Selected Issues in Master Lease Pass-Through Transactions
February 1, 2010
I. TRANSACTION OVERVIEW.
A. Developer-owned landlord entity (“LL”) rehabilitates a historic or pre-1936 building, leases the building to a master tenant entity (“MT”) owned by a tax credit investor (but managed by a developer entity) and elects to pass-through the rehabilitation tax credit to MT. See Internal Revenue Code of 1986 (“Code”) §§47 and 50(d)(5) and former Code §48(d). The amount of the credit is a percentage of qualified rehabilitation expenditures (“QRE’s”): 20% for historic buildings and 10% for other pre-1936 buildings. Code §47(a). Basic perceived advantage of master lease structure as opposed to direct investment in owner is to separate purchase of credits from investment in real estate.
1. Investor avoids inclusion of real estate income and loss, especially depreciation, in its financial statements.
2. Easier for developer to retain preponderant share of cash flow and other property economics.
B. Investor contributes cash to MT in exchange for, typically, a 99.99% interest in MT, with a developer-controlled entity owning the remaining .01%. MT subleases the building to the actual occupants, collects rents and pays expenses. MT pays base rent to LL sufficient to cover LL’s debt service.
C. MT contributes some or all the capital contributions received from the investor to LL in exchange for an interest in LL that typically ranges from 10%-30%. Any investor contributions not so contributed are used by MT to pay costs that do not constitute QRE’s, for example, reserves, leasing costs, or costs of personal property.
D. The term of the master lease is generally at least 80% of the recovery period of the property: 22 years for residential rental property and 32 years for other real property. Such a term avoids a reduction in credit for property treated as “shortterm lease property” and permits MT to be treated as having purchased the property for its fair market value and to receive the full amount of available credit. Treas. Reg. §1.48-4(c)(2); PLR 8943074; see also, Treas. Reg. §1.48- 4(a)(2) and PLR 8951072 confirming that for properties having no “class life” the requisite lease term for full pass-through of credits is 80% of recovery period.
1. If property is “short-term lease property,” the amount of credit that can be passed through is reduced to a percentage corresponding to the percentage of the recovery period represented by the lease term. Treas. Reg. §1.48- 4(c)(3).
2. Property is not “short-term” leased property if it is leased pursuant to a “net lease” within the meaning of former Section 57(c)(1)(B), Treas. Reg. §1.48(b)(2)(iv), but there are definitional and economic uncertainties with such net leases so they are used infrequently. But see PLR 8943074.
E. LL can only pass-through credits for property which is “new” in its hands and which would be “new” in the hands of the MT if actually purchased by the MT, meaning that the master lease structure must be in place and the investor must be a member of MT at the time of placement in service. Treas. Reg. §1.48-4(a)(1).
F. Real estate investment trusts and regulated investment companies subject to tax under Subchapter M of the Code are not eligible to make the pass-through election. Former Code §§48(d)(1) and 46(e). Savings and loans and other institutions to which Code §593 applies have been permitted to make the election since 1996. Code §50(d).
G. A tax credit investor will typically expect cash distributions sufficient to produce a small cash on cash return and to cover any tax liabilities with respect to its distributive share of MT income. In this connection, MT is required to include in income an amount equal to the amount credit passed through, which amount is amortized over the applicable recovery period, with any unamortized balance recognized upon termination of the lease. This inclusion is in lieu of the basis reduction that would be required if the owner of the rehabilitated property claimed the credit. Former Code §48(d)(5). The investor’s noncash or “phantom” income from the amortization of the credit may be offset by either or both of its share of depreciation from MT’s interest in LL or from deductions for accrued supplemental rent under the master lease.
H. Exit. After expiration of the five-year credit recapture period, the investor typically has an option to put its interest in MT to the developer or an affiliate for a fixed price, typically 5%-20% of its investment. If this put option is not exercised, the developer has an option to purchase the investor’s interest in MT at fair market value. Note that by purchasing the investor’s interest in MT, the developer also reacquires 100% of LL.
II. AT RISK ISSUES WHEN LL INCLUDES INDIVIDUALS OR CLOSELY HELD C CORPS.
A. LL’s “credit base,” the QRE’s, is reduced by any “nonqualified nonrecourse financing” with respect to such credit base to the extent any member of LL is a taxpayer described in Code §465(a)(1). See Code §49(a)(1).
B. “Nonqualified nonrecourse financing” is defined as any “nonrecourse financing” (defined to include even fully recourse financing from persons with an interest in the activity other than as creditor) which is not “qualified commercial financing” defined in Code §49(a)(1)(D)(ii) as:
1. financing of property not acquired from a related party; and
2. nonrecourse financing not in excess of 80% of the credit base; and
(a) from a governmental entity or pursuant to a loan guaranteed by a governmental entity; or
(b) from a lender actively and regularly engaged in the business of lending money which (i) is unrelated to the borrower, (ii) is not a person from whom the borrower acquired the property and (iii) does not receive a fee with respect to LL’s investment in the property; and
4. financing which is not convertible debt.
