June 07, 2007
That which was lost has now been found. With careful structuring, low-income housing tax credits under the IRC are once again viable for developing tax-exempt bond-financed mixed-income apartment projects with only 20 percent of the units affordable. For many years, the affordable housing industry has struggled to develop an ownership structure that allows tax credits to be sold for projects meeting the minimum affordability requirements for tax-exempt bond financing. The federal tax-exempt bond rules require an owner to rent some of the apartment units to tenants making below certain income levels: either 20 percent of the units to tenants making 50 percent or less of area median income or 40percent of units to tenants making 60 percent or less of area median income. Historically, owners have elected the 20 percent of 50 percent test, and these projects have become known as 80-20 deals, referring to the percentage of unrestricted units to restricted units. The renewed availability of these credits means big additional dollars to project owners. This development tool is so valuable that one tax credit syndicator is rumored to be in application for a U.S. patent on its allegedly unique structure to produce these credits. This article will discuss the history of tax credits and 80-20 deals, the Private Letter Ruling that reopened the door, variants on structures, and related economic and regulatory concerns.
Years ago, a number of tax lawyers concluded that partnerships could specifically allocate tax depreciation of certain apartment units, like affordable units, to a certain class of limited partner. Those attorneys also advised that all the tax credits attach to the specifically allocated depreciation of the affordable units. Based on this advice, a number of partnerships were structured with class A partners receiving the economic and tax benefits from the unrestricted units and the class B partners receiving the economic and tax benefits, most importantly the depreciation, from the restricted units. This structure fell out of favor when the tax attorneys for a number of the end-credit users criticized the legal analysis upon which these conclusions were based. First, no authority exists allowing for depreciation to be allocated to certain units in a building on a parcel. Second, no authority exists supporting the position that tax credits attach solely to the depreciation produced by the affordable units.
Prior to the groundbreaking Private Letter Ruling No. 200601021 dated December 28, 2004, the industry struggled with various alternative structures to the class A/class B partnership. One structure involved allocating all the depreciation to the tax credit investor limited partner with a special gross income allocation, leaving the non-tax credit partner in the same net tax position as if they had received the depreciation from the market rate units. The tax rules required certain economic allocations with this structure that many parties could not stomach. The structure never developed legs.
We also played with the structure that was ultimately blessed by the Private Letter Ruling: that is, transferring ownership of the affordable units to a separate entity. Prior to the Private Letter Ruling, bond counsel struggled with various bond tax rules raised by separate ownership of the affordable units. Concerns included how the first available unit rule was satisfied and whether the Bond financing of the market rate units remained tax exempt if the affordability compliance was an obligation of a separate owner, due to how the Treasury Regulations define a qualified residential project.
The Private Letter Ruling
The Private Letter Ruling tackled the primary issue of whether, in a split-ownership structure, the Bonds financed something other than a qualified residential rental project that meets the income qualifications. The IRS focused on the issue of whether the affordable units could be considered a separate building under the Treasury Regulations. Because the affordable units are dispersed throughout the project, and low-income tenants and market rate tenants jointly use the common facilities, the IRS concluded that split ownership of a Bond-financed project is permissible under the tax rules.
Although the Private Letter Ruling does not address tax credits, it reaches favorable conclusions on a number of tax-exempt bond issues regarding separate ownership structures that troubled bond counsel. The Private Letter Ruling also does not indicate whether it applies to separate real estate mapping of the affordable portion of the project. There is no tax authority that supports allocating all the credits to a part of a parcel that is separately owned. Moreover, separately owning a single parcel may violate state map act requirements. Pillsbury is actively advising clients that the first step to this structure is to condominiumize the affordable units as a separate parcel. Once mapped, those units can be sold or leased in a long-term lease that transfers tax ownership to a separate entity. In a project where the current ownership does not want to lose ownership control of the affordable portion to a third party, the project owners can be managing members or general partners of the affordable owner. The tax credit limited partner or member can be admitted and allocated almost all the depreciation from the affordable portion of the project with almost all the tax credits attached. The general partners will receive most of the economic benefits of the affordable units. However, in our experience, once the affordable owner pays its portion of debt service and expenses, cash and expected sales proceeds from the affordable operations are not significant. What is significant is the amount of capital contribution raised by admitting a partner receiving the benefits of the credits. This amount can then be transferred through myriad possible mechanisms to the original project owners to decrease their equity requirements.
Economic and Regulatory Concerns
These structures raise a number of unique economic and regulatory concerns. 80-20 project owners, many of which are pension funds, have investment horizons that are shorter than the typical 15-year exit strategy of a tax credit transaction. To address this concern, Pillsbury advises negotiating roll-up provisions with the tax credit investor allowing for buyout at fair market value at any time. The parties should also negotiate transfer provisions allowing the market rate portion of the development and the general partnership interests of the affordable owner to be sold with tax credit investor limited consent rights. Teams working on these transactions have also developed various approaches to the first available unit rule issue. An additional concern involves the performance of the market rate units. Tax credit investors are comfortable underwriting affordable units but not market rate units. If rents on market rate units decline, the project, including the portion owned by the affordable owner, may suffer a foreclosure. Foreclosure wipes out future and possibly past credits. The investor must either underwrite the market rate rents or cover the risk through a developer guarantee.
In our experience, these structures are very complex, requiring a team of experienced developers, consultants and investors. This article simplifies and generalizes a large number of devilish details. Pillsbury is available to help teams structure and close these transactions.