Tax Credits after Historic Boardwalk Hall Qualifying, Applying for and Using Historic and Other Tax Credits to Structure Real Estate Projects

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WEDNESDAY, APRIL 3, 2013

Presenting a 90-Minute Encore Presentation of the Teleconference with Live, Interactive Q&A

Anthony Ilardi, Jr., Member, Dykema, Detroit

Peter J. Berrie, Partner, Faegre Baker Daniels, Minneapolis

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Tax Credits After Historic Boardwalk Hall April 3, 2013

Anthony Ilardi, Jr.

Dykema Gossett PLLC

Peter Berrie

Faegre Baker Daniels LLP

Outline

• HTC Background and Requirements

• Monetizing the Tax Credits

• Pre-HBH Case Law Including Virginia Historic Tax Credit

Fund 2001

• Historic Boardwalk Hall: Background and Tax Court Decision

• Considerations for Structuring Deals

• Conclusion

6

History of Federal Historic Tax Credits

• 1986 Tax Reform Act enacted

current federal tax credits

• Goals:

– Reduce demolitions of

historic structures

– Decrease cost of

renovation below value of

building

– Make rehabilitation

competitive with new

construction Photo: Wikimedia Commons/Local Hero

Book-Cadillac Hotel, Detroit, MI

7

General

• Two types of federal historic tax credits under Section 47 of IRC

• Amount of credit under each is based on percentage of Qualified

Rehabilitation Expenditures (QREs)

– “Historic” Tax Credit = 20% of QREs

– “Old Building” Tax Credit = 10% of QREs

• (Note: the term “Old Building” Tax Credit is not used in the

industry, so any attempt to impress insiders by using it will

backfire.)

8

General (cont.)

• The credit is a one-time credit available only to a taxpayer with an

appropriate ownership interest at the time the project is placed in

service.

• The credit can be used entirely within one year, and to the extent

not used, it can be carried-forward for up to 20 years.

• The basis of rehabilitated buildings will be reduced by an amount

equal to the credit earned. (But no basis reduction if credit is

passed through to a qualifying tenant.)

9

Requirements to Obtain HTC

• Rehabilitation must be substantial

– In general, the qualified expenditures must exceed the building’s adjusted basis at the start of the testing period or $5,000.00

– The testing period is a 24-month period selected by the developer

– Expenditures for personal property, acquisition costs, or enlargement costs are not QRE

• Building must have been in service before rehabilitation

• Renovations must be consistent with historic character of the building

10

Photo: Wikimedia Commons/Local Hero

Broderick Tower, Detroit

Five Year Recapture Period

• The original owner must own the building and continue its historic

features for five years

• If not:

– Full or partial recapture of credit

– Recapture period

• Starts: Building placed in service

• Ends: Five years following

– Recapture amount decreases by 20% each year of compliance

period (e.g., only 80% of credits are recaptured if ownership

transfer occurs in second year after PIS)

11

Basic Qualification for “Historic” (i.e., 20%) Tax Credits

• 20% credit available for “certified historic structure”

– Listed in the National Register of Historic Places or

– Located in a registered historic district and certified as being of

historical significance to the district

• For certified historic structures, the rehabilitation expenditures

must satisfy the Secretary of the Interiors Standards for

Rehabilitation.

• It should be noted that these standards typically increase the cost

of the rehabilitation significantly.

12

Basic Qualification

• The National Park Service (“NPS”) formally has to approve the

rehabilitation plan

• Approval generally is delegated to the State Historic Preservation

Office (“SHPO”)

Application process:

• Part 1: NPS evaluates significance to determine if “certified

historic structure”

• Part 2: Establish a rehabilitation plan prepared by an architect

versed in historic rehabilitations, and request SHPO review

• Part 3: Request for certification of completion from SHPO

13

Pre-1936 Buildings

• Buildings erected before 1936 that do not meet historic criteria

may qualify for a federal credit of 10% of QRE

• The pre-1936 buildings must keep intact 50% of the external

walls, use 75% of the external walls as either interior or exterior

walls, and retain 75% of the existing framework

• This credit (unlike the 20% credit) is not available for buildings

that provide housing.

• No governmental designation is required.