C. Deferred developer fees are likely “nonqualified nonrecourse financing” and thus not includible in the credit base if the at risk rules apply to LL or any of its members.
1. Assuming the investor is not subject to these rules, consider having MT, in its capacity as a member of LL, assume the deferred fee.
2. The assumption of this liability should be treated as a capital contribution of money by MT to LL in the amount of the deferred fee, increasing MT’s capital account in LL and replacing the “nonqualified nonrecourse financing” on LL’s balance sheet. Treas. Reg. §1.704-1(b)(2)(iv)(c).
3. In order for the assumption of the deferred fee to be respected, the MT should be personally obligated to pay the fee and the payee must be notified of the assumption, be able to enforce it against MT and release LL from its obligations. Treas. Reg. §1.752-1(d).
4. The deferred fee can be paid from MT cash flow.
5. It is recommended that the assumption occur after placement in service and accrual of the fee but prior to the end of the year in which placement in service occurs in order to assure that the fee is initially an LL cost includable in the credit base.
D. Financing of property acquired from “related parties,” as defined in Sections 267(b) and 707(b), but substituting 10% for 50% and determined as of the end of the year in which placement in service occurs, is “nonqualified nonrecourse financing.”
1. Transfers of an unrehabilitated building between related parties should not taint the financing of the rehabilitation which is treated as separate property not acquired from a related party. PLR 8828063 and PLR 9016032.
2. However, if LL acquires the property from a related party after commencement of the rehabilitation (but prior to placement in service), the avoidance of the at risk rules is less certain, at least with respect to the rehabilitation costs incurred by the transferor.
3. The provision of seller financing by a transferor raises additional concerns but, again, if no QRE’s are included in the transfer the better view seems to be that such seller financing does not reduce the credit base. See Alperin, “Is the Rehabilitation Tax Credit At Risk?” J. Real Est. Tax, Vol. 18 No. 3, Spring 1991.
E. For purposes of the 80% limit in nonrecourse financing, it should be permissible to allocate such financing between acquisition and rehabilitation costs in proportion to the amounts of each. PLR 9016032. Less certain is whether, under appropriate facts acquisition financing can be traced exclusively to acquisition costs or capital contributions can be traced to rehabilitation costs.
III. TAX-EXEMPT USE PROPERTY.
A. General Rules: Code §§ 50 and 47 (c)(2)(B)(v)
1. No credit shall be determined with respect to any property used by an organization exempt from tax (other than a cooperative described in Section 521) or by the United States, any State or political subdivision, any possession of the United States or any agency or instrumentality of the foregoing. Code §§ 50(b)(3) and (4).
2. QRE’s do not include any expenditure allocable to a portion of a building which is or may reasonably be expected to be tax-exempt use property within the meaning of Code §168(h). Code §47(c)(2)(B)(v).
3. These rules are implicated whenever LL or MT is a partnership that includes tax-exempt or governmental partners. See D below for rules for determining the portion of property which is tax-exempt use property when the property is owned by partnerships with taxable and tax-exempt partners.
B. UBTI Exception. The general rules do not apply if property is used predominantly in an unrelated trade or business the income of which is subject to tax under Code §511. Code §§ 50(b) and 168(h)(1)(D).
1. Debt Financed Income. If property is debt-financed property (as defined in Code §514), Code §50(b)(3) allows a portion of the rehabilitation credit corresponding to the portion of the income from the property treated as debt financed. This seemingly clear rule is, however, called into question by Code §168(h)(6)(D) which provides that whenever property is owned by a partnership with taxable and tax-exempt partners, the determination whether the property is used in an unrelated trade or business is made without regard to Code §514.
2. The UBTI exception does not apply to entities whose exempt status is not derived from Code §501(a) and, thus, are not subject to Code §511 – for example, governmental pension funds exempt under Code §115.
C. Rents Based on Net Profits. The general exclusion of real estate rents from UBTI does not apply to rents determined “in whole or in part” upon the net income or profits derived by any person from the property leased. Code §512(b)(3)(B)(ii). Thus, it may be possible to cleanse the tax-exempt use taint created by when LL has a tax-exempt partner by structuring the master lease to provide for some rent based on net profits of MT.
1. For REIT purposes if a master lease provides for rent based on net profits of MT but all the subleases have only fixed rents, the master lease rents are qualifying income. Code §856(d)(6).
2. Although treatment of rent based on net profits under the UBTI regulations generally follows the REIT regulations, Treas. Reg. §1.512(b)- 1(c)(2)(iii)(b), the REIT regulations do not yet reflect Code §856(d)(6). In addition, the UBTI regulations expressly do not follow a REIT rule that treats only a portion of rent from a master tenant as nonqualifying income when only a portion of the subleases provide for rents based on net profits.
