If you are the general partner or managing member of a project using low income housing tax credits (“LIHTC”) that closed more than 12 years ago, then you need to begin the process of determining what will happen when the investor exits the LIHTC project (the “Project”) in the 15th year after the first tax credits were taken for the Project (“Year 15”). There are many issues to consider, all of which are important for the long term success and viability of the Project.
Most LIHTC transactions use either a limited partnership or a limited liability company taxed as a partnership as the entity that owns and operates the LIHTC project (the “Ownership Entity”). The Ownership Entity is formed pursuant to an “Organizational Document,” which may be either a limited partnership agreement or an operating agreement.
If the Ownership Entity is a limited partnership, the Ownership Entity usually consists of (i) a general partner that contributes very little capital to the Project, but is responsible for the day-to-day operations and management of the Project, and (ii) a limited partner that purchases the LIHTCs and provides much of the capital for the Project. The limited partner is not involved in the day-to-day operations of the Project, and generally only gets involved with the Project if there are major decisions to be made regarding either the Ownership Entity or the Project, or if the limited partner is in danger of losing the LIHTCs it purchased.
If the Ownership Entity is a limited liability company, the role of the general partner is generally handled by the managing member, and the role of the limited partner is generally handled by the entity that purchased the LIHTCs. I will refer to the entity that serves as general partner/managing member as the “Manager Entity” and the entity that serves as the limited partner/purchaser of the LIHTCs as the “Investor Entity”.
Why is Year 15 So Important?
The details of the LIHTCs are described in Section 42 of the Tax Reform Act of 1986 (the “TRA86”), which initiated the LIHTC program. In each state, LIHTCs are administered by a housing credit agency (“HCA”) that awards LIHTCs to Projects based on a scoring system. The LIHTCs are then sold to an Investor Entity who purchases the tax credits to offset their federal income tax liability Project. The proceeds from the sale of the LIHTCs are then used to provide financing for the low income housing Project. Most LIHTC investors are institutional investors, and the price paid for LIHTCs frequently fluctuates. The Investor Entity claims the LIHTCs over a period of 10 years, but the tax credit compliance period is 15 years (the “Compliance Period”). The Project must be operated in strict compliance with TRA86 during the Compliance Period, or the Investor Entity may lose the tax benefit of some or all of the LIHTCs that it purchased.
After the Compliance Period is over, the Investor Entity will have received the benefit of all of the LIHTCs, and there no longer will be any danger that it can lose any of the LIHTCs or other tax benefits. At this point, the Investor Entity usually will be ready to exit the Project. In addition, the Manager Entity usually will be glad to have the Investor Entity out of the transaction since the Investor Entity typically places some fairly burdensome reporting requirements on the Manager Entity.
The first step the Manager Entity should take as Year 15 approaches is to reevaluate the entire Project. This should include an examination of the physical condition of the Project, possible future uses of the Project, and a market study to evaluate the continuing viability of the Project.
Three Ways to Dispose of the Project
There are three basic ways to dispose of the Project, which are as follows:
#1: The first is the exercise of a right of first refusal or other purchase option (“Purchase Option”) to purchase the Project. For qualified non-profit organizations and certain governmental entities (including most housing authorities) and their nonprofit designees, a special right of first refusal is usually available after the Compliance Period. The purchase price is typically the outstanding balance of any debt on the Project, plus any federal, state, and local taxes the Investor Entity is required to pay to exit the Project. The relatively low purchase price usually makes this a very attractive option for the Manager Entity or its designee. For a for-profit entity, the purchase price usually uses the appraised value of the Project as a factor in determining the price of the Purchase Option. The capital accounts of the parties need to be carefully monitored, as a Year 15 reconciliation may lead to unexpected results in determining the appropriate price for the Purchase Option.
#2: The second option is the purchase of the Investor Entity’s interest in the Ownership Entity. In this situation, the Investor Entity’s interest in the Ownership Entity is purchased, not the Project itself. Since this results in the Manager Entity owning a 100% interest in the Ownership Entity, which in turn, owns a 100% interest in the Project, the net effect is the same as the Manager Entity’s purchase of the Project itself. The transaction costs associated with this approach can be lower than exercising the Purchase Option, which makes this a factor to consider when deciding which option to use.
#3: The third option is an arm’s length sale to a third party. This would typically be used when the Manager Entity either does not want to or cannot (i) exercise the Purchase Option, or (ii) purchase the Investor Entity’s interest in the Ownership Entity. This could occur for a variety of reasons, including the Manager Entity’s inability to obtain funding to either exercise the Purchase Option or purchase the Investor Entity’s interest, or the Manager Entity’s desire to terminate the involvement with the Project.
A key consideration is the amount of exit taxes that may be due and payable by the Investor Entity when it exits the transaction, and may occur when either the Investor Entity’s interest in the Ownership Entity is sold or the Project itself is sold. There are only exit taxes when the Investor Entity’s capital account is negative, which occurs when cumulative tax losses exceed the investor’s invested capital and are calculated by taking the negative amount in the Investor Entity’s capital account divided by the Investor Entity’s tax rate, which will usually include a gross-up factor. Exit taxes can be avoided by not allowing the Investor Entity’s capital account to become negative. During the operation of the Project, there are a number of strategies that can be used to keep the Investor Entity’s capital from becoming negative, such as capitalizing repairs instead of expensing them, and allocating expenses to the Manager Entity and income to the Investor Entity. If any exit taxes are due, possible sources of payment are new funds from a refinancing or the application of any cash reserves remaining in the Project.
Other issues to consider for Year 15 include determining if there are any expiring rent subsidies and the status of any restrictive covenants on the Project. In order to initially obtain the LIHTCs, many HCAs require that the Project be used for low income housing for thirty years.
Also keep in mind that each Project is unique and may have other factors that need to be considered in determining the appropriate exit strategy and possible future uses of the Project. These factors include the restrictions placed on public housing units financed with HOPE VI or capital funds, as well as a number of unique issues that must be considered if bond financing is involved.
The Future of the Project
As part of your analysis, you should contact your team of professionals and let them know that Year 15 is approaching. Your financial consultant can advise you on current market conditions and advise you on any loan or financing you may need in conjunction with any purchase of the Project or related interests, and can give you the necessary guidance if you choose to refinance using LIHTC again. Your accountant can advise you on the tax implications of the various exit strategies that may be used in Year 15. Involving your accountant cannot be overemphasized since the tax impact on you may be the single most important factor in determining which exit strategy to use. Last, but not least, get your attorney involved. They will need to review the Operating Document to see how the Year 15 issues are addressed and what other options you may have as part of Year 15. Your attorney can also provide advice on your post-Year 15 transaction structure, and draft and negotiate the necessary documentation.
Early planning is the key to successfully transitioning a low income housing tax credit Project after Year 15. This planning should include involve reevaluating all aspects of the Project, including but not limited to, market conditions for the units, physical condition of the property, and the general financial health of the Project. Finally, the tax implications of any restructuring should be carefully examined, as these may ultimately determine the final structure of the transaction.