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History and the Hill: HTC Industry Reacts Positively to IRS Revenue Procedure

Published by John Leith-Tetrault on Saturday, February 1, 2014

Journal cover February 2014   Download PDF

On Dec. 30, 2013, the Internal Revenue Service (IRS) gave the historic tax credit (HTC) industry something to celebrate the New Year: Revenue Procedure (Rev. Proc.) 2014-12. Two amendments to Rev. Proc. 2014-12 were subsequently published on Jan. 8. The issuance of Rev. Proc. 2014-12 was the product of a transparent consultation process between IRS and Treasury officials and representatives of the Historic Tax Credit Coalition (HTCC) and others in the HTC industry. The dialogue included several face-to-face meetings, numerous conference calls and an IRS review of draft procedure suggestions and examples from the law firms who make up the HTCC’s IRS guidance committee.

Patrick Robertson, lobbyist for the HTCC, said, “The IRS and Treasury were tremendous partners in this process. They listened to input from the industry, engaged in a dialog and responded in a timely manner to the issues that had eroded investor confidence in the HTC. While most observers thought guidance could take 18 months to two years, the commitment of our government partners meant this guidance was issued in less than nine months.”

The purpose of Rev. Proc. 2014-12 was to address questions left unanswered by the August 2012 U.S. Court of Appeals for the 3rd Circuit decision in Historic Boardwalk Hall v. Commissioner (HBH) where the Appeals Court held that an HTC investor, Pitney Bowes, was not a partner because it did not share in either the upside potential or downside risks of a partnership formed to rehabilitate Historic Boardwalk Hall in Atlantic City. Following an uptick in related IRS audits, investors largely withdrew from the market last spring because it became unclear what investor guarantees were permissible, and how much variable upside was needed for the IRS to respect an investor’s partner status.

While industry lawyers continue to parse every word of the guidance, there is early consensus from developers, investors, accountants and law firms that the consultative process worked well and produced a revenue procedure that should restore the flow of capital to historic properties. Rev. Proc. 2014-12 is the first significance guidance issued by the IRS about the HTC in the 37-year history of federal incentives for historic preservation.

Related articles by Tom Boccia of Novogradac and Company and Forrest Milder of Nixon Peabody elsewhere in this issue focus on an analysis of the legal and accounting provisions of Rev. Proc. 2014-12. A PDF of Rev. Proc. 2014-12 and a memo prepared by the HTCC’s IRS guidance committee that interprets the guidance can be found at www.historictaxcredits.com. This memo reflects conversations between HTCC tax attorneys and the IRS/Treasury immediately following the release of the guidance, and it specifically addresses some of the gray areas of the Rev. Proc. 2014-12. Highlights of Rev. Proc. 2014-12 include the following:

  • The principals (developer affiliate) must have a minimum partnership interest of 1 percent.
  • Investors must have a minimum interest in each material item of partnership income, gain, loss, deduction and credit equal to at least 5 percent at all times that it owns an interest in the partnership. This 5 percent minimum investor interest allows for a “partnership flip” from 99-1 percent to 5-95 percent after the expiration of the 5-year compliance period.
  • Principals and partnerships may no longer have a right to call an investor’s interest. Rev. Proc. 2014-12 allows investors to have a put as long as the put is at or below fair market value.
  • The value of an investor’s interest may not be reduced by fees, lease terms or other arrangements that are materially different from practices on non-Section 47 transactions.
  • The investor’s partnership interest must constitute a “bona fide equity interest” with a reasonably anticipated value commensurate with the investor’s overall percentage interest in the partnership exclusive of tax benefits.
  • Investors must contribute a minimum unconditional equity contribution of 20 percent prior to placement in service.
  • At least 75 percent of the expected pay-ins must be “fixed” in amount.
  • Investor guarantees may include developer performance of acts necessary to claim the credits, construction completion, operating deficits, environmental and financial covenants. These guarantees must be unfunded with the exception of operating deficit reserves that may be funded up to a maximum of 12 months of operating expenses including debt service. No party in the partnership may guaranty recapture or disallowance.

