acquisition/rehabilitation: the 10% anti-churning rule james f. duffy, esquire nixon peabody llp 100...
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ACQUISITION/REHABILITATION: THE 10% ANTI-CHURNING RULE
James F. Duffy, Esquire
Nixon Peabody LLP
100 Summer Street
Boston, MA 02110-2131
(617) 345-1129
(866) 947-1697 (fax)
AFTER THE CLOSING: MAXIMIZING VALUE AND AVOIDING PITFALLS AT TAX CREDIT PROPERTIES
IPED, INC.
San Diego, California
April 25-27, 2007
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THE RULE
Section 42(d)(2)(B)(iii) of the Code provides that in order to receive acquisition credits the building cannot previously been placed in service by the taxpayer or by a related person.
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RELATED PERSON TEST
Section 42(d)(2)(D)(iii)(II) tells you that a “related person” to a taxpayer means 10% or greater common ownership.
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How do you determine your percentage ownership in a LIHTC Partnership?
LIHTC Partnerships are structured with partners receiving different percentage interests in different items:
- Tax Credits - Cash Flow - Sale/Refinancing Proceeds - Maybe State Tax Credits
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Selling Partnership
GP OldLP
Property
Cash
Buying Partnership
NewLP
GP
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The LIHTC industry has prudently decided that if you have a 10% or greater interest in any item in the seller, you have to have less than a 10% interest in all items in the buyer.
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Since a developer (GP) tends to have more than a 10% interest in Cash Flow in the old Partnership (the seller), the developer tends to have a 9.9% interest in Cash Flow and in Sale/Refinancing Proceeds in the new Partnership (the buyer).
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Not your typical LIHTC business deal if the syndicator/investor has 90.1% of Cash Flow and Sale/Refinancing Proceeds.
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So, what typically happens?
- Partnership Management Fee
- Incentive Management Fee
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The question is whether or not these fees exceed a reasonable fee which would be paid to a third-party service provider performing the same services.
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Anything paid (or payable if there were Cash Flow) in excess of a reasonable fee could be reclassified as additional Cash Flow to the General Partner.
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And, since we’re already at 9.9% of the Cash Flow going to the General Partner, there’s no room for error.
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The risk is the loss of all of the Acquisition Credits if the General Partner is deemed to really have a 10.01% interest in Cash Flow.
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Look at these Cash Flow fees to see if they’re “reasonable.”
For instance, would a third-party service provider agree to be paid only if there were sufficient Cash Flow at that point in the Cash Flow waterfall?
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A Cash Flow fee looks more like a real fee, rather than like a Cash Flow distribution, if it accrues, even if there is no Cash Flow available to pay it currently.
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Newer Techniques:
- Higher Property Management Fees
– recently saw a property management fee equal to 14% of gross rental income, with the argument that there were very low rents
– the property manager was affiliated with the General Partner
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Purchase Money Notes
― Payable by the buying partnership to the selling partnership out of Cash Flow of the buying partnership
― a good appraisal is important
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Co-GP to Receive Cash Flow
- Existing GP has 9.9% of Cash Flow and new Co-GP has 70-80% of Cash Flow.
- Need to closely examine the full relationship between the two GPs.
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Ground Lease
- to an affiliate of the seller
- appraisal issue
- market rate ground lease
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Development Fee for the Rehabilitation
- especially if minimal rehabilitation
- similar issue with fee to an affiliated general contractor for the
rehabilitation work
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Some investors are more risk adverse than others, so find out early on what is acceptable.
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The Investor as a “Related Party”
Also, don’t forget the 10% test from the investor side.
10514191.1
- Usually OK to use the same syndicator as long as the ultimate investors don’t cause a 10% problem.
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