Eric Pettit: Section 303 of the Affordable Housing Credit Improvement Act has Serious Constitutional, Tax and Fiscal Problems

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Eric Pettit: Section 303 of the Affordable Housing Credit Improvement Act has Serious Constitutional, Tax and Fiscal Problems

I am writing in regard to your July 24, 2019, blog post, “Congress Considering Retroactive Changes Affecting Low-Income Housing Tax Credit Property Owners,” which addresses Section 303 of the Affordable Housing Credit Improvement Act (AHCIA). I am a partner in the Los Angeles office of Boies Schiller Flexner LLP, and have represented investor limited partners in LIHTC partnership disputes, including a recent case involving the proper interpretation of a “right of first refusal” granted to a Washington nonprofit pursuant to the safe harbor created by Internal Revenue Code (IRC) Section 42(i)(7). Senior Hous. Assistance Grp. v. AMTAX Holdings 260, LLC et al., No. C17-1115 RSM. I agree with many of the concerns raised in your post, and wanted to provide some additional relevant information.

In 1989 Sens. John Danforth and George Mitchell proposed creating a statutory safe harbor that would permit nonprofits focused on affordable housing to hold a unilateral option to purchase LIHTC projects at below-market prices after all of the tax credits had been earned. Congress rejected this proposal, however, because giving nonprofits an option to force a below-market sale would eliminate any possibility that an investor holding virtually all of the equity in a LIHTC partnership would receive any tax-independent upside from its investment based on the appreciation of the LIHTC property’s value. Pursuant to fundamental tax principles on which Congress based the entire LIHTC program, this would not only create precisely the type of tax shelter that the Tax Reform Act of 1986 sought to eliminate, but also would effectively transfer ownership of the projects for tax purposes–and the corresponding right to receive tax credits–from investors to nonprofits, thereby undermining the functioning of the entire LIHTC program.

Accordingly, Congress decided instead to limit nonprofits to a below-market right of first refusal (ROFR), which under well-established law can only be exercised if the owner receives a genuine third-party offer to buy the property that it intends to accept. As clearly reflected in the legislative history from that period, Congress reasoned that because a ROFR is a defensive right that cannot be used to compel an unwilling owner to sell, it does not raise the same tax ownership problem as a below-market option. The legislative history eliminates any doubt that Congress intended the ROFR to be an actual ROFR, as that term is understood at common law, specifically in order to leave more power in the hands of the owner and, by extension, the limited partner investors.

The balance Congress struck between promoting nonprofit involvement in LIHTC properties while respecting bedrock tax principles and avoiding tax shelters has been in place for decades. During that period investors, nonprofits and other stakeholders have relied on the distinction Congress drew between an option and a ROFR when negotiating the rights of nonprofits to purchase LIHTC properties. Indeed, LIHTC partnership agreements often give nonprofits both a unilateral option to purchase at fair market value and a ROFR to purchase at a below-market price should the owner decide to sell. 

A Washington state nonprofit that recently attempted to ignore this distinction and exercise its below-market ROFR unilaterally and without owner consent ran into trouble in the United States District Court for the Western District of Washington, where the court rejected the nonprofit’s efforts to use sham purchase offers from straw buyers to self-trigger its ROFR, and found the nonprofit to have acted in bad faith. That nonprofit was likely emboldened to act as it did by an earlier Massachusetts state court decision that upheld similar conduct by a different nonprofit based largely on what it deemed the “purpose” and “key policy goals” of the LIHTC program. The Massachusetts court, however, explicitly stated that it was not considering the implications of its decision on the functioning of the LIHTC program or the ability of investors in LIHTC partnerships with ROFR provisions to receive and use the tax credits generated by those partnerships. 

Having encountered resistance in court, nonprofits have turned to legislative avenues. On June 4, 2019, just two months after the decision in the Western District of Washington, Sen. Maria Cantwell, D-Wash., introduced a bill that seeks to override the federal court’s ruling by redefining ROFR such that, just like an option, it can be exercised unilaterally.

Section 303 is unnecessary to ensure that LIHTC projects remain affordable because whether or not a ROFR can be exercised has no effect on the rent restrictions that run with the land and bind future owners. Section 303 is likewise not needed to ensure the continued involvement of nonprofits because its ROFR is a defensive right that protects the nonprofit from being displaced from the project. As currently drafted, however, Section 303 of the AHCIA would:

  • fundamentally transform well-settled property rights in the guise of a “clarification” of existing law, even though the proposed “clarification” was considered and rejected by Congress thirty years ago;
  • contravene bedrock tax principles on which the LIHTC program is based;
  • constitute a per se taking under Takings Clause of the Fifth Amendment and raise serious due process concerns if applied retroactively; and
  • have a substantial and negative fiscal impact by transferring properties worth billions of dollars to entities that pay no taxes.

