Special Issues for Projects Involving Nonprofits

IPED Housing Tax Credits “101”March 5-6, 2009

Molly R. Bryson

Thomas A. Giblin

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Overview

• Roles nonprofits play in tax credit deals

• Federal tax-exempt status of nonprofits

• Federal grants to nonprofits

• Tax-exempt use property issues

• Nonprofit Set-Aside

• Right of First Refusal

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Examples of Nonprofit Participation in Tax Credit Projects

• General partner, or co-general partner with a for-profit

• Developer or property management agent

• Lender

• Social service provider

• Lessor under ground lease (or managing general partner) to qualify for property tax exemption/abatement

• Holder of right of first refusal under § 42(i)(7)

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Obtaining and Maintaining 501(c)(3) Status: Background

• Difference between nonprofit under state law and federal law

• Tension between:• the tax credit program, which encourages nonprofit involvement and

joint ventures with for-profit organizations; and

• the IRS concern that nonprofits would be taken advantage of

• Serving charitable purpose vs. benefiting a for-profit• long history of what the IRS and courts will not allow

• obtaining 501(c)(3) status has been challenging and time-consuming

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Obtaining and Maintaining 501(c)(3) Status: IRS Memo Dated 4/25/06

• IRS memo outlines many factors, but failure of one is not fatal

• Limit the amount and length of the operating guarantee (6 months of expenses; 5 years from break-even)

• Use a fixed price construction contract

• Treat the payment on a tax credit guarantee as a capital contribution or loan (rather than outside the partnership)

• Limit the amount of tax credit guarantee (to extent of fees)

• Limit the repurchase price to 100% of capital contributions

• Remove only for cause after a reasonable cure period

• Hold a right of first refusal to purchase the project

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Federal Grants

• Often awarded to exempt organizations

• Reduce eligible basis

• Result in taxable income to the partnership receiving the grant

• Instead, structure grant award to exempt organization followed by a loan to the partnership

– partner non-recourse debt: potential issue if investor’s capital account goes negative

– 79/21 solution (use of a second unrelated exempt organization as minority stockholder of the general partner)

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Tax-Exempt Use Property

• 40-year depreciation of residential real estate (may be ok)

• Qualified allocation (0.01% interest in all tax items, including cash flow and sale/refinance proceeds)– be alert to incentive fees

• For-profit subsidiary of the nonprofit serves as general partner and makes a Section 168(h)(6) election, which results in taxable income to the subsidiary but 27½-year depreciation– election made on tax return

– also attached to exempt parent’s tax return

– must state it is a 168(h)(6) election

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Nonprofit Set-Aside

• Each state tax credit agency must set aside at least 10% of its annual credit ceiling each year for projects involving qualified nonprofit organizations

• Many states provide preferences for nonprofit sponsored projects by assigning “points” to projects with nonprofit involvement

• Whenever there is nonprofit involvement, need to determine whether the tax credit agency actually awarded credits from the nonprofit set-aside

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Nonprofit Set-Aside (cont’d)

• Nonprofit organization must be exempt from federal income tax under Section 501(c)(3) or 501(c)(4) of the IRC

• One of the organization’s exempt purposes must include the fostering of low-income housing

• Nonprofit cannot be “affiliated with or controlled by” a for-profit organization

• Nonprofit must own an interest in the project (directly or indirectly)

• Nonprofit must materially participate in the development and operation of the project throughout the compliance period

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Right of First Refusal Under IRC Section 42(i)(7)

• Added to IRC Section 42 in 1990 to facilitate nonprofit ownership of tax credit properties at the end of the 15-year compliance period

• Eligible holders and minimum purchase price are specifically set forth in IRC Section 42(i)(7)

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Eligible Holders of a Right of First RefusalUnder IRC Section 42(i)(7)

• Tenants of the project (in cooperative form or otherwise)

• Resident management corporation of such building

• Qualified nonprofit organization

• Government agency

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Determining Minimum Purchase Price Under IRC Section 42(i)(7)

• Minimum purchase price is equal to the sum of:

1) the principal amount of the outstanding indebtedness secured by the buildings (other than indebtedness incurred during previous 5 years), plus

2) all Federal, state and local taxes attributable to such sale

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Right of First Refusal: General Observations

• A right of first refusal is not an option. Needs to be triggered by a bona fide third party offer

• A right of first refusal can be granted at any time during a project’s lifecycle

• Parties may come together in year 15 to negotiate fair price

• Congress expected minimum purchase price to be favorable to nonprofits

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Business Considerations When Granting a Right of First Refusal

• The statutory purchase price is a minimum price. • Statutory purchase price does not include:

– accrued but unpaid fees to limited partners

– unpaid limited partner loans

– unpaid tax credit adjusters

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Business Considerations When Granting a Right of First Refusal (cont’d)

• Need to understand how sales proceeds are distributed under the partnership agreement

• Right of first refusal should terminate if an affiliate general partner withdraws or is removed

• Need to determine a specific term for the right of first refusal

• Loan documents should contemplate a sale in year 15

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