Q&A: Breaking Down Revenue Procedure 2014-12

Published by Thomas Boccia on Saturday, February 1, 2014
Journal thumb February 2014

Question: The Internal Revenue Service’s (IRS’s) recently issued Revenue Procedure (Rev. Proc.) 2014-12 is described as safe harbor guidance. What are the requirements of Rev. Proc. 2014-12, and what do they mean?

Answer: In Rev. Proc. 2014-12, issued Dec. 30, 2013 and updated Jan. 8, 2014, the IRS provided clarification on two matters and established a framework whereby if the requirements are met, the IRS will not challenge a partnership’s allocation of Internal Revenue Code (IRC) Section 47 historic rehabilitation tax credits (HTCs) to its partners. Rev. Proc. 2014-12 was largely issued in response to the HTC industry’s request for guidance in wake of the 3rd Circuit’s opinion in the Historic Boardwalk Hall case where the court determined that “because [the investor] lacked a meaningful stake in either the success or failure of the [partnership], it was not a bona fide partner.” (See the related article by John Leith-Tetrault in the October 2012 Novogradac Journal of Tax Credits.)

With that in mind, it’s important to understand the specific framework and requirements contained within Rev. Proc. 2014-12, and what some of the implications are for transactions. Rev. Proc. 2014-12 provides guidance for establishing a “safe harbor” for HTC investments in a single tier or a master tenant transaction structure.

First, Rev. Proc. 2014-12 addresses ownership interests of the developer (referred to as principal in the guidance) and investor. Rev. Proc. 2014-12 requires that at all times the developer must have a minimum of a 1 percent interest in each material item of partnership gain, loss, deduction and credit. Conversely, the investor must have at all times a minimum interest of at least 5 percent in each of those same material items. What this essentially authorizes is a partnership “flip” structure whereby the developer and investor interests are initially 1 percent and 99 percent respectively, and then flip to 95 percent and 5 percent, respectively, with the change occurring five years after the project is placed in service. In addition, if a master tenant structure is used, the investor cannot hold an interest in both the master tenant and the landlord (real estate entity), unless the interest in the that entity is held indirectly as a result of the master tenant holding an interest, which is typical in the master tenant structure. However, Rev. Proc. 2014-12 does explain that this restriction does not apply to a separately negotiated, distinct economic arrangement, such as a separate arm’s length investment in the landlord to share in allocations of federal new markets tax credits (NMTCs) or low-income housing tax credits (LIHTCs).

The next requirement of Rev. Proc. 2014-12, which is generating much discussion among practitioners and industry experts, is the section regarding how an investor’s interest must constitute a bona fide equity investment with a reasonably anticipated value commensurate with the investors overall percentage interest in the partnership. So what does this mean? Many interpret this to be that it must be reasonable to expect that the investor will share in the value of the venture irrespective of the tax benefits. This is achieved by the investor sharing in 99 percent of the cash flow pre-flip and 5 percent of cash flow and residual value post-flip. However, Rev. Proc. 2014-12 provides that the value of the investor’s interest may not be reduced through fees, lease terms and other arrangements that are unreasonable as compared to similar items for a real estate development project that does not qualify for credits. This essentially says that features of the agreement between the developer and the investor that “strip out” cash flow such that the investor’s returns are fixed and not contingent or variable based on the venture’s operating success or failure. Often this has been referred to an investor having “upside potential” in the venture. Thus, for structuring transactions, further underwriting and review will be necessary to assess which of the various items including fees, leases and similar are reasonable. Transactions with sublease arrangements to any person that is affiliated with the developer will be deemed unreasonable unless mandated by a third party. In addition, unless the term of the sublease is shorter than the term of the master lease, this lease arrangement will be deemed unreasonable as well. The bottom line is that “unreasonable” arrangements between the parties to manage how the economics are shared will not satisfy the safe-harbor guidance.

In addition to those points focused on establishing upside potential, Rev. Proc. 2014-12 also establishes requirements for investors to establish downside risk in the venture. The first requirement is that an investor must contribute at least 20 percent of its total expected capital contributions as of the date the building is placed in service. The investor also must maintain this minimum contribution throughout its ownership of its partnership interest. This minimum contribution must not be protected against loss through any direct or indirect arrangement by the developer or persons affiliated with the developer. Second, at least 75 percent of the investor’s total expected capital contributions must be fixed before the project is placed in service. Except for the 20 percent requirement, the fixed portion can be subject to the typical benchmarks we are all familiar with in HTC transactions such as placed in service, cost certification, National Park Service Part 3 approval or similar. Thus for investors more of their investment capital is now at risk than may have been in previous transaction structures

Rev. Proc. 2014-12 also defines requirements that address downside risk to provide that an investor bears some risk of loss. These are in the form of permissible and impermissible guarantees. Permissible guarantees include the guarantees for the avoidance of any acts or omissions of the developer and guarantees that are not described as impermissible. In either case, except for certain allowances, such guarantees must be unfunded guarantees. So, what are impermissible guarantees? In general, an impermissible guarantee is any guarantee of the tax structural risk other disallowance or recapture events that are NOT due to an act or omission of the developer or the guaranty of cash distributions or economic returns. It is clear from Rev. Proc. 2014-12 that an investor can procure insurance or other similar product to protect itself against such events. However, such cost of this must be borne by the investor and not by any persons involved in the rehabilitation. The result of the guarantee sections of Rev. Proc. 2014-12 is to essentially cause the investor to assume 100 percent of the transaction structuring risk, which will create more stringent diligence by the investor to insure compliance with these requirements.

Prior to the issuance of Rev. Proc. 2014-12, it was common for HTC transactions to have puts and calls whereby a put was at the option of the investor to exit a transaction and a call was at the option of the developer to acquire the investor’s partnership interest. Rev. Proc. 2014-12 eliminates the developer’s right to have a call option but allows the investor to have a put option, and that put option cannot exceed fair market value. Although the guidance is clear that the put cannot exceed fair market value, there is some question whether the put be less than fair market value. Depending on the facts, acquiring the investor’s interest at less than fair market value could be construed as abandonment of the investment, which is not permitted under Rev. Proc. 2014-12. In addition, assuming the transaction employs the “flip” discussed earlier, the fair market value is now based on a 5 percent partnership interest, which needs to be taken into consideration as this provision is analyzed.

The HTC industry pooled its resources together to make this guidance a reality. Now that we have it, those required to interpret and apply Rev. Proc. 2014-12 in practice are reviewing all aspects of it to determine how to apply it to HTC transactions. Many of the requirements under Rev. Proc. 2014-12 are straightforward and not subject to much interpretation. However, there are certain requirements that have caused debate among industry participants and will continue to get attention as these provisions are incorporated into transactions.

This article is intended to be an overview of some of the requirements that Rev. Proc. 2014-12 governing HTC transactions addresses. Having a general understanding of what some of these requirements mean will help industry participants understand how these requirements may be applied. However, Rev. Proc. 2014-12 and its provisions are complex and as such, it is critical to work closely with your historic adviser to insure compliance with this guidance.