Benefits and Overview of Nonprofits. Participating in LIHTC Partnerships

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1 Benefits and Overview of Nonprofits Participating in LIHTC Partnerships for the Florida Housing Coalition Conference Christina Apostolidis Partner, Naples, FL Novogradac & Company LLP September 4,

2 Agenda Benefits of using LIHTCs and Overview Safe Harbor Rules for Nonprofit Organizations in Affordable Housing Structure and Partnership Agreements Protecting the Credit Life after LIHTC Brief discussion on Tax Reform and the LIHTC Industry September 4,

3 Affordable Housing Overview

4 x 10 years Section 42 Tax Liability Investor Low-Income Housing Tax Credit Partnership LLC S-Corp DEBT DEBT Equity Tax Liability Developer/ Owner Total Project Costs Income limits Rent limits Suitability for Occupancy

5 $10.8mil Ineligible costs: Land Marketing P ship org. costs Commercial property Off-site improvements* $800k Eligible Basis = $10mil Total Project Costs A B Eligible basis $ 6mil $ 4mil DDA/QCT basis boost x 130% x 130% Eligible basis (adjusted) $ 7.8mil $ 5.2mil Applicable fraction x 75% x 100% Qualified basis $ 5.85mil $ 5.2mil Annual tax credits $ 527k $ 468k Ten years x 10 x 10 Total tax credits $ 5.27mil $ 4.68mil See IRC 42(b)

6 $10.8 Mil $8.46M Equity 78% x Total Project Costs A B Eligible basis $ 6mil $ 4mil DDA/QCT basis boost x 130% x 130% Eligible basis (adjusted) $ 7.8mil $ 5.2mil Applicable fraction x 75% x 100% Qualified basis $ 5.85mil $ 5.2mil Annual tax credits $ 527k $ 468k Ten years x 10 x 10 Total tax credits $ 5.27mil $ 4.68mil

7 Benefits of using LIHTCs How can LIHTCs help you further your mission? What assets do you have to make a deal work? September 4,

8 Safe Harbor Test for Low-Income Housing Organizations A low-income housing organization seeking 501(c)(3) charitable status, can either qualify using a facts and circumstances test or, more easily, by satisfying the following 4-part test (Rev. Proc ): Minimum percentage tests; Actual occupancy requirements; Affordable to charitable beneficiaries; and Special requirements for multiple building projects.

9 Minimum Set-Aside Test For each project, at least 75% of the units are occupied by residents that qualify as low-income (80% of the area s median income (AMI) and either 50% - at least 20% of the units are occupied by residents with incomes at or below 50% of AMI, or 60% - 40% of the units are occupied by residents that do not exceed 60% of AMI (or 120% of Very Low Income). Similar to Section 42 the and 60% tests match the minimum set-aside requirements for LIHTC. However, the overall requirement that 75% of units must be rented to people at or below 80% of AMI is an additional requirement.

10 Minimum Percentage Tests Safe Harbor * Min. Set-Aside for 501(c)(3) status = 75 at 80 LIHTC Minimum Set-Aside = 40 at 60 * Rev. Proc identifies 10 factors to evaluate in determining whether a nonprofit entity is serving its charitable purpose even if safe harbor requirements are not met

11 Minimum Percentage Tests Additional facts and circumstances A substantially greater percentage than required by the safe harbor of residents with incomes up to 120 percent of the area s very low-income limit Safe Harbor (60% of AMI) Min. Set-Aside for 501(c)(3) status = 75 at 80 LIHTC Minimum Set-Aside = 40 at 60

12 Actual Occupancy Requirements The project must actually be occupied by poor and distressed residents. A reasonable Transition Period is permitted for the organization to place the project in service. Reasonableness is determined by all facts and circumstances. If a project does not require substantial construction or rehabilitation, 1 year is generally considered reasonable. If a project operates under a government program that permits a longer period, that longer period governs. Next Available Unit Rule The safe harbor will continue to be met even if a resident s income increases, but only if the resident s income does not exceed 140% applicable income limit or the next comparable non-qualifying unit is rented to someone under the qualifying income limits. Same as the LIHTC Next Available Unit Rule

13 LIHTC Available Unit Rule Search Tax credits. Simplified.

14 Affordable to Charitable Beneficiaries The housing is affordable to charitable beneficiaries (low-income and very low-income individuals). This requirement is ordinarily satisfied by the adoption of a rental policy or mortgage policy that complies with government-imposed rental restrictions or mortgage limitations. In practice, renting to tenants at 30% of the applicable AMI percentage (30% of 50% or 30% of 60%) is deemed charitable.

15 Special Requirements for Multiple Buildings Projects Generally, if a project has multiple buildings and each building does not meet the first 3 prongs of the 4-part test, the buildings must share the same grounds. Exception: this prong is not required if the units are individual homes or apartments located at scattered sites in a community and provided exclusively to families with income at or below 80% of the area s median income.