14

Pre-1936 Buildings

Original Pre-1936 Building Renovated Building

Original external wall still intact

although no longer external

25% of original external wall demolished for expansion

50% of original walls still intact as external walls

15

Structuring Credit Deals

Equity Investment Structure

• Investor must be a member of

the ownership entity (usually an

LLC) before building is placed in

service

• Investor receives 99.9% interest

in entity and proportionate credit

allocation

Master Tenant Structure

• The investor owns all, or

substantially all, of the master

tenant

– Master tenant subleases projects

to end users

• Frequently, the developer group

is the manager of the master

tenant and is responsible for

leasing to the ultimate tenants

16

Equity Investment Structure

Investor Member Managing Member

Building Owner (Pass-Through Entity,

e.g. LP or LLC)

99.99% ownership

0.01% ownership

17

Master Tenant Structure

Investor

Member

MT Managing

Member

Master

Tenant Building

Owner

10–20%

Master

Tenant

Managing

Member

80–90% 99.99% 0.01%

Lease

Sublease(s) to

ultimate users

18

Frequent Issues in HTC Cases Before and After Historic Boardwalk Hall

19

John Harvey House (Inn on Winder), Detroit

Commissioner challenges HTC

projects which use partnerships

where:

• Transaction’s substance does

not match its form

• Disguised sales

• Investors not actually partners

or partnership is a sham

• Transaction lacks economic

substance

The Precursor to Historic Boardwalk Hall: Virginia Historic Tax Credit Fund LP 2001

• IRS Arguments: The IRS challenged the partnership’s tax return

and argued

– That the investors were not partners and their investment was a

sale of state tax credits; or

– Even if the investors were partners, the contribution was a

disguised sale of state credits

• The Tax Court rejected both of the IRS’s arguments and found

that (i) the investors were partners and (ii) there was no disguised

sale

• The IRS appealed

• The Fourth Circuit overturned the Tax Court

20

The Precursor to Historic Boardwalk Hall: Virginia Historic Tax Credit Fund LP 2001 (cont’d)

• The Code presumes that a sale occurs if

– There is a transfer of money to a partnership, and

– There is a related transfer of property by the partnership to the

partner

– The Code presumes there is a sale if the two transfers occur

within two years

– The presumption is rebuttable

21

Virginia Historic Tax Credit Fund LP 2001: Fourth Circuit Court of Appeals

• The Court of Appeals found that even if the partnership was a

true partnership, the transactions were disguised sales under

Section 707(c) of the Internal Revenue Code

• The Fourth Circuit held the credits were like property and:

– The investors lacked entrepreneurial risk

– The transaction was like “an advanced purchaser who pays for an

item with a promise of later delivery”

22

Historic Boardwalk Hall Background

• East Hall placed in service in 1929

• East Hall designated as a National Historic

Landmark

• NJSEA enters a lease for East Hall from ACIA in

1992

• East Hall renovations begin in December 1998

• Historic Boardwalk Hall LLC is formed in June, 2000

with NJSEA as its sole member

• A Pitney Bowes affiliate is admitted as an investor

member in September 2000

• NJSEA transferred the Hall to a partnership (HBH)

• The investor was a 99.9% member of the partnership

• The investor was entitled to a three percent preferred

return

• Agreement provided put and call options for the

members of the partnership

• Agreement provided a tax benefits guarantee

contract where the municipal owner agreed to pay

investor if partnership did not obtain tax credits

• The U.S. Court of Appeals for the Third Circuit

reversed the Tax Court’s taxpayer favorable decision

on August 27, 2012

23

Photo: Library of Congress, Prints & Photographs Division, NJ,1-ATCI,18-11

Boardwalk Hall, Atlantic City, New Jersey

Other Relevant HBH Facts

• By end of 1999, NJSEA issued $50 million of bonds and received

commitment from Casino Reinvestment Development Authority to

reimburse “all costs in excess of bond proceeds.”

• Before construction began, consultant approached NJSEA about

selling tax credits to get $11 million of benefits that would be similar to

an $11 million interest-only loan that may not need to be repaid.

• Ultimate investor offering memo was entitled “The Sale of Historic Tax

Credits . . .”

• Proposed structure would allocate 99% of profits, (credits) and losses

to investor but only a “small portion” of cash flow.

• NJSEA (governmental entity) provided guarantees (construction

completion, operating deficit, tax recapture, environmental indemnity).

24

Other Relevant HBH Facts (cont’d)

• Projections (financial forecast) changed wildly from September 1999 (showing annual net operating losses of $1.7 million) to early 2000 (showing net operating income ranging from $716,000 to $1.24 million). – Syndicator suggested shifting expenses to landlord to show investors a

“working operating model.”

– Projections were later adjusted again to add $1 million in annual revenues through new naming rights and an increase in parking and concession revenues

• “After reality finished with the pretense of profitability” HBH’s actual operating results were much worse—net operating losses in the millions.

• Use of investor’s capital = $14,000,000 developer fee to NJSEA, $527,000 for tax-credit transaction costs, and the creation of a $1,826,920 working capital reserve fund.

• GIC secured put/call option price.

