Developers of low-income housing tax credit (“LIHTC”) projects generally believe that the “deal” with the tax credit investor is that the developer receives somewhere between 80 and 90 percent of the cash flow and residual value of the completed LIHTC project. Where the capital account of the investor remains significantly positive at the end of the compliance period however, developers may be surprised to discover that the investor’s percentage share of residual value can be substantially greater than 10 or 20 percent.
The reason for the investor’s greater interest in residual value is rooted in the tax based nature of the LIHTC program. To be respected for federal income tax purposes, allocations of tax benefits by LIHTC partnerships must be made in accordance with the partnership allocation rules set forth in Section 704 of the Internal Revenue Code. The Section 704 rules require that a partnership liquidate in accordance with the positive capital accounts of the partners. With higher credit prices, the initial capital accounts of investors have increased, and the possibility of an investor having a significantly positive capital account at the end of the 15 year compliance period has also increased.
What can a developer do to reduce the value of the investor’s interest in the LIHTC partnership? Frequently LIHTC general partners negotiate to obtain a purchase option to acquire the interest of the investor partner for fair market value. Where the investor’s interest is valued by reference to an immediate sale of the property followed by a liquidation of the partnership, the value of the investor’s interest is maximized.
Typically, the value of an investor’s interest is reduced because the investor’s lack of control and the illiquid market for limited partner interests. Where the investor has the power to force the general partner to sell the project and distribute the proceeds, however, the investor holds both control and a liquid asset and the valuation discount is minimized. To increase the discount, the investor could give up the right to force a sale and relax its consent rights with respect to refinancing.
Strategies to reduce the value of the investor’s interest that disregard the allocation rules of Code Section 704 should be avoided, including provisions that attempt to avoid the rule that proceeds derived from sale of the property of a partnership would be distributed in accordance with capital accounts. Investors and developers should consult with their tax advisors to fashion an acceptable strategy to deal with the anticipated exit of the investor at the end of the compliance period.