Question: In a lease pass-through structure, how do funds from historic tax credit (HTC) equity flow to the project level? 

Answer: Equity contributions received by the lessee entity from the HTC investor in a lease pass-through structure can be transferred to the project level in several ways. The funds can take the form of equity contributions, loan proceeds or prepaid lease payments as they make their way to the project level. 

The lease pass-through structure is a common structure used in HTC transactions. The Internal Revenue Code (IRC) allows the owner of a HTC property to lease the property to a lessee and “pass through” all or a portion of the HTC to the lessee by making an election pursuant to Treasury Regulation Section 1.48-4(a)(1). The lessor continues to hold legal title to the property and the lessee operates the property under a master lease arrangement. Under this structure, the HTC investor makes its investment into the lessee and the lessor incurs the costs related to the rehabilitation of the project. Generally, once the HTC equity is received, the funds will need to make their way to the project level to source the construction costs of the historic rehabilitation. This can be accomplished by using a couple of different methods. 

The first method in which the funds from the HTC investor can be transferred from the lessee to the lessor is through a partnership interest in the lessor. In this arrangement, the lessee receives the HTC equity and makes equity contributions to lessor in exchange for a partnership interest in the lessor. Typically, this partnership interest is nominal in order to minimize the tax credit investor’s indirect ownership of the property and maximize the project owner’s depreciation deductions and operating cash flows. 

Another method to transfer HTC equity to the project level in a lease pass-through structure is by the lessee making a direct loan to the lessor. Under this scenario, the lessee uses the HTC equity it receives to make a loan to the lessor. The loan needs to be respected as true debt to prevent the proceeds from being viewed as equity contributions.

A third method that can be used to flow HTC equity funds to the project level is through the use of prepaid lease payments. The lessee transfers funds to the lessor as a prepayment of rent under the master lease agreement. The prepayment of rent will be impacted by tax implications and consequences related to IRC Section 467.

Lease pass-through structure

The lease pass-through structure provides flexibility in terms of how HTC equity funds can be structured to reach the project level, but this can also be a complicated process. Despite the complexity, there are a plethora of benefits for project owners using a lease pass-through structure. The structure does not require a reduction of the property owner’s basis in the property by the amount of the HTCs, it permits the project owner rather than the tax credit investor to claim depreciation and it provides the project owner greater control over the project’s cash flow. Given the technical aspects and tax implications involved, it is imperative to give careful consideration in choosing the suitable lease pass-through structure to flow HTC equity to the project level. 

Contact Novogradac & Company LLP for assistance with HTC transaction structures or any related questions.