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LIHTC Exit strategies

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There are multiple opportunities and obstacles facing affordable housing projects during their life span. One of the more complex decisions is to determine how and when to exit the project. There …

There are multiple opportunities and obstacles facing affordable housing projects during their life span. One of the more complex decisions is to determine how and when to exit the project. There are several items to consider when making this determination in order to effectively and efficiently exit the project with the least amount of legal and tax ramifications.
The first step in the process is to review and become familiar with all of the legal documents associated with the project including the partnership agreement, loan documents, development agreements, and other restrictive covenants. These agreements give a baseline as to what, if any, constraints the project will face at the time of disposing either the property or the partnership interest.
Analyzing the debt structure of the project and any discrepancies with the original underwriting is a necessary step to take early in the life span of the project. If there is a substantial amount of debt on the project, then a determination needs to be made regarding the payment or forgiveness of this debt prior to end of the project. It is imperative to determine the type of debt on the project and what limitations are associated with the debt. Refinancing the project prior to exiting might also be a viable solution.
Once a determination is made that an exit strategy is warranted, then the strategies associated with the project may range from selling the property itself to having one or more of the partners selling their specific interest. Depending upon the strategy taken, the exit taxes, from a federal, state and local perspective may be substantially different.
With the various agreements, covenants, financing sources, physical and market conditions of the project, it is never too early to begin planning for the disposition of an affordable housing project. If you would like more specific information on this topic, please download the attached presentation

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  • 1. Exit Strategies: Opportunities and Obstacles
    By: Nancy M. Morton |nmorton@doz.net| 317-819-6141
    Jessica Cooper | jcooper@doz.net| 317-819-6152
    Corrie McConnell|cmcconnell@doz.net |317-819-6144
  • 2. Agreements to consider
    Right of first refusal
    Conversion to market
    Issues related to deferred development fee
    Refinance options
    Discharge of indebtedness
    Exit strategies
    Exit taxes
    Conclusion
    Outline
  • 3. Initial Considerations
    What to consider:
    Agreements affecting year 15
    Right of first refusal
    Evaluate the state of the project
    Extended use provisions and qualified contract
    Conversion to market units
    Re-financing options
  • 4. Initial Agreements
    Know the exact terms of the agreements and whether a right of first refusal agreements is in place.
    Are there any buy-sell agreements?
    Provisions in the partnership agreements, lender agreements, or regulatory agreements that may contain restrictions and/or requirements on the disposition of the property.
  • 5. Right of first refusal
    IRC 42(i)(7)(A) provides that a project, after the close of the compliance period, will not lose its federal tax benefit with respect to any qualified low-income building merely by reason of a right of first refusal held by the tenants or residential management corporation of the building or by a qualified nonprofit organization or government agency that purchases the property for a defined minimum price.
  • 6. Defined minimum price
    IRC 42(i)(7)(B) defines a minimum price as the sum of the principal amount of the outstanding indebtedness secured by building (other than any indebtedness incurred within the five-year period ending on the date of the sale to the tenants), plus all federal, state, and local taxes attributable to the sale.
  • 7. State of the Project
    Financial health of project/Fair value of owners’ interest
    • Physical condition of property
    • 8. Market conditions
    • 9. Current fair market value of property
    • 10. Realistic cash flow of property
    Review the regulatory agreements
    • Future restrictions on operations and/or refinance
    • 11. Extended compliance period based upon state and local requirements
  • Extended Use Provision
    IRC 42(h)(6) requires the owner of an LIHTC project, receiving an allocation after 1989, to maintain the percentage of low income tenants for at least 15 years after the close of the LIHTC compliance period.
    The LIHTC compliance period is defined in IRC 42(i)(1) as the period of 15 taxable years beginning with the first taxable year of the credit period.
  • 12. Extended Use Provision
    Only compliance violations occurring in the compliance period will elicit the tax credit recapture provisions.
    There are several different potential penalties for owners failing to meet the additional affordability requirements including:
    • A lawsuit by the tenants
    • 13. Legal action by the housing credit agencies for breach of contract
    • 14. Refusal by HFA to allocate tax credits or other local, state or federal resources to future development by the owner
    • 15. Refusal by potential project buyers to take on a property that is out of compliance.
