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COVID-19 Pandemic Causes Delays, Challenges for Syndicated HTC Developments
Business and industries across the economic spectrum have been impacted by the onslaught of COVID-19. The historic tax credit (HTC) world is no exception.
In development, time is money and construction delays–regardless of the cause–are costly. While all 50 states temporarily ordered closure of non-essential businesses, states and municipalities vary widely in their treatment of construction. In some areas, all construction is treated as essential and disruptions are relatively minor, limited to delays in material delivery and staggered work schedules implemented to maintain social-distancing protocols. Other areas adopted stricter restrictions on construction, allowing only emergency repairs. In yet other areas, exceptions to a general shutdown policy have been made for work on roads, bridges, transit facilities, utilities, hospitals or health care facilities, affordable housing, and homeless shelters.
Construction delays, as well as COVID-19-related legislation, are expected to have significant effects on syndicated HTC projects. Here are some of the more significant impacts.
Effect of Delays on the Ability of Developments to Meet the Substantial Rehabilitation Requirement
A building is treated as having been substantially rehabilitated–a requirement for HTC eligibility–only if the qualified rehabilitation expenditures during the 24-month period selected by the taxpayer (60 months for phased developments meeting certain requirements) and ending with or within the taxable year, exceed the greater of the adjusted basis of such building (and its structural components), or $5,000. Construction delays caused by coronavirus disruptions may cause some projects to fail this requirement. Additionally, nonphased developments intended to qualify for one-year credits under the transition rule provided in P.L.115-97 must satisfy the 24-month substantial rehabilitation requirement by June 20, 2020, and the development must be placed in service by Dec. 31, 2020. COVID-19-related delays will likely cause a number of developments to fail these requirements.
Qualified Improvement Property
The Coronavirus Aid, Relief and Economic Security (CARES) Act provided a much-awaited technical correction for the recovery period of qualified improvement property (QIP). QIP is defined as any improvement to an interior portion of a building that is nonresidential real property, if such improvement is placed in service after the date the building was first placed in service. QIP specifically excludes expenditures attributable to the enlargement of the building, any elevator or escalator or the internal structural framework of the building. The passage of the CARES Act corrected the drafting error made in P.L. 115-97, which was intended to change the recovery period of QIP from 39 years to 15 years. This change also made QIP eligible for immediate expensing through 2022.
Because a significant percentage of QREs incurred in connection with the rehabilitation of nonresidential real property is typically QIP, this change will result in tax costs and benefits being materially different from forecast. Because most syndicated HTC transactions include a flip down of the investor’s ownership percentage after the compliance period, these timing changes may, depending on the project structure, also cause the planned allocation of such costs and benefits between investor and developer to be materially altered. Affected developments should update projections to identify, quantify and plan for such impacts. In some cases, the investor and developer may wish to amend certain project agreements to mitigate the unforeseen results of this change.
In order for QIP costs to qualify as QREs, the development owner must affirmatively elect out of bonus depreciation with respect to this property class for the placed-in-service year. In addition, the change to QIP will also increase the annual IRC Section 50(d) income recognition requirement for investors in lease pass-through transaction structures, triggering unanticipated tax equivalency payment requirements to investors. Because this recent change is retroactive to 2018, development owners must consider whether to amend any relevant tax returns and understand all of the tax and business implications of making that decision as well. Choosing to amend, if applicable, can have a significant impact on the transaction, not only for the developer but for the investor as well. In addition, changing the depreciable life of QIP should be discussed with the tax credit investor because it will have an impact on their annual income recognition under IRC Section 50(d).
Equity Pricing Adjustments
COVID-19 will almost certainly delay many properties from achieving a timely completion as originally anticipated. Such delays will most likely have an effect on the total tax credit investor equity to be funded into a project. For developments that fail to be placed in service within a specific tax year originally negotiated with the tax credit investor or for projects original anticipated to satisfy the HTC transition rule, as previously discussed, such delays will generally trigger downward equity pay-in adjustments, resulting in the developer having to provide additional capital to cover such shortfall.
Timing of Equity Installments
Typically, tax credit investors contribute capital into HTC developments in installments based on the achievement by the developer of certain milestones and the satisfaction of certain conditions, such as construction completion, achieving operating “stabilization,” conversion of construction financing to permanent financing and receipt of National Park Service Part 3 approval. Each of these benchmark dates will be affected by the general construction slowdown for developments.
Additionally, if the broader economy remains in a downturn for more than a short time, properties, particularly those in asset classes such as hospitality and retail, are likely to struggle to achieve lease-up and thus achieving a stabilized occupancy benchmark. Consequent delays in the receipt of investor capital will increase project costs as tax credit bridge debt remains outstanding longer than originally anticipated.
These are challenging times but it is important to keep HTC developments on the path towards completion. The economic impact of these projects to cities, both large and small, is significant but developers will face many challenges ahead in order to bring these projects to fruition.
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