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

• 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

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

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.

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.

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.

State of the Project

• Financial health of project/Fair value of owners’ interest• Physical condition of property• Market conditions• Current fair market value of property• Realistic cash flow of property

• Review the regulatory agreements• Future restrictions on operations and/or

refinance• 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.

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• Legal action by the housing credit agencies for

breach of contract• Refusal by HFA to allocate tax credits or other local,

state or federal resources to future development by the owner

• 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.

• 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.

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.

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.

Conversion to market rate 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• The market rent levels• 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.

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.

• 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.

• 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.

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.

Discharge of Indebtedness

Taxable Income

• Discharge of indebtedness is included in gross income under IRC 61(a)(12)

• Cancellation of Debt (COD) results in ordinary income

Options for Excluding Income

1. The discharge occurs in a title 11 case2. The discharge occurs when the taxpayer is

insolvent3. The indebtedness discharged is qualified farm

indebtedness4. For a taxpayer other than a C corporation, the

indebtedness discharged is qualified real property indebtedness

5. The indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2013

Cost of Exclusion from Income

• Tax Attributes are reduced in this order:• NOL• General Business Credit• Minimum Tax Credit• Capital Loss Carryovers• Basis Reduction – see IRC 1017• Passive activity loss and credit carryovers• 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

• 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

• Basis adjustments are recovered in the manner described in Reg. 1.743-1

Application of Exclusion Rules

Application of Exclusion Rules

• Three most helpful exclusions for real estate developers…1. Bankruptcy2. Insolvency3. Qualified Real Property Indebtedness

• In the case of partnerships, IRC 108 provisions are applied at the partner level

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

• 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

• 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

• Some partners might want the 108(i) election, while others might benefit from a IRC 108 exclusion provision

Deferral of COD Income

Deferral Caution

• 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.

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

COD Arising from Debt Modifications

• Reg. 1.1001-3 explains what a significant modification is

• Some examples…1. Any change in a debt instrument that results

in a substitution of a new obligor, the deletion or addition of a co-obligor.

2. 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.

Significant Modification Examples

3. Change in timing of payment – safe harbor is the lesser of 5 years or 50% of the original term

4. Generally, a change from a debt that is substantially all recourse to one that is substantially nonrecourse

5. Change in security or credit enhancement that results in a change in payment expectations

Exit Strategies and Taxes

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

Agreements affecting year 15

• Buy – Sell Agreement

• Among the Partners

• Partnership Agreement

Exit strategies – end of compliance period

• Sell the Property• Potential Buyers

• General Partner• Related Party• Residents• Unrelated Third Party

Exit strategies – end of compliance period

• Cash Distribution Waterfall

• Gain/Loss on sale of property• Unrecaptured IRC 1250 Gain (25%)• IRC 1245 Depreciation recapture – ordinary

income

Exit strategies – end of compliance period

• Sale of Partnership Interest

• Impact to Selling Partner – Gain/Loss recognition• Unrecaptured IRC 1250 Gain• Potential IRC 1245 depreciation recapture

Exit strategies – end of compliance period

• Impact to Partnership• Potential IRC 708(B) technical termination

• Restart of depreciation lives

• 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

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

• 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

• 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).

• 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

• 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

Re-syndication

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

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• Reducing the Investor interest in the

partnership in years prior to the potential exit year

• 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

• 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.

• 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).

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.• Compare estimated disposition plans with the

original underwriting projections.• Compare all available exit strategies and estimate

potential exit taxes including all state and local taxes.

• 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