Congress Considering Retroactive Changes Affecting Low-Income Housing Tax Credit Property Owners, Part I

Published by Dirk Wallace, Michael Novogradac on Wednesday, July 24, 2019 - 12:00am

Two bills recently introduced in Congress would retroactively alter rights of existing owners of low-income housing tax credit (LIHTC) properties: One bill changes the terms of rights of first refusal (ROFR) and the other alters qualified contract exit price calculation. Part I of this blog post reviews rights of first refusal. Part II will address qualified contracts.

Rights of First Refusal

Under current law, Section 42(i)(7)(A) specifies that “No [federal] income tax benefit shall fail to be allowable to the taxpayer with respect to any qualified low-income building merely by reason of a right of 1st refusal held by … a qualified nonprofit organization …. after the close of the [15-year] compliance period for a price which is not less than the minimum purchase price ….” The minimum purchase price is generally the outstanding debt on the property, plus all tax liability arising on the sale.

The Section 42(i)(7) right of first refusal was enacted in 1989 after a task force convened by Sens. George J. Mitchell, D-Maine, and John C. Danforth, R-Mo., recommended that the safe harbor allow for non-profits to hold a below-market purchase option. Following the task force recommendation, Mitchell and Danforth sponsored a bill in Congress in 1989 (S.980) that would have provided that “the determination of whether any qualified low-income building is owned by the taxpayer shall be made without regard to any option by a qualified nonprofit organization (as defined in subsection (h)(5)(C)) to acquire such building at less than fair market value after the close of the compliance period.”

However, Congress chose not to allow an option, and instead elected to pass a provision that permitted only a below-market right of first refusal. As noted in “Sheltering Social Policy in the Tax Code: The Low-Income Housing Credit,” by expert observer Tracy Kaye, “Congress would not accept … [an option] because of the tax policy concern that use of such options removed any reasonable expectations that investors would derive a profit independent of tax benefits.” Kaye also wrote that a  “right of first refusal is distinguishable from an option, in that an option allows a holder to compel the sale of property.” In this way, Section 42(i)(7) was consistent with historical tax policy that requires transactions to have economic substance beyond solely tax benefits. (Note, this requirement can be distinguished from a profit motive, which can include both tax and non-tax benefits.)

Within the last few years, disputes have arisen between nonprofit general partners holding ROFRs and investor limited partners as to whether the two core requirements of a right of first refusal have been met: a bona fide offer, and a willingness on the part of the owner to sell. The second requirement, assent of the owner to a sale, generally mirrors an assent right the limited partner holds under many partnership agreements.  

On June 15, 2018, in Homeowner’s Rehab, Inc. v. Related Corporate V SLP. LP (479 Mass. 741 (2018)), the Supreme Court of Massachusetts found that a nonprofit general partner appropriately exercised its ROFR even though not all common law ROFR requirements were satisfied.

In reaching this holding, the court gave significant weight to public policy considerations and Congressional intent. For instance, the court noted, “To condition the right of first refusal on a bona fide offer, then, would mean that it would almost never be triggered. We decline to interpret the agreements in a way that would so obviously contravene the purpose of § 42(i)(7).”

The court further stated “Where the agreement was intended to operate ‘in accordance with’ § 42(i)(7), we must interpret its provisions consistently with Congressional intent, and Congress intended for nonprofit organizations to exercise their right of first refusal only when ‘the owner decide[s] to sell.’"

The court then concluded, “Examining the language of the agreements in their statutory and practical context, we conclude that the general partner is authorized to trigger the nonprofit developer's right of first refusal by soliciting an enforceable offer from a third party …. In reaching this conclusion, we emphasize that we are only interpreting the language of the agreements that the parties executed here. We are not declaring that every partnership participating in the LIHTC program must permit a right of first refusal that can be exercised under these circumstances.”

By contrast, on March 29, 2019 the federal court in the Western District of Washington found in Senior Hous. Assistance Grp. v. AMTAX Holdings 260, LLC (Case No. C17-1115 RSM (W.D. Wash. Feb. 19, 2019) that a right of first refusal is a legal term of art and is triggered only if the owner receives a “bona fide offer from a third party, acceptable to the property owner.” The court held that the requirements of the ROFR were not met because the offers in question were “not made in good faith” and were instead “sham offer[s]” and because the property owner “never formed or expressed a willingness to accept” them.

