Transactional Structural Challenges Faced While Pairing HTCs and OZ Incentive

Published by Donald Sabine, CPA on Monday, February 7, 2022
Journal Cover Thumb February 2022

Question: What are some structuring challenges when using the opportunity zones (OZ) incentive in a historic tax credit (HTC) development?

Answer: The OZ incentive and HTC have a number of compatible attributes that make pairing the two benefits an attractive option. While there are a number of possible structures that can combine the benefits of the two incentives, the OZ regulations create significant compliance and structuring challenges. The primary challenges facing investors and developers when pairing the two incentives under common structures are summarized below.

Direct Investment

In a direct-investment structure, the investor member and the project sponsor form a partnership that owns the historic building. The partnership is typically structured such that the investor member owns 99% of the partnership and the project sponsor owns the remaining 1%. When the building is placed in service and the HTCs are earned, there is a required reduction to the basis of the building. Each member must also reduce their bases in the partnership interest by the amount of HTCs claimed. In a structure where either member funds their equity contribution with eligible capital gains under the OZ incentive, the member’s beginning basis in the OZ investment is zero. The required basis reduction for HTCs paired with zero beginning basis under the OZ rules may cause the HTCs to be delayed until the member has sufficient basis to absorb the required partnership interest basis reduction.

HTC Lease Passthrough

As required in the OZ regulations, investors must hold at least 90% of their assets in qualified OZ property. When pairing the OZ incentive with HTC financing, investors commonly use the indirect investment structure where the eligible capital gains are contributed into a qualified opportunity fund (QOF). In the indirect OZ structure, the QOF then makes an equity contribution to a qualified OZ business, which is required to be held for substantially all (at least 70%) of its tangible real and personal property within census tracts designated as OZs. A qualified OZ business is also required to derive at least 50% of its gross income from the conduct of an active trade or business in a qualified census tract.

Treasury Regulation (Treas. Reg.) Section 1.1400Z2(d)-1(d)(3)(iii)(A) states that ownership and operation of real property is the active conduct of a trade or business. The provision also states that a “mere triple-net-lease” is not active conduct of trade or business. An example is included in the regulations where a company leases a portion of its building under a triple net lease and provides managerial and operational activities for the remaining portion of its under lease. Although a portion of the building is merely under a triple net lease, the statute says that employees of the company conduct meaningful managerial and operational activities in carrying out the overall leasing business of the company. As a result, the company conducts an active trade or business.

Typical HTC pass-through structures include a triple net lease of the historic building between the landlord entity and the HTC tenant. It seems clear that a single triple net lease will disqualify the landlord as a qualified OZ business under the active business requirement. While it remains unclear what level of participation constitutes “meaningful managerial and operational activities,” consideration should be given to the level of managerial and operational responsibilities required of the landlord in the HTC lease agreement.

OZ Investment in HTC Tenant

As discussed above, the landlord entity in an HTC passthrough structure can qualify as a QOF or qualified OZ business. Assuming that the HTC tenant owns qualified opportunity zone business property (as defined in Treasury Reg. Section 1400Z-2(d)(2)(D)(i)), it can also qualify as a QOF or qualified OZ business, but doing so comes with a separate set of hurdles. In typical HTC passthrough structures, the HTC tenant will receive HTC equity contributions from the investor and in turn make equity contributions, loans or HTC lease prepayments to the landlord.

In addition to the qualified OZ business requirements discussed previously, a qualified OZ business cannot hold nonqualified financial property exceeding 5% of the average aggregate unadjusted bases of the entity’s property. As defined in IRC Section 1397C(e), nonqualified financial property includes debt and partnership interests. The investments or loans from the master tenant to the landlord as outlined above results in nonqualified financial property that likely exceeds the 5% threshold and disqualify the HTC tenant as a qualified OZ business.

Pairing HTCs with the OZ incentive comes with a certain set of programmatic hurdles, but the additional benefit has proven to help potential projects. Novogradac is highly experienced in structuring areas of program compliance. Please contact Novogradac with any related questions or any other historic rehabilitation questions.