History and the Hill has interviewed a wide variety of HTC industry participants to gauge their reactions to Rev. Proc. 2014-12. Their comments about the impact of Rev. Proc. 2014-12 on the future of the HTC follow.

Investor Reactions
HTC investors interviewed shortly after the issuance of Rev. Proc. 2014-12 were generally positive, stating that the guidance was very helpful in resolving the uncertainties left by the HBH decision. Several expressed the view that, after further internal review and discussions with outside counsel, they believed they would come back into the market.

Matt Philpott of U.S. Bank said, “U.S. Bank is pleased that Treasury has provided safe harbor guidance for HTC transactions. Last year we experienced significant uncertainty in the industry, and we believe that the guidance will be useful in getting this important tax credit back into the service of helping fill financing gaps in historic property rehabilitation. The clarity to certain features under the safe harbor is helpful and appreciated. We do expect to work with the guidance immediately as applicable in our tax credit equity investments.”

Developer Feedback
Steven Stogel of DFC Group in St. Louis was upbeat about the guidance. “This is a very developer friendly procedure,” Stogel said. “It accelerates pay-in schedules, eliminates or reduces some of the guarantees developers previously provided to investors, limits downward adjusters to 25 percent of equity pay-ins and provides an affordable exit strategy in the form of a partnership flip. These provisions should encourage developers to do HTC transactions. My hope is that investors will accept the additional downside risks in exchange for added participation on the upside of these transactions.”

Larry Curtis of Winn Development in Boston said his firm is still reviewing the guidance but, at first read said, “It will create more certainty and should facilitate transactions in the future.”

Law Firm Interpretations
Attorneys have also been busy reviewing Rev. Proc. 2014-12. Bill Machen at Holland & Knight said he believes Rev. Proc. 2014-12 represents a good faith attempt by the Treasury and the IRS to provide a workable set of guidelines that will help to jump start the HTC equity markets. “The very quick action to correct a couple of technical concerns raised by practitioners shows that comments from the industry have not fallen on deaf ears,” he said. “One provision that initially raised questions in the minds of some practitioners is the requirement that the investor’s interest must have “a reasonably anticipated value commensurate with the investor’s overall percentage interest in the partnership, separate from any federal, state, and local tax deductions, allowances, credits, and other tax attributes to be allocated by the partnership to the investor.” Discussions with Treasury officials have confirmed that was intended to mean that the investor’s share of whatever future cash distributions are generated must be consistent with its overall percentage interest in the partnership, undiluted by any unreasonable fees or lease terms. There still is some question as to how to determine the “overall” percentage interest of the investor.”

He continued, “The critical inquiry, and the greatest area of concern to investors, becomes how to determine whether fees and lease terms are unreasonable. The Rev. Proc. requires that fees and lease terms must be comparable to those in projects that do not generate historic tax credits. This may be difficult to do in some situations because of a lack of comparables. It would appear that investors will need to rely on qualified third-party appraisers and other experts for this purpose.”

Machen also noted the number of limitations on guarantees and other protections provided by a “person involved in any part of the rehabilitation transaction.” He said, “This is an extremely broad definition that is not defined. Similarly, and not surprisingly, the Rev. Proc. provides that the investor’s return cannot be ‘substantially’ fixed in nature and that the investor cannot be ‘substantially’ protected against losses from the partnership’s activities. Practitioners will be left to use their own judgment in determining when this ‘substantiality’ threshold is reached.”

Another area of concern Machen highlighted is the effect of Rev. Proc. 2014-12 on the prohibition on “funded” guarantees. “While prohibiting guarantees secured by a cash escrow or guaranteed investment contract of the type used in the Historic Boardwalk decision makes sense, the term ‘funded guarantee’ also includes guarantees containing minimum net worth maintenance covenants,” he said. “Such provisions are common in virtually all commercial guarantees. It remains to be seen how investors will react to this provision.”