For these reasons, explained further below, enacting proposed Section 303 would have significant negative repercussions on the affordable housing industry.

Section 303 Seeks to Transform Property Rights

Under well-established common law, an option differs from a ROFR in that the former can be exercised unilaterally to force an unwilling owner to sell, while the latter can only be used defensively to block a sale to a third party. Indeed, Congress relied on this distinction decades ago when it rejected a below-market option, and instead limited the LIHTC program’s safe harbor to protect only a below-market ROFR. See Tracy A. Kaye, Sheltering Social Policy in the Tax Code: The Low-Income Housing Credit, 38 Vill. L.R. 871, 896 (1993) (explaining that, by selecting a ROFR over an option, Congress ensured that “non-profit groups [do not have] ... the power to compel an unwilling seller to sell”); see also 136 Cong. Rec. S30528 (daily ed. Oct. 18, 1990) (describing the ROFR as applying “should the owner decide to sell”). Investors have similarly relied on this distinction when negotiating agreements that include a below-market ROFR as permitted under the safe harbor, and would not have agreed to include these nonprofit purchase rights in LIHTC partnership agreements but for the shared understanding that they could only be used defensively to block a sale to a third party, and not to compel owners to sell against their will.

Section 303, however, eviscerates the very distinction on which Congress and investors previously relied. Specifically, Section 303(b)(3) provides that a below-market ROFR “may be exercised with or without the approval of the [owner]. . . .” By eliminating the key difference between a ROFR and an option–i.e., owner consent–this provision would effectively convert any below-market ROFR from a defensive, preemptive purchase right into an offensive, affirmative right to force an unwilling owner to sell. While Section 303(b) of the AHCIA misleadingly bears the heading “Clarification with Respect to Right of First Refusal and Purchase Options,” it completely redefines ROFR so that it is synonymous with an option. Indeed, as evidenced by the legislative history summarized above, the definition of ROFR that Section 303(b) attempts to “clarify” has been clearly understood by Congress and others for more than thirty years.

Even more egregiously, Section 303 would effect this transformation retroactively to 1989, so that it would apply to partnership agreements that investors entered into years before based on a completely different and well-understood definition of ROFR. Section 303(c)(2) states that the amendment redefining a ROFR as an option (i.e., Section 303(b)) “shall apply to agreements . . . entered into before, on, or after the date of the enactment of this Act.” The presumption against retroactive legislation, however, “is deeply rooted in our jurisprudence, and embodies a legal doctrine centuries older than our Republic.” Landgraf v. USI Film Prod., 511 U.S. 244, 265 (1994). “Elementary considerations of fairness dictate that individuals should have an opportunity to know what the law is and to conform their conduct accordingly; settled expectations should not be lightly disrupted.” Id. (emphasis added).

Section 303 Is Inconsistent with Bedrock Tax Principles

Section 303 not only reverses the reasoned decision Congress made three decades ago to reject a below-market option, but also ignores the fundamental tax principles that prompted the prior rejection in the first place. Under foundational tax principles on which Congress built the LIHTC program, an investor’s right to use tax credits generated by a LIHTC property is dependent on the investor’s ownership interest in the entity that owns the property. See Historic Boardwalk Hall, LLC v. C.I.R., 694, F.3d 425, 431 (3d Cir. 2012). As a result, any change in the law that could impact the ownership of the LIHTC property for tax purposes would call into question the right of investors to use the tax credits and thereby jeopardize the continuing viability of entire LIHTC program.

As currently drafted, however, Section 303 would do exactly that. Under distinct but related tax principles commonly referred to as the “economic substance” doctrine and the “substance-over-form” doctrine that apply well beyond the LIHTC context, a taxpayer will not be considered the true owner of an asset unless the taxpayer has a meaningful upside potential independent from the tax benefits the asset provides. Id. at 463 (finding investor ineligible to receive tax credits because it “lacked a meaningful stake in either the success or failure” of the partnership). By transforming what has always been a defensive ROFR into an offensive right to compel a sale at a below-market price that typically yields no sale proceeds to the owner or investor, Section 303 shifts any meaningful, tax-independent upside in the success of the project from the owner to the nonprofit holding the below-market ROFR, which could require treating the nonprofit as the true owner of the LIHTC project. See Torres v. Comm’r, 88 T.C. 702, 720 (1987) (taxpayer must possess “sufficient benefits and burdens of ownership to be considered the owner of the [property] for Federal tax purposes”). No sane investor would be willing to commit capital to a LIHTC project if the tax credits were going to flow to the nonprofit (which usually makes no investment in the projects) and not to the investor (who typically contributes millions of dollars).