3. The most assured approach to using rents based on net profits to generate UBTI is to structure rents under both the master lease and one or more subleases based on net profits. However, subleases based on net profits may be workable for some properties such as hotels, but not for others such apartment buildings.
4. If rents are based on net profits, the fact that no such rents are paid or accrued in a particular year either because there are no profits or because of a rent holiday should not cause the property to be tax-exempt use property, unless perhaps the facts also indicate the absence of any expectation that such rents would ever be paid or accrued, but there is not clear authority on point. There is, however, authority that even a de minimis amount of rent based on net profits will cause all rents to be UBTI. John W. Madden, TC Memo 1997-395 (1997).
D. Qualified Allocations
1. Code §§168(h)(5) and (6) provide rules for determining the portion of property treated as tax-exempt use property when the property is owned by, or leased to, partnerships with both taxable and tax-exempt partners. These rules are also incorporated into Code §50(b).
2. When property is owned by such a partnership “and any allocation to the tax-exempt entity of partnership items is not a qualified allocation,” an amount of property equal to the tax-exempt entity’s proportionate share of such property is tax-exempt use property. Code §168(h)(6)(A).
3. Qualified Allocations are allocations to a tax-exempt entity that are consistent with such entity’s being allocated the same share of each item of income, gain, loss, deduction credit and basis and must have substantial economic effect. Code §168(h)(6)(B).
4. Read literally, Code §168(h)(6)(A) seems to imply that qualified allocations completely cleanse property of any tax-exempt use taint and cause no portion of the property to be tax-exempt use property. If LL is claiming the credits, rather than passing them through to MT, this interpretation of the rule is fine because the qualified allocation prevents a tax-exempt member from transferring its share of the credit to a taxable member; consistent with the intent of Code §168(h). When LL wishes to make an election to pass the credit to MT, however, the position that qualified allocation allow 100% of the credit to be passed through to MT would seem to be completely contrary to the purpose of Code §168(h). Notwithstanding the literal language, absence guidance from the IRS the better position is that the tax-exempt entity’s share of the property reflected in the qualified allocation is tax-exempt use property.
E. Tax-Exempt Controlled Entities – Code §168(h)(6)(F)
1. A more reliable technique for eliminating the tax-exempt use taint is for a tax-exempt entity to transfer its interest in the property to taxable blocker corp.
2. However, the blocker will be treated as tax-exempt entity for purposes of Code §168(h) unless the tax-exempt shareholder elects to treat as UBTI interest and dividends received from the blocker as well gain from the sale of the blocker stock.
3. For governmental entities which are not subject to tax on UBTI the availability of this technique is uncertain.
IV. RECAPTURE, FORECLOSURE AND THE DREADED “SUPER” SNDA.
A. A disposition of the property by LL within 5 years after placement in service will not result in recapture of credits, unless the disposition is to a person who would not have been able to pass through the credits to MT. Treas. Reg. §1.47-2(b)(2)(i) and (ii). A termination of the master lease will, however, result in recapture. Treas. Reg. §1.47-2(b)(2)(iii). Apparently, the IRS views the lessee’s assignment of a lease as a “termination” of the lease unless the assignment represents a mere change in form of MT’s interest in the lease. Rev. Rul. 86-116, 1986-2 C.B.9.
B. In a variety of contexts, lessees frequently request lenders to enter into Subordination Non-Disturbance and Attornment Agreements (SNDA’s). The purpose of an SNDA is to allow a lease to remain in place following a lessor’s loan default especially if there is no lease default.
C. In this tight market for tax credit equity, investors are requesting that lenders grant SNDA’s that prevent lenders from taking any action that would trigger recapture of credits, including one or more of the following:
1. Following default, under the lease because of insufficient cash flow from the property, MT has no obligation to cure and the lease stays in place so long as MT pays to lender all cash generated by the property (after payment of operating expenses) even if less than the required loan payments.
2. Following a foreclosure, lender agrees not to sell the property to a taxexempt entity, a REIT or any other transferee that would cause recapture.
3. If the lender is itself a tax-exempt or governmental entity (or a REIT), it agrees not to foreclose at all and to limit its remedy during the recapture period to becoming a mortgagee in possession. A mortgagee in possession is not treated for tax purposes as acquiring ownership. See, e.g., Hadley Falls Trust Co. v. United States, 110 F.2d 887 (1st Cir. 1940).
V. MISMATCH OF ORDINARY INCOME AND CAPITAL LOSS ON EXIT
A. A sale by the investor of its interest in MT after expiration of the recapture period should require the MT to recognize ordinary income equal to the unamortized portion of the credit.
B. This income will increase the investor’s basis in its interest in MT and reduce the gain or create or increase a loss on this sale.
C. Any loss is likely to be a capital loss and may not offset the income resulting from the amortized credit.
D. Whether the developer or the investor bears the risk of this mismatch is negotiable, especially if the sale proceeds are not sufficient to cover it.
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