Part of a series on creative Real Estate financing.
Using Crowdfunding to finance real estate projects
Using New Market Tax Credits to finance projects

Let the Purchaser do the Financing

The Internal Revenue Service (“IRS”) recently issued important new guidelines regarding the Historic Rehabilitation Credit (“HRC”) reopening a recently moribund financing method. The new guidelines provide a safe harbor sought by investors and developers after an appellate ruling had provided uncertainty regarding how HRCs could be used to finance the redevelopment of historic buildings. The recent IRS revenue procedure, and its convenient framework, will be especially important in New York, Boston, Philadelphia and San Francisco and other cities with significant amount of historic property and limited development space.

Under the Internal Revenue Code, taxpayers are eligible for a 20 percent tax credit for the rehabilitation of a historic building. Traditionally, developers form a partnership with a tax credit investor who provides capital to the project in exchange for fixed risk/loss and the use of all or a portion of the applicable HRC.

However, in the 2012 decision Historic Boardwalk Hall LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012), the Court of Appeals for the Third Circuit held that a tax credit investor in a historic rehabilitation project was not a bona fide partner for tax purposes, and therefore could not be allocated any of the HRC generated by the project. Specifically, the ruling provided that the investor in question was not a partner because it had no meaningful downside risk or any meaningful upside potential in the business conducted by the purported partnership. Because of the ruling, investors became way of entering into similar tax credit financing transactions due to the possibility of IRS scrutiny.

The new IRS Revenue Procedure 2014-12 clarified the financing of developments using HRCs by requiring transactions to be structured so that the investor is tied to the underlying economics of the deal. To be eligible for the safe harbor, the following requirements, amongst others, must be met:

  • i.) An investor must have at least a 5 percent interest in the partnership;
  • ii.) The partnership principal, affiliates or third parties must not substantially protect investor against losses from the partnership’s activities;
  • iii.) Neither the partnership nor the principal in such partnership may possess a put or call option (or any other right of redemption) with respect to investor’s interest;
  • iv.) At least 75% of the investor’s total expected capital contributions must be fixed in place prior to the building being placed into service; and
  • v.) None of the principals or related parties may insure or guarantee that the investor will (a) be able to claim the applicable HRCs or their cash equivalent, (b) receive distributions from the partnership or (c) obtain repayment of any portion of its contribution as a result of the unavailability of HRCs.

As a result of IRS Revenue Procedure 2014-12, developers and investors have a more concrete understanding of the requirements that must be met to incorporate HRCs into their financing of a project. However, the resulting safe harbor also presents a new array of financing obstacles that investors and developers will have to work to overcome. Specifically, investors will now have a seat at the risk table and will be required to frontload the majority of their investment prior to a development’s completion. Nevertheless, if you are planning to redevelop a historic building, HRC is an old financing tool that should be given renewed consideration.