  • Extended low-income housing contract
    The extended low-income housing contract is an agreement between the taxpayer and the housing credit agency. Typically, the agreement has the following provisions:
    • Requires the taxpayer to maintain the percentage of low-income tenants for at least 15 years after the close of the compliance period.
    • 16. The portion of the building used for low-income tenants each year in the extended use period will not be less than the applicable fraction specified during the compliance period.
  • Extended low-income housing contract
    The agreement is binding on all successors of the taxpayer.
    The agreement must be recorded as a restrictive covenant with respect to the building under applicable state law.
    The agreement must prohibit evictions without good cause and rent increases not otherwise permitted in the agreement- LIHTC rents.
  • 17. Extended low-income housing contract
    No LIHTCs are allowed with respect to any building for the taxable year unless an extended low-income housing commitment is in effect at the end of such year.
  • 18. Extended low-income housing contract exceptions
    IRC 42(h)(6)(E) states that the extended use period for any building shall be terminated under the following provisions:
    • On the date that the building is acquired by foreclosure.
    The IRS may reject this exception if it is determined that the foreclosure is an arrangement set forth by the taxpayer with the sole purpose of terminating the extended use period.
    • If the housing agency is unable to present a buyer under a qualified contract arrangement.
  • Qualified Contract
    Under IRC 43(h)(6)(F), a LIHTC project could become a market-rate project upon the owner’s written request and within one-year period beginning on the date after the 14th year of the compliance period if the housing credit agency is unable to find a qualified contract for the acquisition of the low-income portion of the building.
    The qualified contract price for the low-income portion of the building may not be less than the applicable fraction of the sum of the outstanding indebtedness secured by the building, the adjusted investor equity in the building, and other capital contributions not already reflected, reduced by cash distributions from the project.
    It is important to verify with the partnership to determine if more stringent requirements are provided in any agreement or in the laws of the state where the project is located.
  • 19. Conversion to marketrate units
    This is less likely with a post-1989 transaction due to the extended use provisions.
    The conversion will depend upon the following:
    Market factors
    • Amount of affordable housing available
    • 20. The market rent levels
    • 21. Current and future proposed developments
    Physical condition of the project
    • Properties that have deteriorated significantly in the first 15 years are not likely to be attractive for conversion.
    Even if the developer elects the 14-year opt-out with the tax credit agency, the project is still subject to a three-year transition period.
  • 22. Deferred Developer Fee
    Bona Fide Debt:
    • Any debt obligation, including an obligation to pay a deferred developer fee, must be respected as bona fide debt in order to be included in the basis of the project for credit and depreciation purposes.
    • 23. At a minimum, this means that the obligation must have a definite maturity date and the partnership must be able to establish that it is likely to be paid on or before such date.
    • 24. Under IRC 267, depreciation can not be taken on the deferred developer fee until paid under the matching principal. However, IRC 267(a)(2) applies only to the matching of income and deductions; therefore it does not preclude the claiming of credits on fees accrued by a partnership but not included in the income of a related cash basis payee.
  • Deferred Developer Fee
    Care needs to be taken to determine when and how the deferred developer fee is to be paid.
    The partnership agreement and/or the developer fee agreement may have specific language as to when and how this fee is to be paid including having the general partner make a capital contribution to pay the fee as of a certain date.
    The payment of the deferred developer fee may also be part of the waterfall provisions in the partnership agreement.
  • 25. Refinance options
    There may be opportunities to refinance with the state or local housing finance agencies as well as the federal agencies.
    • HUD-approved lenders can help facilitate the refinance of existing multi-family rental housing projects using HUD-insured loans.
    Apply for additional soft loans and/or grants.
    Restructuring of the debt.
