In late 2013, the IRS released Revenue Procedure 2014-12, which established a safe harbor clarifying how the agency will treat allocations of rehabilitation tax credits among partners. The procedure lays out circumstances under which the IRS won’t challenge a partnership’s allocation of credits to an investor/partner.
Safe harbor requirements
The safe harbor is available to two types of partnerships:
- A “developer partnership” owns and restores a qualified rehabilitation building or certified historic structure.
- A “master tenant partnership” leases a building from a developer partnership and elects to treat itself as having acquired the building for purposes of the rehabilitation tax credit.
The entities will generally be eligible for the safe harbor if they satisfy these requirements:
Minimum partnership interests. The principal in the partnership (the developer) must hold at least a 1% interest for the entire partnership term. The investor (the recipient of the tax credit) must hold at least a 5% interest for the taxable year in which the investor’s percentage share is the largest.
Bona fide equity investment. The investor’s interest in the partnership must be a bona fide equity investment with a reasonably anticipated value commensurate with the investor’s overall interest in the partnership. An investor’s interest is a bona fide equity investment only if the reasonably anticipated value is contingent on the partnership’s net income — gain and loss — and it isn’t substantially fixed in amount. Plus, the investor must not be substantially protected from losses from partnership activities, and it must participate in the profits in a manner not limited to a preferred return.
Arrangements to reduce value of partnership interest. The value of the investor’s interest can’t be reduced through arrangements (for example, fees or lease terms) that don’t reflect arm’s-length charges in other projects that don’t qualify for credits. It also can’t be reduced by disproportionate rights to distributions or issuances of partnership interests for less than fair market value.
Minimum contributions. Before a building is placed in service, the investor must contribute at least 20% of its total expected capital contributions. That minimum contribution must be maintained throughout the duration of the investment and generally may not be protected against loss through a guarantee or insurance arrangement with any person involved in the project.
Contingency consideration. Before the building is placed in service, at least 75% of the investor’s total expected capital contributions must be fixed in amount. The investor should reasonably expect to meet its funding obligations as they arise.
Guarantees/loans. The safe-harbor qualification procedure limits the types of guarantees that may be provided to the investor by parties involved in the project. (See the sidebar “Is that guarantee permissible or impermissible?”) Plus, the investor can’t get loans from the partnership or the principal, and the partnership and the principal can’t guarantee or insure any indebtedness the investor incurs to acquire its interest.
Purchase and sale rights. Neither the partnership nor the principal can have a call option or other right to buy or redeem the investor’s interest in the future. The investor may not have a right to require anyone involved in the project to buy or liquidate its interest at a future date at a price exceeding its fair market value.
Intent to abandon. The investor must not have acquired its partnership interest with the intent of abandoning it after the qualified rehabilitation is complete. Such intention is presumed if the investor abandons its interest at any time.
Note that simply complying with these requirements won’t ensure the validity of the tax credits. The credits must also derive from qualified rehabilitation expenditures and such allocations must possess “economic effect” as provided within the 704(b) regulations. The regulation generally requires credits to be allocated to the partners in the same ratio that the partners share the partnership’s taxable income for the year the property is placed in service, although future changes in income allocations are permitted.
Follow the rules
Revenue Procedure 2014-12 is effective for allocations of rehabilitation tax credits made after Dec. 29, 2013. If a building was placed in service before Dec. 30, however, and the safe harbor requirements were met at that time, the IRS won’t challenge the allocation.
As you can see, however, claiming rehabilitation tax credits is hardly simple. Make sure you work with your tax and real estate advisor to ensure the best results.
Is that guarantee permissible or impermissible?
The new IRS safe harbor for rehabilitation credits isn’t available if anyone in the rehabilitation project has entered into certain guarantee or insurance arrangements to protect the investor’s minimum contribution against losses.
Revenue Procedure 2014-12 specifically prohibits developers from providing guarantees of the investor’s ability to claim tax credits or guarantees that the investor will receive distributions or consideration for its partnership interest. It also prohibits developers from indemnifying the investor for its costs if the IRS challenges the investor’s claim of the credits.
However, the procedure does allow “unfunded permissible guarantees,” which can include guarantees of or for the following items:
- Performing any acts required to claim the credits,
- Avoiding an act or omission that would result in the recapture of credits by the IRS because the partnership doesn’t qualify,
- Operating deficit,
- Environmental indemnities, and
- Financial covenants.
The procedure doesn’t prohibit third-party guarantees or insurance from parties not involved in the project.