IRS Issues Safe Harbor Guidance for Developers Using Historic Tax Credit
After concerns surfaced over a court ruling that stopped many historic building developers from using the Historic Tax Credit (HTC), the IRS has issued guidance for future historic tax credit structures.
Rev. Proc. 2014-12 provides a safe harbor for allocating tax credits to investors in historic tax credit deals. Any deal developed before December 30, 2013, will not be challenged based on historic tax credit allocations, as long as the safe harbor rules are followed.
The IRS guidance includes key elements of the court’s Historic Boardwalk opinion and provides a broad road map by which parties can navigate a historic tax credit structured transaction without fear of challenge by the IRS.
“Since the appeals court ruling, there has been a shortage of investors willing to invest in HTC projects. This is welcome guidance for developers that need this tax credit as an alternative funding mechanism. Once again, investors will be interested in these historic projects as a means to reduce their federal tax liabilities,” says Luke Pope, a construction and real estate manager with CliftonLarsonAllen.
Historic Boardwalk Hall case
Under current law, a federal income tax credit of 10 to 20 percent is allowed for qualified rehabilitation expenditures. Funding is often obtained through outside investors with large tax liabilities (typically large corporations) who contribute capital to these rehabilitation deals in exchange for the majority of the credits.
The basic transaction calls for an investment in a partnership at some cost below the value of the credits. There would be a nominal preferred rate of return on the original investment. After the five-year recapture period for the HTC, a put or call option would be exercised by the developer to allow the investor to exit the deal.
In August 2012, the Historic Boardwalk Hall case brought deals with this appealing transaction structure to a crashing halt. The 3rd U.S. Circuit Court of Appeals ruled that unless there was economic risk to the investor, there was no partnership, and the credits could not be transferred to the investor. If the deal looks more like a sale of tax credits than a true partnership, the deal will be at risk of an IRS examination.
IRS safe harbor guidance
The IRS’s main objection to the project structure of Historic Boardwalk was that the historic tax credit investor lacked any meaningful investment risk or reward and, therefore, the structure did not constitute a partnership for tax purposes. The IRS guidance includes key elements of the court’s Historic Boardwalk opinion and provides a broad road map by which parties can navigate a historic tax credit structured transaction without fear of challenge by the IRS.
The following rules helped clarify the IRS’s stance and are included in the its safe harbor guidance:
- The developer, or “principal” per the guidance, must maintain at least 1 percent ownership during the life of the project. Prior to the Historic Boardwalk ruling, most ownership structures would pass 99.99 percent of the credits to the investor and 0.01 percent would remain with the developer. This new rule eliminates this type of credit allocations that used to happen.
- Investors must maintain a minimum ownership of 5 percent during their period as an investor. This provision allows for a 95 percent/5 percent partnership flip to occur after the recapture period, and helps ensure that the investor has some risk after the recapture period.
- Principals or the partnership no longer have a call option to purchase the investor’s interest at the end of the five year recapture period. This helps ensure that the investor is truly involved in the deal for the life of the project.
- The investor’s value in the partnership interest cannot be stripped by “unreasonable” fees, arrangements, or lease terms. Per the guidance, reasonable fees are considered fees that would be reasonable in any non-historic rehabilitation development projects. Pope notes that determining this may be difficult if there are no other non-historic projects to compare to at the time.
- Investors must participate in a way that they share any upside and downside risk with the developer with no guaranteed return of the minimum investment. They must contribute a minimum of 20 percent of their total expected capital commitment before eligible property is placed in service. This minimum investment must be maintained throughout the investor’s ownership in the partnership.
- Any guarantees related to the project have been limited. It is no longer permissible to guarantee that the investor can claim the rehabilitation credits or the cash equivalent of the credits.
“There is still some uncertainty related to a few of the items, such as what will the courts deem reasonable fees or what will be considered a bona fide equity investment,” notes Pope. “However, this provides some clarity that will draw investors back to the historic tax credit market. Additional guidance on some of these uncertainties is sure to follow.”
How we can help
When considering purchasing a historic building, consult with your tax advisor regarding potential credit opportunities as early as possible. Many aspects of the transaction need to be planned before any rehabilitation has begun. We can help with the application process, structuring of the deal, tax effects, cost certifications, modeling, and projections related to the potential rehabilitation project.