|May 2011, Volume II, Issue V||Published By Novogradac & Company LLP|
By now you may have read and heard more than you ever wanted to know about the legal and accounting implications of the March 29 4th U.S. Circuit Court of Appeals reversal of December 2009 Tax Court decision in Virginia Tax Credit Fund v. Commissioner 2001. This column will focus instead on the possible market impacts of this decision in terms of state historic tax credit (HTC) supply, pricing and the net value of these credits to historic rehabilitation transactions. But first let's do a quick review of the original tax court decision and the subsequent reversal upon appeal:
Readers of History and the Hill may remember the February 2010 column in which I reported the general industry euphoria that greeted the earlier tax court ruling. The IRS had based their initial case against the partners in the Virginia Fund primarily on the argument that the individual tax credit investors were not partners, because the investors entered and exited the partnership in less than 12 months, held an aggregate ownership interest of 1 percent, and received tax benefits that were disproportionate to their profits interest. The Virginia HTC, one of the earliest and strongest in the country, must be allocated through a partnership and cannot be sold as a tax certificate. However, the state statute does allow for special allocations, does not have a recapture provision, and does not specify any holding period like the five-year hold required for the federal HTC.
Despite the aggressive structure of the investment partnership, the tax court ruled that the state tax credit investors in the Virginia Fund were indeed partners, and that the credits received were a distribution of allocable tax benefits, not property and not a "disguised sale" as described in IRC Section 707. Judge Diane Krupta went on to say in her December 2009 opinion that the upper tier fund had a legitimate business purpose, and the partners had real economic risks associated with construction completion and Part 3 approval. She noted that the State of Virginia and the federal government had set up these historic tax credit programs to attract capital to projects that financed the rehabilitation of historic buildings that otherwise would not be feasible, and that these transactions should be held to a different pre-tax profit motive standard under IRC Section 183.
Given the nature of the Virginia Fund partnership structure, one would have expected the appeals court to build its reversal around the IRS argument that the investors were not partners, leading to the conclusion that they therefore bought property. Most concerning about the appeals court ruling was its assumption that the individual investors were partners, and that the credit allocation was in fact property obtained in a disguised sale. As a result, the appeals court ruling raises the question of whether any allocation of state tax credits through a partnership is property subject to federal ordinary income tax regardless of how conservatively the partnership agreement is drafted.
The Market Impact
State HTC statutes award credits in a variety of ways including allocation through partnerships, sale of tax certificates, taxpayer refunds and grants in lieu of credits. The chart below summarizes how credits are distributed in key states.
Credits allocated through tax certificates, refunds and grants are not impacted by the 4th Circuit decision. But state HTCs that can only be allocated through pass through entities face considerable uncertainty. Most of the upper tier funds that have been closed in these states have taken a 1 percent interest in the lower tier (operating) partnership. This structure was enabled by state HTC statutes that allowed partnerships to make a disproportionate allocation of state credits. Because the Virginia Fund used this special allocation provision of state law, the appeals court ruling creates a concern that any state fund formed after 2001 will have its state credit allocations recharacterized as property. The appeals court was also not clear as to whether its ruling might also apply to direct investments in operating partnerships that utilized the same special allocation structure.
Going forward, Will Owens of Stonehenge Capital said some developers he has spoken to since the appeals court ruling will assume that an allocated state HTC transaction is a sale of property and will anticipate the payment of ordinary income taxes on syndication proceeds. "The 4th Circuit's decision calls into question the tax treatment of all syndicated tax credit transactions at the upper and lower tiers. The decision has impacted, and will impact the structure and pricing of projects supported by state tax credits. Assuming that a project owner treats the syndication of its state credits as a sale, then the net benefit of allocated tax credits will be significantly less to the project because of the effect of federal and state income taxes," Owens said.
Eric Brubaker of Foss and Company said, "Ultimately the developer and the deal will take the hit in the form of higher taxes. This will create an unanticipated gap for projects in predevelopment unless the LLC has loss carry forwards to cover the taxes generated by the sale."
Typical pricing on allocated state HTCs that vest at placement in service has been 72 to 78 cents on the dollar reflecting in part the loss of the federal deduction for state taxes paid. If on future transactions a lower tier (operating) entity in the 35 percent tax bracket must recognize the syndication proceeds of an allocated credit as income, the net value of these credits to the transaction will drop to 47 to 51 cents.
"This drop will eliminate the 15 to 20 percent value advantage of allocated credits over certificated credits," Owens said. "Credits sold as certificates have a typical value of 82 cents in the market, and after federal income tax, net down to about 53 cents to the deal assuming the lower tier project does not otherwise have the ability to shelter these taxes."
The longer term impact of this ruling will become clearer in the next several months as law and accounting firms, developers, syndicators and investors try to understand the many ramifications of the 4th Circuit ruling, which effects not just state HTCs but all allocated state credits such as brownfields, movie and affordable housing credits. One ominous sign was the IRS' decision to appeal Boardwalk Hall v. Commissioner shortly after the 4th Circuit ruling. The taxpayers had received a favorable decision in that case in the U.S. Tax Court in January. In its Boardwalk brief, the IRS applies some of the same arguments against a federal HTC transaction that it used in its successful appeal of the Virginia Fund case.