Historic Tax Credits and Tax-Exempt Lessee Considerations

Published by David Graff, CPA on Wednesday, December 6, 2017

Question: When structuring a historic tax credit (HTC) transaction, what considerations should be taken into account when a lessee is a tax-exempt entity?

Answer: Structuring a lease with a tax-exempt entity in an HTC transaction requires additional due diligence, as there can be a significant impact on the amount of HTCs that can be claimed. The most important concern is whether or not the leased property is considered “tax-exempt use property.” This is a multistep process and involves determining whether the lease is deemed a disqualified lease under Internal Revenue Code (IRC) Section 168(h)(1)(B)(ii). The specific details of the lease related to these matters should be carefully reviewed and addressed by the appropriate parties before closing the transaction in order to accurately determine how much of the property’s rehabilitation costs qualify to be included in the calculation of HTCs. 

As noted above, the primary concern is determining if any part of the property is deemed to be tax-exempt use property. If any expenditure is deemed to be tax-exempt use property, that expenditure is excluded in calculating qualified rehabilitation expenditures (QREs) and, therefore, also from the HTC basis. There are, however, two exceptions to this rule provided in IRC Sections 168(h)(1)(C) and (D) which include

  1. if the lease is short-term and
  2. if the property will be used in an unrelated trade or business, the income of which is subject to income tax. 

Assuming neither of the above exceptions apply, the next consideration revolves around whether the lease would be considered a disqualified lease. Generally, nonresidential real or residential rental property leased to a tax-exempt entity in which the lease is considered disqualified is deemed to be tax-exempt use property. The exception under IRC Section 168(h)(1)(B)(iii) provides that unless the portion of such property leased to a tax-exempt entity exceeds 50 percent of the property’s net rentable floor space (excluding common areas), the eligibility of the QREs is not conceded and can be included in the HTC basis. For purposes of this exception and calculating whether 50 percent has been exceeded, it is important to make sure the cumulative square footage of all leases to tax-exempt entities in the building are included.

A “disqualified lease” is defined in IRC Section 168(h)(1)(B)(ii) as a lease to a tax-exempt entity where: 

  1. Part or all of the property was financed directly or indirectly by an obligation in which the interest is tax-exempt under IRC Section 103(a) and such entity (or related entity) participated in the financing, or
  2. Under the lease there is a fixed or determinable purchase price or an option to buy, or 
  3. The lease term is in excess of 20 years or 
  4. The lease occurs after a sale or lease of the property and the lessee used the property before the sale or lease. 

Although Rule 3 above may appear to be fairly straightforward, there are situations which could result in a disqualified lease. Pursuant to IRC Section 168(i)(3)(A)(iii), “successive leases that are part of the same transaction or a series of related transactions concerning the same or substantially similar property shall be treated as one lease. This rule applies if at substantially the same time or as part of one arrangement the parties enter into multiple leases covering the same or substantially similar property, each having a different term. If so, then the original lease term will be treated as running through the term of the lease that has the last expiration date of the multiple leases.”

Treasury Regulations also provide that the term of the lease includes all periods for which the tax-exempt lessee (or related party) has a legally enforceable option to renew the lease, or the lessor has a legally enforceable option to induce its renewal by the tax-exempt entity (or a related party), unless the option to renew is at fair-market value which is to be determined at time of renewal. In other words, the lessor can renew the original lease for a period of less than 20 years, as long as the new lease is priced at fair market value. An example of this can be found in the IRS’s Market Segment Specialization Program- Rehabilitation Tax Credit Guide and is as follows:

A taxpayer rehabilitates an historic structure and leases the building to a foreign owned corporation. The lease agreement contains a provision where the lease term is equal to 15 years with a legally enforceable option to renew the lease for an additional 10 years at a fixed, non-negotiable price. Since the lease term is in excess of 20 years, the agreement creates a disqualified lease. If, in this example, the lease agreement contained a 15-year option to renew at the fair market value that will be determined at the time of renewal, the agreement would not result in a disqualified lease.

There are other factors to consider in regard to lease term length and the discussion above is certainly not all inclusive. As each HTC transaction involving a tax-exempt entity is different, all the facts and circumstances of each lease needs to be considered when determining whether QREs incurred by the project can be included in the HTC basis, and thus, generate HTCs. Working closely with your tax advisor and counsel is imperative in understanding the complex rules and what lease structuring options are available to mitigate the potential risk of lost HTCs.