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History and the Hill: Twinning Historic and New Markets Credits Presents Challenges Under the HTC Revenue Procedure

Published by John Leith-Tetrault on Tuesday, April 1, 2014

Journal cover April 2014   Download PDF

It’s the law of unintended consequences. Interventions in complex systems tend to have outcomes contrary to their original intent. The widely applauded historic tax credit (HTC) Revenue Procedure 2014-12, as carefully drafted as it was, has one unintended consequence that has HTC industry lawyers hotly debating solutions: how to best structure a twinned HTC and new markets tax credit (NMTC) transaction to meet the new guidance.

In particular, two provisions of the Revenue Procedure’s guidance are discouraging investors from twinning HTCs and NMTCs. First, Section 4.01 provides that an HTC investor holding an interest in the master tenant partnership may not also hold a direct or indirect investment in the developer partnership (e.g., a NMTC investment) unless such investment is a separately negotiated and distinct economic arrangement from the HTC investment. Second, Section 4.05(c) generally prohibits the developer partnership, master tenant partnership or the affiliates of either from lending the HTC/NMTC investor funds used to acquire an interest in the partnership. Both are discussed below.

The concept of combining HTC/NMTC originated when interim regulations for the NMTC program stated that the Internal Revenue Service (IRS) would rule later on what other federal tax incentives could be combined with the NMTC. In response to a letter from the National Trust for Historic Preservation and other industry comments, in 2002 the IRS ruled in Notice 2002-64 that the HTC could be twinned with the NMTC on projects that are both commercial and located in qualified low-income census tracts.

Community development entities (CDEs) rolled out this financing product in round one of the NMTC program and, based on a survey of CDEs in rounds one through four, twinned transactions accounted for 10 percent of all NMTC transactions and 20 percent of the volume. The compatibility of these two credits is due to the fact that 77 percent of HTC projects are located in qualified NMTC census tracts and 51 percent are commercial in nature. While the Government Accountability Office (GAO) and some members of Congress have been critical of this kind of layered financing, it is clear that the HTC is needed to pay for the higher costs associated with rehabilitating historic buildings. These extra dollars preserve historic exterior and interior features that make these largely vacant and blighted buildings a destination and give them an edge in unproven markets.

Applicable HTC Revenue Procedure Sections
Section 4.05(c) provides that “a Developer Partnership, Master Tenant Partnership or the Principal of a Developer Partnership or Master Tenant Partnership may not lend any Investor the funds to acquire any part of its interests in the Partnership.” Industry lawyers worry that if developer equity is one of the sources of a leverage loan in an HTC/NMTC transaction where there is a single HTC/NMTC investor and the master tenant partnership is within the NMTC structure, the leverage loan might be deemed a loan to the investor to help acquire its interest in the master tenant partnership or the developer partnership. In this commonly used leverage NMTC/HTC structure, the investor owns 100 percent of the investment entity and through it, 99.99 percent of the subsidiary CDE (subCDE). The subCDE owns 100 percent of the master tenant partnership. On this issue, Jerry Breed, a partner with Bryan Cave LLP, said, “There is no way to directly trace those sponsor leverage dollars through a subCDE structure like this as separate and distinct from the HTC equity so we can’t draft an opinion that says the project meets the safe harbor with regard to Section 4.05(c).”

The urgent question that needs to be answered is how to restructure HTC/NMTC investments that were in the closing process when the Revenue Procedure was issued. Many had been held up waiting for the issuance of the Revenue Procedure, and will need to close before the IRS can provide additional guidance on these issues. The transaction diagram below illustrates one recommended structure for twinning HTCs and NMTCs within the guidelines of the Revenue Procedure safe harbor.

Workable Solutions Until Further Guidance
The transaction diagram reflects a preference for separating the HTC and NMTC investments using two investors. This solution as well as a structure where one investor takes both credits were discussed with Breed and Scott DeMartino, also of Bryan Cave LLP, and are summarized below.

  • Separate NMTC and HTC Investors. This approach does away with both concerns that the HTC/NMTC investor is receiving a loan from the principal to help finance the acquisition of its interest in the partnership and that it has an ownership interest in the QALICB other than the indirect interest it owns through the master tenant partnership. Further, if the master tenant partnership is outside of the NMTC structure, as shown in the diagram on page 66, the NMTC and the HTC investments are then likely to be viewed as separate and distinct economic arrangements.
  • Single Investor Takes Both Credits. This approach would require removal of developer equity as a source of the leverage loan and investing 100 percent of the HTC and NMTC equity proceeds through the investment fund, to one subCDE. The subCDE will then invest 100 percent of the aggregate tax credit equity through its 100 percent owned master tenant partnership, into the developer partnership. Removal of developer equity as a leverage loan source will reduce the value of the NTMCs in the event that a replacement source is not identified for the sponsor leverage. However, it does eliminate concerns about safe harbor compliance with Section 4.05(c) and may permit the subCDE, through the master tenant partnership, to make qualified low income community investments (QLICIs) to the developer partnership as debt or equity.

If debt QLICIs can be made, this fix puts additional pressure on the true debt analysis and exposes the developer to possible cancellation of debt income in the event any portion of the debt is later forgiven by the investor. If equity QLICIs can be made, and the sponsor does not have significant capital invested in the QALICB, the investor will be unable to benefit from the “reasonable expectation” NMTC safe harbor. Moreover, many CDEs are not willing to make equity QLICIs in light of the additional redemption and asset management issues that are generated.

When the same investor takes both credits in a two-CDE transaction, it may also be possible to isolate the developer equity component of the leverage loan in one subCDE for tracing purposes and the HTC equity in a second subCDE. While this reduces safe harbor concerns, most developers don’t invest $5 million in sponsor equity, the minimum allocation for most CDEs. There would be excess allocation from one CDE without a source to justify it. This solution also doesn’t work for single-CDE structures.

Conclusions
These approaches may not be popular with developers and investors for a number of reasons. There seems to be limited comfort among investors for novel fixes that are outside their pre-Revenue Procedure experience. Since their primary interest is in the NMTC business, reworking structures to accommodate the HTC is driving some investors to require a separate HTC investor. Developers won’t like either the added transaction costs of involving a separate HTC investor or the reduction in NMTC value caused by eliminating developer equity from leverage loan sources. Eliminating equity QLICIs as a tool to meet the requirements of Section 4.01 may also be problematic for developers.

For the time being, Breed and DeMartino believe that using separate HTC and NMTC investors (as illustrated in the diagram) in a master tenant structure, where the master tenant partnership remains outside of the NMTC structure, is the safest way to go while additional industry thought is given to single investor structures like the one discussed above. Under the two-investor approach, the separate HTC investment would fit within the safe harbor of the Revenue Procedure. Given the added complexity, asset management and transaction costs, it may be well worth it for the Historic Tax Credit Coalition to request that these issues be placed in the IRS’ 2014 Priority Guidance Plan.

John Leith-Tetrault has 38 years of experience in community development financing, banking, community organizing, historic preservation, training and organizational development. He has held senior management positions with Neighborworks, Enterprise Community Partners, Bank of America and the National Trust for Historic Preservation. He is the founding president of the National Trust Community Investment Corporation and chairman of the Historic Tax Credit Coalition. He can be reached at (202) 588-6064 or [email protected].

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