25

PB LLC (“investment member”)

NJSEA

99.9% .1%

99.9% * (up to 3% preferred return)

-Profits

-Losses

-Tax Credits

-Cash Flow

K1

Acquisition Note = $53 M

K1: Sublease East Hall (“sale

& purchase” for tax purposes)

K2: Construction loan K

Loan

$57 M

Totaling $18m and an investor loan of $1.1m - Contributions to pay down acquisition note - Same amt. to be drawn on K loan (increasing balance) and distributed to HBH - Part used by NJSEA to purchase GIC - Part used by HBH to pay NJSEA development fee (w/ associated responsibilities)

K2

GIC K

Title & Insurance

Interest Payments on PB’s

investor loan

Pay

men

t H

iera

rchy

Income Taxes

Current & accrued but unpaid

debt service on notes

.1% Remaining Cash flow 99.9% Remaining Cash flow

1

2

3

4

6

5

6

Vested Call Vested Put

Historic Boardwalk Hall Structure

26

Tax Benefits Guarantee K

3P

Historic Boardwalk Hall

(“HBH”), LLC

(taxed as a partnership)

Historic Boardwalk Hall: IRS Arguments

• The IRS challenged the partnership by arguing:

– The transaction lacked economic substance

– The investor was not a partner

– The owner did not sell or transfer the Hall to the partnership

– The partnership should pay an accuracy penalty

27

Historic Boardwalk Hall: Taxpayer Arguments

• The taxpayer argued that:

– The economic substance doctrine did not apply because

Congress intended HTC to spur otherwise unprofitable

investments to rehabilitate historic buildings

– The investor reasonably expected a 3% return, thus

demonstrating it had a profit motive

– The taxpayer is a partner because there was a partnership

agreement that the parties negotiated

– The transaction documents and the parties’ conduct show that the

Hall was actually transferred to the partnership

28

Historic Boardwalk Hall: Tax Court Findings

• Economic Substance Argument

– Found economic substance:

• Tax Credit

• 3% return

• Partnership could invest more in the renovation because of investor’s

contribution

• Partnership Argument

– Rejected because:

• The investor entered into a transaction to facilitate an investment in

exchange for tax credits and a three percent return

• The investor’s interest was not more like debt than equity

29

Historic Boardwalk Hall: Tax Court Findings (cont’d)

• The court rejected the IRS’s argument that the owner did not transfer the Hall to the partnership because:

– The documents showed an intent that the Hall transfer

– It was irrelevant that the Hall would continue to be operated by the former owner

– The former owner’s purchase option did not destroy the transfer because it was consistent with the operation of the credits

• The court rejected the IRS’s anti-abuse regulations and Accuracy Penalty Argument because:

– There was a real business purpose to the transaction

– Congress intended the HTC to spur investment by reducing participant’s tax liabilities; therefore, it was unimportant that the investor’s tax liability was reduced by the transaction

30

Historic Boardwalk Hall: Result

• The Tax Court upheld the partnership’s 99.9% allocation of the HTC to

the investor

• The IRS appealed the result to the Third Circuit Court of Appeals

arguing:

– The investor was not a partner because it had no entrepreneurial risk or

potential for upside gain

– The partnership was a sham

– The partnership was not the owner of the Hall

• The Taxpayer’s arguments on appeal were:

– The partnership is a real partnership and both partners are bona fide

– The partnership is not a sham

– The Hall was transferred to the partnership

31

Historic Boardwalk Hall: Result (cont’d)

• To a large extent, the taxpayers argued that Congressional policy

to encourage historic rehabilitation should override traditional

partner analysis while the IRS argued that the benefits intended

by Congress only flow to true partners

• Other credits, such as the Low-Income Housing Tax Credits and

New Markets Tax Credits, appear to obviate this issue by different

investment rules contained in the Internal Revenue Code

32

Historic Boardwalk Hall: Court of Appeals

• On June 25, 2012, the Court of Appeals Third Circuit in Philadelphia heard oral arguments

• At oral argument, observers noted that the judges questioned whether the investor had any risk in the partnership because of the various guarantees and indemnities

• Third Circuit Decision issued on August 27, 2012 reversed the Tax Court decision and ruled that the Pitney Bowes affiliate was not a true partner in Historic Boardwalk Hall, LLC

– As a result, the Third Circuit affirmed the IRS Administrative Adjustment to reallocate all of the Historic Rehabilitation Tax Credits from Pitney Bowes to the tax-exempt New Jersey Sports and Exposition Authority, a political subdivision of the State of New Jersey

33

Factors on Which the Third Circuit Relied

• Substance-over-form analysis

• The Court heavily relied on its interpretation of Comm’r v.

