It’s the kind of thing that keeps developers and accountants up at night: a court case that tears up the rule book for a program they depend on. Last summer, that’s exactly what happened in the U.S. Court of Appeals for the Third Circuit. The shock waves from the Historic Boardwalk Hall decision are still rolling through the industry.
“People are trying to feel their way through,” says Thom Amdur, executive director for the National Housing & Rehabilitation Association.
Because of the decision, historic tax credit investors now structure their investments to demonstrate to any auditor that they are not just tax credit investors—they have a clear stake in the economic success of the property they are investing in.
In August 2012, the court ruled Pitney Bowes is not a bono fide investor in the redevelopment of Historic Boardwalk Hall into a new conference center in Atlantic City, N.J. That means Pitney Bowes is not entitled to any of the historic rehabilitation tax credits from the property.
According to the court, Pitney Bowes did not have a clear stake in the economic success of the development—even though the firm invested $16.4 million. The deal was carefully structured with guarantees so that Pitney Bowes would achieve the same yield whether the rehabbed conference center turned a profit or not.
The case is less relevant for deals in which an investor buys both low-income housing tax credits (LIHTCs) and historic tax credits, along with the equity stake in an affordable housing property. That’s because investors in LIHTCs face a clear potential downside in their investments, including possible recapture over a 15-year compliance period.
“A lot can happen in 15 years,” says Jerry Breed, a partner with Bryan Cave, LLP, a law firm based in Washington, D.C.
Investors who focus on the five-year historic rehabilitation tax credits have more to prove to federal auditors.
Theoretically, that could include properties that closed their financing long ago and have already been placed in service. Don’t panic, however. The Internal Revenue Service (IRS) is unlikely to suddenly audit thousands of historic rehabilitation tax credit deals that closed years ago, according to experts interviewed for this story. After all, the IRS has limited resources to spend on mass audits, which would probably irreparably harm the historic rehabilitation tax credit program. “The Treasury has been very good with not playing ‘gotcha,’” says Breed.
Investors are, however, changing the way they structure their historic rehab tax credit deals going forward.
All of these changes are designed to increase the amount of “economic substance” that investors have in the developments they participate in.
“Investors have to have a legitimate upside and a legitimate downside,” says Amdur.
Some of these changes are good for developers. For example, many investors have cut back on the guarantees they demand from developers, for example. That means investors share more of the downside risk if a development runs into trouble.
“In general, there is not a 100 percent guarantee of tax credits ... maybe 80 percent,” says Breed. Guarantees provided by developers now tend to burn off as the project progresses.
A number of investors also are putting their capital contributions into a project more quickly. “There is real cash from the investor during construction,” says Breed.
Other changes are not so good for developers. Investors now insist that their cash returns from tax credit investments must be variable, depending on the performance of the asset. “There is a real share of upside cash,” says Breed.
Some investors—but not all—also now shy away from once-common structures like “puts” or “calls.” A put gives the historic tax credit investor the right to sell its ownership stake in a property back to the sponsor for a set price. A call gives the developer the right to buy the investor’s share of the development. Developers liked the put because the majority of the time investors exercised it, providing certainty for everyone in the deal.
The U.S. Treasury is eventually expected to issue guidance on how to safely structure deals, but don’t hold your breath. Not long ago, the affordable housing industry needed guidance from the Treasury to confirm how nonprofit partners can behave in LIHTC deals, and the guidance took about four years, says Breed.
The regulators at the Treasury are also cautious to avoid creating unforeseen loopholes that could cause trouble for them later. “The Treasury has steadfastly refused to come up with an ‘angel’s list,’ to which the condition of economic substance does not apply,” says Breed.