16 Other Charitable Purposes Can Qualify Renting to low-income persons is not the only qualifying charitable purpose. Other charitable purposes include Combating Community Deterioration Lessening the burdens of government Elimination of Discrimination and Prejudice Lessening Neighborhood Tensions Relief of the Distress of the Elderly or Physically Handicapped

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18 P ship Investor(s) Developer/ Owner GP Fund Non-Profit GP LP Non-Profit GP Fund LP Developer/ Owner GP P ship

19 Typical Ownership Structure Owner/Borrower Entity P ship Fund LP Developer/ Owner GP

20 Typical Ownership Structure with Non-Profit MGP Owner/Borrower Entity P ship Fund LP Managing GP Developer Fee Administrative GP Non-Profit For-Profit

21 Allocation of Tax Benefits (including Tax Credits) Owner/Borrower Entity P ship Managing Administrative Fund LP GP GP Tax Credits, Profits, and Losses Non-Profit For-Profit 99.99% 0.001% 0.009%

22 Allocation of Cash Flow Owner/Borrower Entity P ship Managing Administrative Fund LP GP GP Tax Credits, Profits, and Losses Non-Profit For-Profit 99.99% 0.001% 0.009% Residual Annual Cash Flow 10.00% Fixed Fee Prior to Residual Allocation 90.00%

23 Allocation of Sale and Refinance Proceeds Owner/Borrower Entity P ship Managing Administrative Fund LP GP GP Tax Credits, Profits, and Losses Non-Profit For-Profit 99.99% 0.001% 0.009% Residual Annual Cash Flow 99.99% Fixed Fee Prior to Residual Allocation 00.01% Residual Sale and Refinance Proceeds 10.00% 90.00% Note: Residual annual cash flow and sale proceeds are negotiable

24 Limited Partnership Provisions during Operations: Cash Flow Waterfall Operating Cash Flow = NOI less (Debt Service and Lender Reserves) Fixed Asset Management Fee to tax credit investor Fixed MGP Fee if Nonprofit included in ownership structure Investor Loan Recovery (if operating loans made) Deferred Developer Fee GP Loan Recovery (if operating loans made) Incentive Management Fee to Sponsor/General Partner 90% Balance according to ownership interests 99.99% to Investor 00.01% to Sponsor/General Partner

25 JOINT VENTURING WITH FOR-PROFIT ORGANIZATIONS Factors to consider when partnering with a For- Profit Experience requirement Development activities and negotiating the developer fee Cash Flow splits Liability exposure

26 JOINT VENTURING WITH FOR-PROFIT ORGANIZATIONS Nonprofit assets must be used EXCLUSIVELY for charitable purposes The IRS is very concerned when nonprofit organizations joint venture with for-profit organizations. This creates the possibility that the charity s assets will benefit the for-profit.

27 $10 Millions $2 3 Credits Remaining 1 Cost overruns, Slow lease-up, Perm loan shortage Perm Loan Closing Lease up Debt Balance Casualty (Fire/Hurricane/Flood) NOI Risk 4 Noncompliance with tax credit rules Tax Credit Period Compliance Period $10 Mil LIHTCs $8 Mil Equity $2 Mil Perm Loan 30 yr amort 7.0% int rate Potential Recapture + Interest Rise in operating costs, Drop in rental revenue Construction Fund LP

28 1 Cost overruns, Slow lease-up, Perm loan shortage Development Completion Guaranty Lease up Tax Credit Period Compliance Period 0 17 Construction Fund LP

29 2 Rise in operating costs, Drop in rental revenue Perm Loan Closing Lease up Operating Deficit Guaranty NOI Tax Credit Period Compliance Period 0 17 Construction Fund LP

30 Credits Remaining Possible reasons for reduction of tax credit amount: 1. Reduction in eligible basis 2. Rental to non-qualified occupants 3. Rental rates exceeding LIHTC limits 4. Noncompliance due to property condition Risk 4 Noncompliance with tax credit rules Tax Credit Guaranty (nonrecourse to Guarantor) Perm Loan Closing Potential Recapture + Interest Lease up Tax Credit Period Compliance Period 0 17 Construction Fund LP

31 IRS Guidance - The Choi Memo Specific guidance has been issued for processing taxexemption applications for nonprofit organizations that want to be the general partner in a partnership with a forprofit, such as an LIHTC investor. See Memorandum for Manager, EO Determinations from Robert S. Choi, Director EO Rulings and Agreements, Re: Low Income Housing Tax Credit Limited Partnerships (July 30, 2007)

32 IRS Requirements to Process Application Limited Partnership Agreement or LLC Operating Agreement must specify that the LP or LLC will operate housing that it owns in a manner that furthers charitable purposes by providing decent, safe, sanitary and affordable housing for low income persons and families (including the elderly or physically handicapped, where appropriate). Choi Memo

33 Charitable Purpose Prevails Partnership/Operating Agreement must provide that in the event of a conflict between the obligations of the nonprofit (in its capacity as general partner or managing member) to operate the LP or LLC in a manner consistent with such charitable purpose, and any duty to maximize profits for the limited partners or other members, the charitable purposes contained in the LP agreement or the LLC governing documents will prevail. Choi Memo