  • 26. Discharge of Indebtedness
  • 27. Taxable Income
    Discharge of indebtedness is included in gross income under IRC 61(a)(12)
    Cancellation of Debt (COD) results in ordinary income
  • 28. Options for Excluding Income
    The discharge occurs in a title 11 case
    The discharge occurs when the taxpayer is insolvent
    The indebtedness discharged is qualified farm indebtedness
    For a taxpayer other than a C corporation, the indebtedness discharged is qualified real property indebtedness
    The indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2013
  • 29. Cost of Exclusion from Income
    Tax Attributes are reduced in this order:
    • NOL
    • 30. General Business Credit
    • 31. Minimum Tax Credit
    • 32. Capital Loss Carryovers
    • 33. Basis Reduction – see IRC 1017
    • 34. Passive activity loss and credit carryovers
    • 35. Foreign tax credit carryovers
  • Attributes are deemed reduced on the first day of the year after discharge
    Allows attributes to be used in the year the debt is discharged
    Application of Exclusion Rules
  • 36. Taxpayer may elect to reduce basis first
    • Partnerships – the basis reduction is an adjustment to the basis of the partnership property with respect to that partner only
    • 37. Basis adjustments are recovered in the manner described in Reg. 1.743-1
    Application of Exclusion Rules
  • 38. Application of Exclusion Rules
    Three most helpful exclusions for real estate developers…
    Bankruptcy
    Insolvency
    Qualified Real Property Indebtedness
    In the case of partnerships, IRC 108 provisions are applied at the partner level
  • 39. Deferral of COD Income
    IRC 108(i) – Deferral and ratable inclusion of income arising from business indebtedness discharged by the reacquisition of a debt instrument
    Created by the American Recovery and Reinvestment Act of 2009
    Rev. Proc. 2009-37 provides guidance
  • 40. Permits business taxpayer that reacquires its own debt at a discount during 2009 or 2010 to make an irrevocable election to:
    • Defer the resulting COD Income
    For 5 years if it occurred in 2009
    For 4 years if it occurred in 2010
    • Spread that income over five years after the deferral period is over
    Partnerships make the election at the partnership level
    Deferral of COD Income
  • 41. Rev. Proc. 2009-37 allows a partnership to make a partial election
    • Make election for amounts that are allocable to some partners while not making the election for the COD income allocable to other partners
    • 42. Some partners might want the 108(i) election, while others might benefit from a IRC 108 exclusion provision
    Deferral of COD Income
  • 43. DeferralCaution
    When you make a deferral election for a particular amount of COD income, the income is generally ineligible for the COD income exclusions.
    Electing to defer will expose the taxpayer to whatever federal income tax regime exists in those years (2014-2018)
    COD income deferred under IRC 108(i) is accelerated if the partnership liquidates, sells its assets, ceases operations or goes bankrupt
    Amounts deferred at the partner level due to partnership elections are accelerated if the partnership interest is sold, exchanged, redeemed or abandoned, or if the partner dies or liquidates.
  • 44. COD Arising from Debt Modifications
    Significant modification of debt terms can be considered an exchange of the old debt for the new
    New debt generates debt forgiveness income if the issue price of the new debt is less than the balance of the old debt
  • 45. COD Arising from Debt Modifications
    Reg. 1.1001-3 explains what a significant modification is
    Some examples…
    Any change in a debt instrument that results in a substitution of a new obligor, the deletion or addition of a co-obligor.
    A change in the yield of a debt instrument if the change exceeds the greater of 25 basis points or 5% of the original yield of the instrument.
  • 46. Significant Modification Examples
    3. Change in timing of payment – safe harbor is the lesser of 5 years or 50% of the original term
    Generally, a change from a debt that is substantially all recourse to one that is substantially nonrecourse
    Change in security or credit enhancement that results in a change in payment expectations
  • 47. Exit Strategies and Taxes
  • 48. Year 15 Issues for a LIHTC project
    Exit strategies available for investors and general partners and their tax consequences
    How a LIHTC partnership can better prepare for year 15
  • 49. Agreements affecting year 15
    • Buy – Sell Agreement
    • 50. Among the Partners
    • 51. Partnership Agreement
  • Exit strategies – end of compliance period
  • Exit strategies – end of compliance period
    • Cash Distribution Waterfall
    • 57. Gain/Loss on sale of property
    UnrecapturedIRC 1250 Gain (25%)
    IRC 1245 Depreciation recapture – ordinary income
  • 58. Exit strategies – end of compliance period
    Sale of Partnership Interest
    • Impact to Selling Partner – Gain/Loss recognition
    UnrecapturedIRC 1250 Gain
    Potential IRC1245 depreciation recapture
  • 59. Exit strategies – end of compliance period
    • Impact to Partnership
    Potential IRC 708(B) technical termination
    • Restart of depreciation lives
    • 60. Sale to general partner
    Original partnership remains intact
    No real estate transaction costs
    GP owns both the GP and LP partnership interests and continues to service the debt
  • 61. Exit strategies – end of compliance period
    Charitable Contribution/Bargain Sale of Property or Partnership Interest
    • Partnership donates or sells the property at a reduced price to a charitable organization
    • 62. Investor donates or sells her partnership interest at a reduced price to a charitable organization
  • Exit strategies – end of compliance period
    • Reg. 1.170A-(4)(C)(2)(ii)
    Two step process – part sale/exchange of property; part charitable contribution
    • Charitable contribution is the fair market value of the property donated less the sales price or amount of debt assumed by the not-for-profit organization
  • Exit strategies – end of compliance period
    Partnership recognizes gain on sale of property
    • Adjusted basis of property sold shall bear the same ratio as the amount realized bears to the fair market value of the property
    • 63. The amount realized (sales price or debt assumed) less adjusted basis equals the amount of gain recognized
  • Items to consider when re-syndicating:
    • There must be at least $6,000 per unit of rehabilitation costs within a 24-month period as defined in IRC 42(e)(3)(A)(ii).
