Combining Historic and Affordable Housing Credits Forrest David Milder 617-345-1055, fmilder@nixonpeabody.com IPED February 5, 2009 © 2009 -- Forrest David Milder

“The same only different” Despite the similarity of these credits, their typical deal structures are different, and the concerns raised in each kind of investment are different. For example, the way in which profit motive is addressed is different for each kind of credit. With the LIHTC, there’s a regulation (1.42-4) that provides that no profit motive is necessary; with the HTC, there’s usually an annual cash distribution and a schedule that shows how the investor could get its money back (in cash).

Fundamentals of the LIHTC - 1 LIHTC has two rates – 9% (new or rehab w/o tax-exempt bonds) and 3-4% (purchase of existing building, bond-financed, or both) The credit based on “qualified basis” in a housing project. The credit is taken over 10 years. Thus, the total credit is 90% of costs for non-bond-financed new construction and rehabs, and 30-40% for other projects.

Fundamentals of the LIHTC - 2 The credit applies to cost of the building and rehabilitation, but not land or cash reserves. Adjacent expenditures (e.g., landscaping) may be eligible. The credit may be subject to recapture. Owner must commit to low income restrictions for at least 15 years plus another 15 years.

Fundamentals of the LIHTC - 3 In general, the credit is applied for and it is competitively awarded, or it may be paired with tax-exempt bonds that finance a housing project (But -- don’t forget the far smaller 3-4% credit rate applies to bond-financed projects). State agencies monitor compliance throughout the 10-year credit period

Fundamentals of the HTC HTC is generally a 20% credit (sometimes 10%) based on “qualified rehabilitation expenditures”. It is taken all at one time, when the project is placed in service, provided the owner has spent at least as much on QREs as on acquisition of the building. Does not apply to acquisition, expansion, or adjacent facilities. The credit may be subject to recapture for 5 years. The credit is not competitive, but the Parks Service must approve the rehabilitation to get the 20% credit.

Allocation Rules - 1 These credits are allocated using different methodologies. LIHTC follows depreciation; HTC follows profits. This means that we care about allocations of profits in HTC deals, even if we don’t care in LIHTC deals.

Allocation Rules – 2 In other words, the popular technique in LIHTC deals, of giving the developer/GP 80-90% of cash flow, which doesn’t matter in LIHTC, can be a problem in HTC. Many tax advisors worry that cash flow is a “proxy” for profits. Instead, use fixed fees or a percentage of gross rents. E.g., 5% of gross rents, not 80% of excess cash flow

Profit Motive Profit Motive – What do you need to show? What about the 3% cash on cash distribution that is common to HTC deals? Do you still need it in an LIHTC deal where the owner is claiming both credits? Section 1.42-4 of the regulations says that profit motive doesn’t apply to buildings for which the LIHTC is “allowable”.

§1.42-4 and the Not for Profit Rules (a) Inapplicability to section 42. In the case of a qualified low-income building with respect to which the low-income housing credit under section 42 is allowable, section 183 does not apply to disallow losses, deductions, or credits attributable to the ownership and operation of the building. (b) Limitation. Notwithstanding paragraph (a) of this section, losses, deductions, or credits attributable to the ownership and operation of a qualified low-income building with respect to which the low-income housing credit under section 42 is allowable may be limited or disallowed under other provisions of the Code or principles of tax law. See, e.g., sections 38(c), 163(d), 465, 469; Knetsch v. United States, 364 U.S. 361 (1960), 1961-1 C.B. 34 (“sham” or “economic substance” analysis); and Frank Lyon Co. v Commissioner, 435 U.S. 561 (1978), 1978-1 C.B. 46 (“ownership” analysis).

Basis Reduction The HTC reduces tax credit basis in the typical structure. E.g., a $10m rehabilitation generates a 20%, or $2m HTC, but this reduces basis by that same $2m. Thus, the owner’s basis in the project becomes $8m. This can greatly impact the computation of the LIHTC, because the housing credit is based on “eligible basis”, which starts with the depreciable basis after adjustment for the HTC.

Illustration of Basis Reduction Suppose $10m rehab, and credits are 80¢ per dollar In a “single tier” deal with both credits – HTC: $10m x 20% x .80 = $1.6m LIHTC: ($10m less $2m) x 90% x .80 = $5.76m Total = $7.376m In a single tier deal with one credit – LIHTC: $10m x 90% x .80 = $7.2m So, the HTC only raised $.176m on $2m of HTCs. This is less than 9¢ per dollar of HTCs.

The Lease Pass-through Structure Well-known in the HTC world, but not nearly as common in LIHTC transactions Section 50(d)(5) of the IRC, applying “similar rules” to Section 48(d) of the pre-1986 IRC Uses two partnerships (or LLCs) – one is the “landlord” and claims the LIHTC. The other is the master tenant and claims the HTC, using the “pass through” Important Feature – there’s no basis reduction. So, there’s no reduction in the LIHTC.

Diagram of Lease Pass-through LIHTC Investor LIHTC Partnership LIHTC Capital Contribution LIHTC Partnership builds and owns project Rehabilitated Housing Project Pass-through Agreement Capital Contribution and Rent Payments HTC Investor Master Lease HTC Capital Contribution HTC Partnership HTC Partnership Subleases apartments Tenants

Illustration of Lease Pass-through Again: Suppose $10m rehab, and credits are 80¢ per dollar Two-tier deal with both credits – HTC: $10m x 20% x .80 = $1.6m LIHTC: $10m x 90% x .80 = $7.2m Total = $8.8m Compare this to the “single tier structure” that only raised $7.376m. We’ve raised another $1.424m. Instead of less than 9¢ on the dollar ($0.176m) for the HTC, we get the full 80¢, or $1.6m.

LIHTC Lease Pass-through Issues Can the HTC and LIHTC partnerships have the same owners? Should they have any common ownership? (Use common ownership for §1.42-4 and to offset the “anti-depreciation”) Should there be any cash distributed to the HTC investor? Should the HTC partnership show a profit motive in any way? Will the IRS allow the LIHTC partnership to claim the credits when it is not the landlord to the tenants?

Miscellaneous Issues Exit strategies often involve puts at modest prices after 5 years, but the LIHTC transaction continues for at least 10-11, likely 15. HTC investor may want a way to exit early Tax-exempt GPs can be a problem if they have varying interests in the owner, because of the “tax exempt use” rules. So, use special care when there is a tax exempt GP, or a “tax-exempt controlled” subsidiary “Reportable Transactions” rules apply to HTC but not LIHTC

Effect of the 2008 Act The 2008 Act allows the state to award up to 30% more LIHTCs to a project. (IRC §42(d)(5)(B)) Is this a “simpler” solution to the reduced basis problem? E.g., in our first illustration, the $5.76m of LIHTC (due to the HTC basis reduction) can be restored to the “full” $7.2m with a 25% increase.

Thanks! Forrest Milder is a partner with Nixon Peabody LLP in the firm’s Boston office where he is a tax partner in the firm’s syndication group. He structures and writes tax opinions for a broad range of tax-advantaged investments, including all of the major credits – LIHTC, HTC, NMTC, ETC, and PTC – as well as the partnership and other tax issues relevant to these investments. He is the chair-elect of the American Bar Association’s Forum on Affordable Housing and Community Development. He can be reached at 617-345-1055 and fmilder@nixonpeabody.com