34 Must have a Conflict of Interest Policy Nonprofit must adopt a conflict of interest policy to protect the Nonprofit s interest when it is contemplating entering into a transaction or arrangement that might result in an excess benefit transaction or might benefit the private interests of the applicant s officers, directors, trustees or its partners. The sample conflict of interest contained in the Instructions for Form 1023, or a similar conflict of interest policy, may be adopted. Choi Memo

35 Protecting the Nonprofit Must limit the Nonprofit s financial exposure as General Partner in case the Project doesn t go forward as planned. A number of protections are listed, but alternative protections can be used if shown to protect the Nonprofit Must have an independent Phase I environmental report on the proposed project and exercise due diligence to minimize any risk before entering into any agreements for any environmental indemnification. Choi Memo

36 Protecting the Nonprofit More financial protections Must have a fixed price construction contract with a bonded contractor or one that has a letter of credit Operating Deficit Guarantees must be limited either to: Not more than 5 years from break-even operations, or 6 months of operating expenses (including debt service) Choi Memo

37 Protecting the Nonprofit More financial protections Must have a fixed price construction contract with a bonded contractor or one that has a letter of credit Operating Deficit Guarantees must be limited either to: Not more than 5 years from break-even operations, or 6 months of operating expenses (including debt service) Choi Memo

38 Protecting the Nonprofit Limits on Credit Adjusters If the Nonprofit is obligated to make adjuster payments to the LIHTC investor, such payments must be limited: Not exceed the amount of developer fee and other fees that the Nonprofit is entitled to, or Provide that payments of adjusters will be treated as capital contributions or a loan which takes priority over any other distribution of residual assets upon sale or refinancing Choi Memo

39 Protecting the Nonprofit Nonprofit Right of First Refusal The Nonprofit must get the Section 42 Right of First Refusal (ROFR) ROFR purchase price cannot be less than debt plus exit taxes Choi Memo

40 Protecting the Nonprofit Repurchase Price Limitations LIHTC Partnership agreements frequently provide that the Investor can require that its interest be repurchased by the General Partner for failure to meet certain critical items, such as failure to qualify for LIHTC. Limitation the LIHTC investor cannot receive more than its capital account from the Nonprofit. Choi Memo

41 Protecting the Nonprofit Consent Limitations LIHTC Investors can have consent rights Examples of consent right matters: sale or refinancing of the LIHTC project; admission of a new partner or member; acquisition of additional property; transfer of the applicant s interest in the limited partnership or limited liability company; (v) borrowing substantial additional funds; entering into contracts with affiliated entities; amendment of the limited partnership agreement or operating agreement; change of accountant or property manager; and/or approval of annual budget Choi Memo

42 Protecting the Nonprofit Limitations on GP Removal The LIHTC Investor s right to remove the Nonprofit General Partner should only be for cause. Partnership Agreement must provide the Nonprofit General Partner with Written Notice of the proposed removal Reasonable Cure Period Choi Memo

43 Limitations on Choi Memo The Memo does not attempt to apply itself to already existing nonprofits. On its face the Memo is limited to situations where taxexempt applications will be processed. Some large pre-existing nonprofits feel comfortable operating outside the Choi memo. The Memo does not attempt to list the full extent of what Nonprofits, only gives a safe harbor, that if complied with, will get an application for tax-exemption processed However, the Choi Memo has been added to the Internal Revenue Manual which is generally used by the IRS. It has also been cited in one audit which was settled. Choi Memo

44 Protecting the Credit: Tax Credit & Compliance Period

45 Protecting the Credit: What is Recapture? Eligible Basis x Applicable Fraction Qualified Basis x Tax Credit Percentage Annual LIHTCs 6,250,000 x 80% 5,000,000 x 9% 450,000

46 Protecting the Credit: What is Recapture? Casualty loss Reconfiguring space Disrepair Building disposition Over-income tenants Bad files Rent too high Violate Available Unit Rule, Full-Time Student Rule, Vacant Unit Rule

47 Protecting the Credit: What is Recapture? Casualty loss Reconfiguring space Disrepair Building disposition Over-income tenants Bad files Rent too high Violate Available Unit Rule, Full-Time Student Rule, Vacant Unit Rule

48 Life after LIHTC period: Option to Buyout LP In Year 15 Option to buyout LP in Year 15 non-profits (as GP) Nonprofits can have option price of: Partnership debt + Taxes (i.e. exit taxes) (Great Deal! If taxes don t exist, then just assume debt!) Technically supposed to be right of refusal; often worded as an option though Very important to monitor, manage, and babysit the LP s capital account, to make sure it doesn t head negative

49 Tax Reform and LIHTC Industry Reduction in corporate tax rate makes the LIHTC less valuable to investors Business Interest Limitations & Depreciable Lives Bonus Depreciation Opportunity Zones September 4,