Five Years after HBH Decision, Historic Tax Credit Market Healthy and Growing
Five years after a landmark legal decision disrupted the historic tax credit (HTC) market, the industry has adjusted and grown–to record numbers.
An annual report that will be released this fall by Rutgers University and the National Park Service (NPS) will report the largest year-over-year increase in Part 3-certified HTC transactions since the advent of the current HTC structure in 1986. The “Annual Report on the Economic Impact of the Federal Historic Tax Credit for 2016,” which based its analysis on data provided to the NPS for each HTC transaction from Oct. 1, 2015, through Sept. 30, 2016, cites a record $1.2 billion in certified HTCs, an increase 32 percent over 2015’s totals. The Historic Tax Credit Coalition, which is a participant in drafting the report, provided the data.
There were 1,039 buildings certified through the HTC program in the 12-month period and a record $5.9 billion in qualified rehabilitation expenses. There was also a dramatic year-over-year increase in impact to the local economy (up 27 percent) and the HTC program was responsible creating 109,000 jobs, with a $6.2 billion impact on the gross domestic product.
By all measures, the HTC industry is strong. The numbers are even more impressive when you remember where the industry was five years ago this month.
On Aug. 27, 2012, the U.S. Third Circuit Court of Appeals issued its ruling in the Historic Boardwalk Hall (HBH) case, finding that the investor in New Jersey’s Historic Boardwalk Hall development lacked a meaningful stake in the success or failure of the partnership, so it wasn’t a bona fide partner and therefore not entitled to the claimed losses and tax credits.
The decision chilled the HTC market, as well as all other markets for transactions in which a developer and investor share business and tax benefits. Uncertainty after the decision led to months of slowdown in the HTC market. It also led to subsequent guidance by the Internal Revenue Service (IRS) after the Supreme Court let the lower court ruling stand.
Five years later, we celebrate a record year, which is no surprise to longtime observers. Even in the wake of the Great Recession and the Historic Boardwalk Hall case, the HTC is a proven success. Since the program debuted in 1978 (eight years before taking its current form), it has rehabilitated more than 42,000 buildings and created $131.8 billion in historic rehabilitation expenditures, according to the Rutgers report. Perhaps most significantly, it has generated $29.8 billion in federal taxes while costing the Treasury $25.2 billion in tax credits–a net gain of $4.6 billion to the federal government.
The record year for HTCs is a reminder that tax credit industries can adjust and adapt to changing circumstances–an attribute highlighted by events since the HBH decision.
Historic Boardwalk Hall
By 2012, the HTC was well established and predictable–it had been part of the Internal Revenue Code since 1978. In 1981, the federal HTC became a three-tier credit, then as part of the 1986 tax reform, it became a two-tiered credit– generally a 10 percent for nonresidential building placed in service before 1936 and a 20 percent credit for structures deemed historic by the NPS. The industry was stable and there was virtually no IRS litigation involving the HTC until 2007–when the IRS filed suit in the HBH case.
The historic Boardwalk Hall was a popular landmark in Atlantic City, N.J. The New Jersey Sports and Exposition Authority renovated the property in the early 2000s, using equity from federal HTCs to help with financing. It partnered with Pitney Bowes Corporation, through its subsidiaries, and Pitney Bowes received the tax credits.
The IRS insisted that Pitney Bowes had no stake in whether the development succeeded–that it invested in the credits solely for a tax break. The case went to the Tax Court, which ruled in favor of the taxpayer in January 2011. The IRS appealed to the Third Circuit, which overturned the verdict 18 months later.
The decision was a surprise to some in the HTC world. There had long been questions about how significant an economic role the investor needed to play, but few people in the HTC world were prepared for the decision by the Third Circuit Court. It sent shockwaves and the decision was appealed to the Supreme Court. The pace of development slowed, waiting for a final verdict.
Nine months later, May 28, 2013, the Supreme Court delivered a decision: The court refused to hear the case, leaving the Third Circuit Court case standing.
The Supreme Court’s choice had a chilling effect on HTC investment.
Initially, there was fear that the IRS might audit properties with completed investments. Subsequently, there was some confusion about how to structure future transactions. Developers and investors began examining transactions in the process of closing, seeking ways to assure their success. Historic preservation activity came largely to a stop while issues were hashed out. Help was needed, so many industry leaders–notably the Historic Tax Credit Coalition–asked the IRS to issue guidance to navigate the suddenly choppy waters. Meanwhile, the HTC market began slowing ramping back up, with developers and investors approaching transactions cautiously.
Rev. Proc. 2014-12, Section 50(d) Income
For most of 2013 and nearly all of 2014, speculation and rumors swirled about looming IRS guidance. After some starts and stops, the IRS in late 2014 issued Revenue Procedure 2014-12, which created a safe harbor for investors. The revenue procedure required that the developer must have a minimum of a 1 percent interest in each material item of partnership income, loss, deduction and credit; while the investor needed a minimum interest of 5 percent in those items.
The emphasis of the guidance was to ensure that the economic value of the investor’s interest wasn’t to be reduced through fees, lease terms or other agreements that are unusual in transactions that don’t qualify for the HTC and that the investor had an economic risk as a result of its investment.
Though the guidance addressed many of the structuring questions that resulted from the HBH decision, one problem remained: The guidance didn’t address Section 50(d) income–the income inclusion rules that apply to a lessee of a property when the lessor elects to treat the lessee as having acquired the property. That led to some continuing uncertainties for HTC participants.
Again, guidance was sought and promised–this time to clarify Section 50(d) income rules.
Finally, in July 2016, the IRS issued temporary regulations on 50(d) income, which basically settled this issue for the industry. In broadest terms, the IRS ruled that 50(d) income is a partner item, not a partnership item; that the income is recognized by the partners of the lessee in proportion to how they claimed the tax credits; and that partners are not entitled to increase their bases in their partnership interest as a result of Section 50(d) income inclusion.
Things were finally clear.
Lessons of HBH
In the years following the HBH decision, the HTC industry continued to grow as investors and developers found structures that worked, even while waiting on the IRS guidance. Renovations continued. Investment increased. Then 2016 happened and records were set.
The half-decade since the HBH verdict is instructive, providing broader lessons, even to those in other tax credit communities–particularly regarding activism and adaptability:
- The months following the Supreme Court’s decision to let the lower-court ruling stand revealed the importance of activism to get clarity on issues. Each year, the IRS seeks input for its priority guidance plan and the push for the IRS to consider and issue guidance that turned into Rev. Proc. 2014-12 and the Section 50(d) guidance came after HTC advocates sought it. Next year’s deadline to suggest guidance will presumably be June 1, so consider being part of a group that makes suggestions to the IRS about what the agency should address in 2018-2019.
- The ability to react and respond to the HBH ruling, as well as the subsequent IRS guidance, also showed that the HTC world–as well as those for other tax credits–is smart and adaptable. Historic preservation is desirable, the investments are sound and members of the HTC community navigated their way through changes.
The Historic Boardwalk Hall decision slowed the HTC community for a bit, but didn’t stop it. The results of the Rutgers report show that the industry is healthy and thriving. And setting records.
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