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CRE Finance World Autumn 2015
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Lance Levine
Counsel
Kaye Scholer LLP
ith real estate markets having rebounded from the
latest bust, lenders are once again funding major
renovations, including rehabilitation projects that
benefit from federal historic preservation tax incentives.
A lucrative (but complex) program for developers and
tax investors since inception in 1976, historic tax credit (HTC)
projects had returned to favor following the Financial Crisis of
2008. While an appellate court decision sent a chill through the
market in 2012,1 a new set of IRS tax guidelines applicable to
HTCs at the beginning of 2014 has set the groundwork for HTC
projects to flourish once again. The lender who understands the
intricacies of HTCs will have a clear advantage in an arena that
promises attractive opportunities in the coming years. This primer
on HTCs offers a starting point to such an understanding.
The Program
The HTC program, administered by the National Park Service (NPS)
in conjunction with the applicable State Historic Preservati
(SHPO), provides for a reduction in, and a credit against,
income taxes of up to 20% of the cost of rehabilitating c
historic structures2. The HTCs, claimed in the year rehab
is completed, remain subject to recapture if it fails to meet the
program’s ongoing requirements during the ensuing five-year
period. While most real estate developers do not have sufficient
income to fully utilize the tax credit, developers may pass HTCs
through to high-income tax investors that do.3 The transaction
may not be structured as a sale of HTCs; instead the tax investor
must become a partner in the real estate transaction.4 Still, HTC
transactions are typically structured to provide the tax investor a
financial incentive to sell its interest back to the developer at the
conclusion of the recapture period.
Developers and tax investors typically utilize one of two distinct
deal structures:
• Single-Tier Structure. In the single-tier structure, the tax investor
is admitted as a partner of the property-owning entity (which is
entitled to claim the HTCs).
• Master-Lease Structure . The property owner leases the property
to an entity owned at least 99% by the tax investor.5 The master
lessee in turn obtains a 10% stake in the property owner. The
property owner incurs the qualified rehabilitation expenditures
but is permitted to pass the HTCs to the master lessee, and to
the tax investor through its interest in the master lessee.
The advantages of the single tier tax structure are its simplicity
and lower transaction costs. The master lease structure, on the
other hand, has the advantages of not reducing the property owner’s
basis in the property by the amount of the HTCs and permitting
the developer, rather than the tax investor, to claim depreciation.
It also permits the developer greater control over the property’s
cash flow. Another benefit of note to lenders in a master-lease
structure is that foreclosure will not result in a termination of the
master lease, so long as the parties have entered into a subordination,
non-disturbance and attornment agreement (SNDA), and therefore
is generally not a recapture event. 6
Historic Boardwalk and New Guidelines Suggest Robust
Return of HTC Marketplace
Just as the economy was rebounding from the latest recession,
a federal appellate court in New Jersey issued a decision in 2012
that stalled the market’s revitalization.7 The court’s ruling in Historic
Boardwalk Hall LLC v. Commissioner, 694 F.3rd 425, held that the
tax investor lacked a meaningful stake in the success or failure of
the partnership owning the property, and therefore not a bona-fide
n and consequently not entitled to claim its
ucture utilized in the Historic Boardwalk
ical of the way HTC deals were being
y dampen the market for new HTC deals.
The widespread backlash resulting from the Historic Boardwalk
case, however, led the IRS to issue Revenue Procedure 2014-12
on December 30, 2013 and a clarification on January 8, 2014
(collectively, the Guidelines), describes a “safe harbor” for structuring
new HTC transactions. With the safe harbor in place as a guide
post, the expectation is that the industry players will return to
the market8. As the tax experts work through the kinks in the
Guidelines, and successful structuring precedents are established,
many anticipate the HTC market to return unabated. 9
The Guidelines’ overarching requirement is for the tax investor’s
partnership interest to “constitute a bona-fide equity investment
with a reasonably anticipated value commensurate with the investor’s
overall percentage interest in the partnership”10 , without taking tax
attributes into account. The tax investor’s economic interest may
not be reduced by unreasonable developer fees, lease terms or
other arrangements, a test necessitating a comparison with non-HTC
transactions. Underwriting based on non-HTC transactions has
increased as a result. Most transactions are structured conservatively
until a consensus develops as to the practical limitations of the
“commensurate rule” and to how much leeway the IRS and courts
are likely to permit. The tax investor must fund at least 20% of its
capital contribution before the property is placed into service. The
developer is required to maintain at least a 1% interest and the
tax investor to maintain at least 5% of its largest percentage in
each material item of partnership gain, loss deduction and credit,
meaning that after the recapture period the tax investor’s partnership
interest can be structured to automatically flip from 99% to 5%,