The Land of OZ: Some Potential Marriages

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Investing Opportunity Fund Proceeds Into Tax Credit Projects

The IRS has recently published an eagerly anticipated, thoughtful and helpful Opportunity Zone Program (OZP) guidance. That guidance provides answers to questions regarding eligibility, fund formation and opportunity zone business qualification. This now provides us all with sufficient information to assess how the OZP interacts with tax credit programs, specifically New Markets Tax Credit (NMTC), Low Income Housing Tax Credit (LIHTC), Historic Rehabilitation and Renewable Energy. So let’s look at the marriage of the OZP with each of these credits:

New Markets Tax Credits
A number of the requirements of the OZP applicable to a Qualified Opportunity Zone Business (QOZB) borrow elements from the NMTC program. Each governor designates Opportunity Zones from NMTC eligible census tracts located in his or her state. “Sin businesses” that are exempted from NMTC investment are also excluded from OZP Investment. Like the NMTC, the OZP investments must be made into active businesses that do not have excessive “non-qualified” financial property.

However, other NMTC program requirements make a marriage of NMTC and OZP investments very difficult.

NMTC investments are structured as equity investments into a fund that borrows funds and invests the aggregate amount into equity interests in a Community Development Entity (CDE). The CDE then provides permanent financing to a Qualified Low-Income Community Business (QALICB). Since the assets of the CDE (long-term loans) constitute “non-qualified” financial property, the CDE cannot qualify as an Opportunity Zone business. Moreover, many QALICBs are nonprofit organizations that cannot issue equity interests as required for OZP investment. Accordingly, NMTC transactions are not compatible with the OZP. While a for-profit QALICB could issue OZP interests to an investor in a side-by-side transaction, the OZP investment is not leveraged by the NMTC.

Low Income Housing Tax Credits
Because the traditional large bank investors in LIHTC projects do not consistently have large amounts of qualifying capital gain, most LIHTC investors will not routinely use OZP funding to make investments in projects located in Opportunity Zones. Moreover, 80 to 90 percent of the residual value and cash flow of LIHTC projects are typically allocated to the general partner. As a result, the possibility of appreciation to maximize the benefit of the fair market value basis step-up applied to OZone investments after ten years—an attraction to potential Opportunity Fund investors—is very limited.

OZone funds compiled from those who do collect capital gains, however, may well be an equity source for developers who locate LIHTC projects in OZones. Such projects may support additional investment funds beyond the tax credit equity and available hard and soft loans to bridge the gap created by increased construction costs. An OZP-funded general partner will obtain OZP FMV step-up several years before the project reaches the expiration of the 15-year LIHTC compliance period. Although the general partner’s percentage interest in the operating income of the entity that owns the affordable housing project is typically small (generally anywhere from 0.01 to one percent), its carried interest of 80 to 90 percent of sale and refinancing proceeds provides a potential significant upside. The amount of appreciation that is sheltered from taxation by means of the OZP basis increase will depend on the applicable facts and circumstances—the affordability restrictions (including the term and the level of restrictions in place), terms of any soft debt financing the project and the location and condition of the project itself. Rural Mississippi projects, for example, do not have the same upside potential of suburban projects in rapidly growing metropolitan areas.

A note of caution should be sounded, however, with respect to OZP-funded LIHTC general partners. LIHTC developers rarely contribute significant capital to LIHTC projects. Frequently the capital is proportional to their small-percentage interest in operating profits. A basis step-up to 90 percent of the value of a project with respect to an OZone capital contribution of a few thousand dollars does not appear to be consistent with the statutory intent. While the general partner’s capital contribution would clearly qualify for OZP benefits under the current statute, the proposed regulations invite comments on whether there are circumstances which may be considered abusive. If the IRS believes that a de minimis capital investment does not support a disproportional gain exclusion, the IRS could recharacterize a portion of the general partner’s share of sale and refinancing proceeds as compensation for the services of the general partner with respect to the project – and deem it ineligible for inclusion in the amount of appreciation that avoids taxation under the OZP. LIHTC developers should monitor future guidance with respect to the “abuse” exception to OZP benefits.

