(Published in the Spring 2015 issue of The Bankers' Statement)
In the wake of the Third Circuit’s decision in Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012), cert. denied, U.S., No. 12- 901, May 28, 2013 (the Historic Boardwalk), investment in the historic rehabilitation of buildings generating federal historic rehabilitation tax credits (Historic Tax Credits) was brought nearly to a complete halt. In light of Historic Boardwalk’s chilling effect on Historic Tax Credit investment, the Internal Revenue Service acted quickly to issue Revenue Procedure 2014-12 establishing a safe harbor intended to address the perceived abuses discussed in the Historic Boardwalk opinion and provide comfort to encourage investors to return to the Historic Tax Credit market.
It has been a little over a year since the safe harbor was issued and, while complying with the safe harbor is not without its challenges, many investors have returned to the market, and once again are investing in transactions generating Historic Tax Credits.
Financial institutions frequently invest in partnerships generating Historic Tax Credits and other federal tax credits, not only to reduce taxable income, but also because investments with community impacts may generate regulatory credit for participation in community investments under the Community Reinvestment Act (CRA).1 Historic Tax Credits may also be a financing vehicle for financial institutions seeking to rehabilitate their own historic office and branch buildings.
By way of background, Section 47 of the Internal Revenue Code provides a 20% Historic Tax Credit for “qualified rehabilitation expenditures” incurred in connection with the “substantial rehabilitation” of a “certified historic structure”.2 The entire Historic Tax Credit may be taken in the year in which the substantial rehabilitation is placed in service. Unlike the low-income housing tax credit or the new markets tax credit, which are subject to government allocation, the Historic Tax Credit is available by right if the requisite statutory and regulatory requirements are met.
The Historic Boardwalk opinion disallowed the allocation of Historic Tax Credits to an institutional investor in a partnership engaged in the rehabilitation of Boardwalk Hall in Atlantic City, New Jersey on the basis that the investor was not a “bona fide” partner in the partnership because it did not share in any “meaningful downside risk or meaningful upside potential…” of the partnership. In other words, the Third Circuit viewed the transaction between the investor and the developer as a “sale” of the Historic Tax Credits as opposed to an investment by the investor in Boardwalk Hall. As a result of the Historic Boardwalk decision, many investors simply stopped investing in Historic Tax Credit transactions in light of the uncertainties related to tax risk.
Intending to address such uncertainties, the safe harbor provides a series of requirements that, if met, will result in the IRS not challenging a partnership’s allocation of Historic Tax Credits. These requirements are intended to test whether a partner has a meaningful stake in the success or failure of the partnership and include, among other requirements, that the investor meet unconditional minimum funding obligations, the investor (and principal) hold a minimum interest in each material item of partnership income, gain, loss, deduction and credit, the parties do not reduce the value of the investor’s interest through off-market arrangements (e.g., fees or lease terms) and impermissible guarantees do not disproportionately eliminate investor risk.
While the safe harbor presents challenges in light of its complexity and ambiguity, many investors are returning to the Historic Tax Credit market and are seeking to comply with the safe harbor in connection with their investment. Financial institutions may find that opportunities exist as a result of the safe harbor not only to reduce their tax liability but also to generate CRA credits as well as to finance their own buildings.