Culbertson, 337 U.S. 733 (1949)

• Specific Factors

– Lack of “downside” risk

• Investor’s contribution contingent on sufficient construction progress to

ensure anticipated credit allocation

• The NJSEA guaranteed the tax benefits, plus penalties, interest and up to

$75,000 in legal fees

34

Factors on Which the Third Circuit Relied (cont’d)

• The Investor lacked risk because the project was fully funded

before the Investor entered into the transaction and, accordingly,

the investment funds were not necessary to complete the project

(the Court thus implying that the investment did not meet the

Congressional goal of encouraging tax credit investments in

projects that otherwise would not be funded)

• Although the 3% preferred return was not formally guaranteed,

the Investor could exercise a put option and obtain any unpaid

preferred return

• Moreover, the put option was supported by a Guaranteed

Investment Contract purchased by NJSEA

35

Factors on Which the Third Circuit Relied (cont’d)

• The Third Circuit noted:

“[T]he parties agreed to shield [the Investor’s] ‘investment’

from any meaningful risk. [The Investor] was assured of receiving

the value of the [historic rehabilitation tax credits] and its

Preferred Return regardless of the success or failure of the

rehabilitation of the East Hall and [the Partnership’s] subsequent

operation.”

• Lack of meaningful upside potential

– NJSEA had a call option at fair market value

– The Court concluded that the fair market value would never

exceed the unpaid preferred return; thus, there was no upside

36

Factors on Which the Third Circuit Relied (cont’d)

• Projections

– The Third Circuit was troubled by what it perceived as heavily

manipulated projections on which the parties ostensibly relied, but

which, the Court concluded, were not grounded in reality:

“To put it mildly, the parties and their advisors were

imaginative in creating financial projections to make it appear

[the Partnership] would be a profit-making enterprise.”

37

Historic Boardwalk Hall Conclusions & Recommendations

• “No risk, no partner” is a basic tenet of federal tax common law

• Bad facts make bad law

• Partnerships should be cautious in excessively reducing risk to investors when structuring HTC transactions

• Some practitioners have concluded that a put option may be reasonable on the theory that it protects against being stuck in a bad deal, but a call option should not be used since the call option arguably eliminates the ability to make a profit (but others have proposed eliminating the put and keeping the call, while yet others are keeping both)

• Caution should be exercised in restructuring closed transactions now, since such restructuring may trigger unintended consequences and create a roadmap for the IRS

38

Historic Boardwalk Hall Conclusions & Recommendations (cont’d)

• Master Tenant Structure

– Some have suggested this as a solution

– Under the Master Tenant structure, the Investor leaves the property and, in accordance with tax rules, passes through the credit to the Master Tenant

• Issues with this structure

– Lease must be a true lease, including rent at fair rental value

– The owner recoups its costs from rental payments, which typically are not received up front. This may necessitate additional financing

• Traditionally, master tenants frequently are also partners making capital contributions (which are then used to fund construction) thus not avoiding the Historic Boardwalk issues

• There is some limited indication that the IRS may consider issuing guidance, but no certainty that it will

39

Historic Boardwalk Hall Conclusions & Recommendations (cont’d)

• Structuring Considerations

– “Sandwich” Leases

– “Super” Subordination Agreements (SNDAs)

– Timing and Amount of Investor Equity

– Capital Contribution Installment at end of compliance period

equaling put price

– Level of Guaranties

• Operating Deficit Guaranty capped.

• Tax credit recapture guaranty limited.

– Control provisions changing after the 5-year compliance period

40

But Wait, There’s More

• On January 17, 2013 Historic Boardwalk Hall and the New Jersey

Sports and Exposition Authority filed a Petition for a Writ of

Certiorari in the United States Supreme Court seeking reversal of

the Third Circuit Opinion in the Historic Boardwalk Hall Case

• The IRS’ opposition to the Petition is due February 22, 2013

41

Dms.us.51559489

Tax Credit Resources on the Web

Historic/Rehabilitation Tax Credits

General

General information on Rehabilitation Credit from National Park Service:

http://www.nps.gov/tps/tax-incentives.htm

Application

Link to Application (includes Part 1, 2 and 3):

http://www.nps.gov/tps/tax-incentives/application.htm

IRS Form 3468 (for claiming credits)

http://www.irs.gov/pub/irs-pdf/f3468.pdf

42

Tax Credits After Historic Boardwalk Hall April 3, 2013

Anthony Ilardi, Jr. Dykema Gossett PLLC 248-203-0863 ailardi@dykema.com

Peter Berrie Faegre Baker Daniels LLP 612-766-7080 peter.berrie@FaegreBD.com

dms.us.51559489