Section 303, Applied Retroactively, Would Result in an Unconstitutional Taking and Raise Other Constitutional Concerns

“The Fifth Amendment’s Takings Clause prevents the Legislature (and other government actors) from depriving private persons of vested property rights except for a ‘public use’ and upon payment of ‘just compensation.’” Landgraf, 511 U.S. at 266 (quoting U.S. Const., amend. V). As revised, however, Section 303 could retroactively shift control over the ownership of existing LIHTC projects from investors to nonprofits, resulting in the effective and actual transfer of real property from one set of private parties to another without just compensation in violation of the Takings Clause.

As noted above, Section 303(c)(2) of the AHCIA provides that the amendment redefining a ROFR as an option (i.e., Section 303(b)) “shall apply to agreements . . . entered into before, on, or after the date of the enactment of this Act.” If this language is interpreted to apply Section 303’s purported “clarification” retroactively, the proposed legislation would effectively result in transfers of real property from one set of private parties to another without just compensation, which constitutes a per se taking under binding Supreme Court precedent. See, e.g., Loretto v. Teleprompter Manhattan CATV Corp., 458 U.S. 419, 427 (1982).

Section 303(c) includes a “savings” provision that, read in isolation, appears to suggest that the legislation would not disrupt existing contracts. See S. 1703, 116th Cong., 1st Sess., Title III, Section 303(c)(3). This language, however, is incompatible with Section 303(b)(2), which states unequivocally that the proposed legislative changes to the common law meaning of a ROFR are intended to apply to agreements entered into before those changes are enacted. Congress cannot have its cake and eat it too: it cannot pass legislation that redefines the universally accepted “manner of execution [and] terms” of a ROFR for contracts entered into before its enactment while simultaneously providing that it does not supersede “the manner of execution or terms” of any ROFR included in those existing agreements.

The risk that Section 303 would result in the appropriation of private property, moreover, is not simply theoretical. In 2017, a nonprofit holder of numerous contractual below-market ROFRs filed a lawsuit in federal court in Seattle seeking to compel the sale of seven properties. The nonprofit argued that that its below-market LIHTC ROFR could be exercised against the owner’s objection and in the absence of a bona fide third party offer. The court, however, rejected that position, and instead found that the nonprofit had acted with unclean hands when it solicited sham purchase offers tendered solely in order to trigger its below-market ROFR. Senior Hous. Assistance Grp. v. AMTAX Holdings 260, LLC et al., No. C17-1115 RSM, 2019 WL 1417299, at *12 (W.D. Wash. March 29, 2019). Following this ruling, the drafters of the AHCIA revised Section 303 in order to do an end-run around the court’s decision and establish a federal statutory ROFR that functions as a unilateral option to purchase the property at a below-market price.

Even where a “public use” is found to exist, the government is required under the Takings Clause to provide just compensation when it appropriates private property, and may not sidestep its obligation by disavowing–or redefining out of existence–traditional property rights long recognized under state law. Phillips v. Washington Legal Found., 524 U.S. 156, 167 (1998). Because (a) just compensation is normally measured by fair market value, and (b) Section 303 could require owners to sell LIHTC properties at prices that are indisputably below fair market value, the new legislation, if enacted, could require the government–and ultimately, the American taxpayer–to compensate owners for the difference between the below-market purchase prices and fair market value.

The retroactive language in Section 303 also raises serious due process concerns. Substantive and retroactive changes to the law are always disfavored because “if retroactive laws change the legal consequences of transactions long closed, the change can destroy the reasonable certainty and security which are the very object of property ownership.” Eastern Enterprises v. Apfel, 524 U.S. 498, 548 (1998) (Kennedy, J., concurring in part and dissenting in part). Moreover, because Section 303(b)(3) seeks to strip valuable contractual protections from thousands of LIHTC partnership agreements that were negotiated decades earlier, it would have a severe impact on the stability of investments. Id. at 548. 

As demonstrated by the comment from a consortium of nonprofit advocacy groups that Novogradac recently published on its blog, nonprofits have argued that LIHTC investors never wanted or expected to receive any upside from their investment beyond tax credits and other tax benefits, and therefore cannot legitimately argue that Section 303 would deprive them of a valuable property right. Even if this dubious claim had empirical support, however, it does not change the fact that, under the bedrock tax principles upon which Congress built the LIHTC program, an investor must have an meaningful stake in a project in order to be the legitimate recipient of the tax credits it generates.

Section 303 Would Have a Substantial Negative Fiscal Impact

Finally, the need to compensate investors for the governmental appropriation of their private property is not the only feature of the revised legislation that prevents it from being revenue neutral. In addition, by transferring LIHTC projects collectively worth hundreds of millions of dollars from taxpaying investors to tax-exempt nonprofits, the new legislation would significantly reduce tax receipts in connection with the thousands of LIHTC properties subject to below-market ROFR–one more reason why Congress should reject this flawed legislation.

Eric Pettit, Partner
Boies Schiller Flexner LLP