On June 4, the Senate and House introduced companion legislation: the Affordable Housing Credit Improvement Act of 2019 (AHCIA, or S. 1703 in the Senate and H.R. 3077 in the House). The AHCIA is a reintroduction of legislation introduced in 2017 (S. 548), with material modifications, some of which were outlined in a previous Novogradac post. These bills, if enacted as introduced, would change the requirements of nonprofit general partners’ ROFR contained in IRC Section 42(i)(7). (For ease of reading, “nonprofit general partner” is used throughout this discussion to indicate, collectively, tenants, a building’s resident management corporation, certain low-income and/or senior housing nonprofit organizations, or government agencies.)

2019 AHCIA versus its 2017 predecessor

Prospective change – 303(a)

Both the 2019 AHCIA and its 2017 predecessor would change IRC Section 42(i)(7) on a prospective basis such that a nonprofit general partner has a below-market option to purchase property rather than merely a ROFR. Both would expand this option to both the property and partnership interests relating to the property. These changes are proposed to be prospective, such that they apply to agreements entered into after the enactment of the legislation.

Retroactive change – 303(b)

Unlike its 2017 predecessor, the 2019 AHCIA further provides, on a retroactive basis (as a “clarification” going back to the original date of enactment in 1989), several changes, including:

  • A nonprofit general partner’s option or right of first refusal may be exercised without the consent of any other partners; and
  • A nonprofit general partner’s option or right of first refusal may be exercised in response to a purchase offer by a related party; and
  • “Property” may include any assets “held for the development, operation, or maintenance of a building.”

These provisions would eliminate the core requirements of a right of first refusal (offer and assent) that Congress considered in 1989. The result, in substance, is converting the ROFR to an option.

Section 303(c)(2) states that the amendments made in Section 303(b) shall apply to agreements among the owners of the project entered into before, on, or after the date of the enactment of the act. However Section 303(c)(3) provides that the entire amendment shall not supersede agreements among the parties. The reference to the paramountcy of agreements among parties has caused considerable confusion among stakeholders as to the effect of Section 303(c)(3). Does Section 303(c)(3) mean

  • no existing ROFR agreements would be affected by the amendments, or
  • certain aspects of existing ROFR agreements are unaffected by the amendments?

And if the latter, will future court decisions be needed to interpret which aspects are affected and which aren’t? Or is Section 303(c)(3) wholly ineffective in limiting the retroactivity of Section 303(c)(2).

Effect of a retroactive change to current tax credit investors

Given the ease with which a nonprofit general partner may be able to effect a below-market purchase under the proposed legislation, some have questioned who the true owner of a LIHTC property is, and whether a valid partnership exists. If a partnership is not the true owner, or a partnership doesn’t exist, LIHTCs would not pass to investor partners.

Given the proposal to change Section 42(i)(7) to provide that “No [federal] income tax benefit shall fail to be allowable to the taxpayer with respect to any qualified low-income building merely by reason of an option held by … a qualified nonprofit organization … to purchase the property,” The bills appear to be attempting to exclude certain aspects of transactions from the requirements of existing tax policy. (If the ROFR provision moves in Congress, it will be interesting to see if the Joint Committee on Taxation and/or the Department of Treasury express tax policy concerns similar to the ones expressed in 1989.) However, this language may not be clear enough to support the existence of a LIHTC partnership through which LIHTCs, or other tax benefits, can pass to investors. There is also further concern that even if federal tax benefits are preserved, state tax benefits could be lost, including state tax credits.

In addition, there is concern that this revision to the Code disrupts the expectations of contracting parties from potentially decades earlier, especially in light of the clear legislative history from the time of the original enactment of Section 42(i)(7).

Ability of Congress to make retroactive tax changes

Finally, there is also a broader question as the ability of Congress to make retroactive tax law changes. Based on U.S. Supreme Court precedent, the legislation has the potential to violate the due process clause and the takings clause of the U.S. Constitution because it directly affects contractual and property rights by seeking

  1. to redefine a right of first refusal in a way that converts it into a new below-market option, and
  2. to modify agreements entered into before, on, or after the date of the enactment of the legislation (see Landgraf v. USI Film Prods., 511 U.S. 244 (1994) and U.S. Trust Co. of N.Y. v. New Jersey, 431 U.S. 1 (1977)) , it has the potential to violate the due process clause and the takings clause of the U.S. Constitution.  

In addition, due to the confusion resulting from the direct conflict between 303(c)(2) and 303(c)(3), the legislation does not appear to provide clear Congressional intent for retroactive application, which also raises constitutional concerns.    

Modifications to language may develop to the extent all or parts of the 2019 AHCIA proceed through the House Ways and Means Committee and the Senate Committee on Finance. Novogradac will continue to monitor for updates and will post new information as it is available.