Historic Rehabilitation Tax Credit Transactions After The Safe Harbor

Lenders, Developers and Borrowers were all frustrated by the chilling effect that revenue rulings and court cases had on Historic Rehabilitation loans in 2013, causing delays in closings and delays in admitting Federal tax credit investors as partners of the Borrower. After issuance of Revenue Procedure 2014-12, a Safe Harbor for Historic Tax Credit Transactions, a resurgence of Federal investor interest is now apparent; however, structuring loans for these transactions after the Revenue Procedure involves tackling new territory.

Developers in Virginia are eligible to apply for tax credits in a total aggregate amount of 45% (20% Federal; 25% Virginia) of eligible qualified rehabilitation expenses incurred in connection with adapting and rehabilitating certified and contributing historic structures. These incentives were provided to spur urban revitalization. Before December 30, 2013, the Developer would carefully structure a limited liability company or limited partnership to bring in state and federal credit investor members to allocate the tax credits and thereby offset the additional expense involved in a rehabilitation and adaptive re-use project over new construction. Lenders relied on the capital contributions of these investors to pay down the rehabilitation loan to the amount that the project could sustain on a permanent loan. After a series of court cases and revenue rulings gave rise to instability and uncertainty in this market, Federal investors disappeared.

The pre-2014 rulings and cases overturned the structure of the partnerships and the allocation of the credits primarily on the basis that the partnership agreement and related transaction documents did not give investors real substance as a tax partner. Overall, the court cases provided a lot of information on what one should not do, but gave little guidance on what one could do to properly structure a partnership for the allocation of tax credits to investor members.

Representatives of Investors, Developers and Financial Institutions clamored for a Safe Harbor Revenue Procedure from the Internal Revenue Service to provide certainty and guidance. At the end of 2013, the IRS published and then modified in early January 2014, Revenue Procedure 2014-12. The Revenue Procedure is short, not particularly complete and accompanied by an announcement that the IRS would no longer issue private letter rulings on the structure of these partnerships. The critical components of the Revenue Procedure are intended to make the Federal investor a real partner. Recently, in spite of the real partnership risks, institutional Federal tax credit investors have re-entered the market and new investor groups, including those formed by developers more familiar with the development risks, have formed to acquire these partnership interests. There is also a higher likelihood than before the Revenue Procedure that the Developer or his principals may retain the Federal credits.

The retention of the Federal tax credits by the Developer entity and its members presents interesting issues for a Lender in structuring the loan transaction to bring equity into the Developer/Borrower to reduce the rehabilitation loan to the permanent loan amount. The members of the Developer are less likely to contribute additional sums to the Developer for the credit allocation ahead of the availability of the credits since they presumably have already made equity contributions to the Developer for their membership interests. To capture the future tax credit equity, the Lender might consider requiring notes from the members to the Borrower and an assignment of these from the Borrower to the Lender.

The Revenue Procedure provides guidance on a "flat" structure and a "master tenant" structure, fundamentally requiring that the Federal tax credit investor be exposed to some financial and development risk, including up front capital contribution of 20% of the anticipated contribution (75% of the anticipated contribution must be fixed), participation in profits and losses, and no funded guarantees or guarantee from the Developer of its principals that the Federal investor can use the credits. The Developer has lost any "call" rights, but the Federal investor retains a "put" option after the recapture period. There are a number of nuances and complexities as well as vagaries in the Revenue Procedure but, for now, the Revenue Procedure seems to have presented sufficient stability for some Federal investors to re-enter the market.