of liabilities to the partner may be needed to retain the benefit of the HTC to a partner lacking a sufficient capital account—a tax issue beyond the scope of this guidance.

Master tenant partnerships

The guidance also applies to master tenant partnerships – i.e., partnerships that lease a building from a developer partnership where an election is made to treat the master tenant partnership as having acquired the building solely for purposes of the rehab credit. A sublease agreement of the building from the master tenant partnership back to the developer partnership or to certain others will be deemed unreasonable unless the sublease is mandated by a third party unrelated to the principal. Other specific requirements also exist for master tenant partnerships

Analysis

Rev. Proc. 2014-12 contains two examples which basically restate the requirements put forth above, but may be worth reading to help understand those requirements.

The guidance provides meaningful safe harbors that investors can follow to ensure they’re respected as partners in the partnership. However, not all the requirements are as objective as they first appear. The requirement for a “bona fide equity investment with a reasonably anticipated value commensurate with the investor’s overall interest in the partnership” is not specifically defined. In addition, the difference between a funded and an unfunded guarantee is important under this guidance. While unfunded guarantees (such as completion guarantees) are allowed, investors cannot put any money to the side; and they cannot put any property to the side. The IRS still has a lot of room for interpretation under these criteria. Additional costs, such as a developer fee analysis and legal costs to satisfy safe harbor requirements, will certainly make HTC projects more expensive. It is clear under this revenue procedure that many unsophisticated investors may no longer want to invest in HTC projects since prior investor protections may no longer be permitted.

Effective date

Rev. Proc. 2014-12 is effective for allocations of section 47 rehabilitation credits made by a partnership to its partners on or after Dec. 30, 2013. If a building was placed in service before Dec. 30, 2013, and all the requirements of the safe harbor were met at the time the building was placed in service and thereafter, the IRS will not challenge the allocations of the credits to investors that are in accordance with section 704(b).

The magnitude of these requirements on HTC projects has many developers, tax advisors, attorneys, and CPAs rethinking their effect on historic rehabilitation projects currently in planning and development. Investors may insist safe harbors be adopted and followed in order for them to be satisfied they will be properly allocated HTCs. Partnership agreements and other documents may need to be substantially revised to meet the safe harbor requirements; however, the extent of necessary revisions and the process is not yet known.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.