Machen said that additional guidance also would be helpful on how to apply the minimum 20 percent investment and 75 percent fixed contribution provisions to large phased projects, many of which contain multiple buildings that are placed in service over a period of several years. “Read literally, the Rev. Proc. would appear to require that the investor contribute 20 percent of the total anticipated equity for the whole project before the initial improvements are placed in service,” Machen said. “Since the Rev. Proc. generally refers to credits relating to a ‘Building,’ one question is whether the minimum unconditional investment requirement could be applied on a building by building basis. There undoubtedly will be other questions that come up as investors, developers and their counsel attempt to implement the terms of the Rev. Proc. in structuring actual transactions. Hopefully, the Treasury and the IRS will continue to be responsive to such questions. Recent history suggests that this will be the case.”

Accounting Firm Responses
In addition to the accountant’s perspective provided by Tom Boccia on page 71. Joel Cohn, a partner at CohnReznick weighed in. “We are very pleased that the ruling was released and are getting encouraging messages from investors that they will be back in the market soon. Historic developers are excited to have the liquidity return and to have a functioning tax equity market,” he said. “Developers are quite relieved that the ruling was released. Developers try to de-risk as many elements of a project as possible, yet they are somewhat disappointed that [Rev. Proc. 2014-12] doesn’t have all of the answers, such as clearer guidance on reasonable fees or lease payments.”

Cohn reports that developers have been most positive that Rev. Proc. 2014-12 takes away some of the caution that previously existed about various elements of deals. “For example, we know that we can now have flips and that we don’t have to prove profit motive, both of which favor developers,” he said. “Also, puts can be at less than fair market value. Right now, developers are anxiously waiting for investors to reveal their new deal terms to really understand the impact of the guidance.”

When speaking with its developer clients, Cohn said most of the focus of the conversations, as it has always been, is about the structure of the investor’s sale right. “Developers have to remember that this option is for the investor to exercise, and not a transaction which the developer controls,” he said.

Impact of Effective Yield Accounting Prospects for the HTC
As reported in last month’s edition of History and the Hill, future discussion with the Financial Accounting Standards Board’s Emerging Issues Task Force about the application of Effective Yield Accounting/Proportional Amortization Method to the HTC would be shaped by Rev. Proc. 2014-12. Bentley Stanton, a partner in Novogradac & Company’s Atlanta, Ga. office, reviewed Rev. Proc. 2014-12 to see how it would affect the eligibility of HTCs for the new accounting treatment recently approved for the low-income housing tax credit. “If the EITF considers the new accounting standards on the Proportional Amortization Method in 2014 for historic tax credits, the impact of the changes in Rev. Proc. 2014-12 could provide investors an easier path to net the amortization of their investment in the tax provision,” Stanton said. “The changes under Rev. Proc. 2014-12 could reduce the burden that ‘substantially all’ of the projected benefits are from tax credits and other tax benefits. With investor returns subject to operating results as a result of market conditions and not the result of a guaranteed cash payment or return, historic tax credit investments could more easily qualify to meet the accounting conditions. This is not to say that every historic tax credit transaction would qualify if the conditions are approved for historic tax credit investments, but you could see a significant increase in the number of qualifying investments based on the anticipated changes to the entity and cash flow provisions.”

Impact on Nonprofit-Sponsored Transactions
Brian Wishneff of Wishneff and Associates, which specializes in helping nonprofit sponsors access the HTC, said the IRS guidance provided both opportunities and challenges for projects such as theaters, health centers and other community benefit projects. He noted that the lack of a minimum cash requirement for the investor’s returns helps these transactions which typically do not generate a lot of cash flow. He was most positive about the affordable exit allowed under a partnership flip exit scenario which will help nonprofits manage these costs. He stated however, that Rev. Proc. 2014-12 did nothing to clarify the tax-exempt use property provisions currently included in Section 168 of the IRC. “Those of us in this nonprofit HTC submarket also need more clarity on when a third party must mandate the master tenant sublease,” he said. “Nonprofit boards are rightly concerned about the quality of property operations after placement in service and will want to know more about what will be permissible.”

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