    • 64. Typically, the project must also meet the 10-year rule, as described in IRC 42(d)(6) to be able to claim acquisition credits.
    Per IRC 42(d)(2)(B)(ii), a federal assisted building is any building that is substantially assisted, financed or operated under section 8 of the U.S. Housing Act of 1937.
    Under the amended IRC 42(d)(6) by the Housing and Recovery Act of 2008, federal or state assisted buildings are exempt from the 10 year rule.
    Exit strategies – end of compliance period
  • 65. Re-syndication
    Re-Syndication
    May need to be structured to generate acquisition credits or there might not be enough tax credit equity
    Depends on availability of tax credits
    Must conform to the qualified allocation plan for the respective state where the project resides
  • 66. Exit taxes
    • Taxes can be a significant liability for the exiting investor partner
    Investor partner recognizes taxable income to the extent it has a negative capital account at time of sale
    • Negative capital account is a result of loss allocations and distributions during the life of the partnership in excess of the original investment
    Tax liabilities include federal, state and even local in some states, and can include franchise or excise tax as well
  • 67. Exit taxes
    Non resident withholding tax liabilities are imposed by some states on the income allocated to the exiting partner
    • This can be an unexpected cash outlay for the partnership
    Minimization strategies
    • Forgiveness of sponsor debt – creates income which increases capital account
    • 68. Reducing the Investor interest in the partnership in years prior to the potential exit year
    • 69. Capitalize rather than expense repairs
  • Exit taxes
    Improve overall property performance to reduce losses and therefore increase capital account balances
    Project can remain affordable with restructuring/withdrawal by the investor
    • Refinancing/debt restructuring lowers debt service and may provide funds to pay the withdrawing investor and fund capital improvements
    • 70. Developer maintains control of the project and continues to receive property management fees
  • Like-kind Exchange
    Like-kind exchanges under IRC 1031 are not a common exit strategy.
    • Some successful like-kind exchange practices have occurred between affordable housing properties and investment grade credit-tenant lease commercial properties.
    • 71. This type of strategy works better for older projects that have completed the required compliance period and have large negative capital accounts and very low basis.
  • Like-kind Exchange
    The end result of this strategy is the investors in the partnership end up owning a credit-tenant property at a more favorable tax position with gain deferral; and the affordable-housing project is recapitalized with new debt, renovated by the new owners, who in turn receive both low-income housing tax credits and depreciation benefits (assuming all requirements are met).
  • 72. Conclusion
    There are multiple obstacles and opportunities to consider when disposing of or retaining a project:
    • Be familiar with all executed agreements including loan documents.
    • 73. Compare estimated disposition plans with the original underwriting projections.
    • 74. Compare all available exit strategies and estimate potential exit taxes including all state and local taxes.
    • 75. It’s never to early to begin planning for year 15 of a LIHTC project.
  • Contact Information:
    By: Nancy M. Morton |nmorton@doz.net| 317-819-6141
    Jessica Cooper | jcooper@doz.net| 317-819-6152
    Corrie McConnell|cmcconnell@doz.net |317-819-6144