Historic and Renewable Energy Tax Credits
Traditional tax credit investors are unlikely to combine OZP funds with investments in Historic Rehabilitation Tax Credit (HTC) and Renewable Energy (RE) projects. Utilizers of these investment tax credits have generally exited their investment soon after the expiration of the five-year recapture period, too brief a holding period to qualify for OZP benefits. Moreover, these transactions have been structured to distribute the smallest possible amount of cash flow and residual value to the investor, sufficient to support the partner/owner status of the investor under the Historic Boardwalk analysis. The general partner/developer side of the transaction will balk at the prospect of transferring five more years of cash flow and residual value to an investor in exchange for an OZP profit enjoyed only by the investor.

The general partner side of HTC and RE transactions, however, enjoys a substantial opportunity to profit from OZone investments. The flip of percentage allocations from 99 percent in favor of the tax credit investor to 95 percent in favor of the developer, allows the developer side to leverage the capital provided by the tax credit investor for their benefit. Moreover, unlike LIHTC transactions, HTC and RE developers frequently deploy substantial capital into transactions. This capital may be sourced through private equity, friends and family investors or through “mezzanine” or “back leverage” indebtedness. These investors, if they are willing to make a ten-year equity investment, can utilize the OZP to enhance their yield. HTC transactions may be better poised to deploy OZP funding since rehabilitated historic properties are not subject to income limitations and can generate significant upside residual value. RE transactions typically depreciate over time, due to the degradation of solar panels and turbines, as well as their shorter economic useful life. Even so, a step up in basis to fair market value in a RE transaction will have the effect of converting depreciation recapture into a tax-free return of equity and significantly enhancing yield. If the private equity investors claim the HTC or RE credits as well, their yield can be further enhanced and additional gain beyond their investment can be sheltered.

Many OZP investments thus far have been made by individuals and closely held corporations. Practitioners and taxpayers in OZP tax credit transactions must resolve the at-risk and passive loss limitations issues that will arise from these investments. These rules are complex and difficult, but can generally be navigated with careful analysis. Taxpayers who marry OZP investments with tax credits must also navigate the basis and distribution rules that hopefully will be addressed in the next round of guidance.

Despite the challenges of structuring these transactions, in a time of increasing construction costs and dwindling governmental subsidy, the OZP may provide a welcome source of additional capital for tax credit projects located in designated OZones.

Disclaimer: This is for general information and is not intended to be and should not be taken as legal advice for any particular matter. It is not intended to and does not create any attorney-client relationship. The opinions expressed and any legal positions asserted in the article are those of the author and do not necessarily reflect the opinions or positions of Miles & Stockbridge, its other lawyers or the National Housing & Rehabilitation Association.

Jerry Breed focuses his practice on tax planning and the structuring of low-income housing tax credit, historic rehabilitation tax credit, new markets tax credit and renewable energy transactions. Mr. Breed has closed many low-income housing, historic rehabilitation, new markets tax credit and renewable energy transactions that permit his clients to maximize tax benefits and investment returns, all within the framework of the client's business goals. He has substantial experience in the taxation of community development and new markets credit investments. Mr. Breed also has represented clients with respect to audits of tax credit investments. Clients of Mr. Breed include syndicators and investors in low-income housing, historic rehabilitation, new markets tax credit and renewable energy transactions as well as developers of these credit projects. In the New Markets Tax Credits area, Mr. Breed represents the owners of qualified active low-income community businesses and community development entities. Mr. Breed also represents state housing authorities that allocate low-income housing tax credits. Frequently, these federal credits include state credits and other federal, state and local subsidies. Mr. Breed has given presentations at numerous seminars and conferences on the low-income housing, historic rehabilitation, new markets tax credits and renewable energy credits including presentations on partnership taxation, and real estate tax issues. He also is author of a number of articles on tax credits and other federal income tax matters.