Buch the Trend — A Commercial Real Estate Blog

“An Overview of Historic Tax Credit Transactions”

By Steve ‘Buch’ Buchwald – The Debt & Equity Finance Group

(Steve ‘Buch’ Buchwald, New York, 2/5/2019) — As it becomes more and more popular to gut renovate beautiful old buildings centrally located in various markets across the county, Historic Tax Credit transactions are becoming more common.  Much to the chagrin of lenders, HTC deals have their own rules and, unfortunately, not all these transactions have identical structures.   This further convolutes what is already a very complex and esoteric intricacy to commercial real estate transactions.

So, let’s back up. Historic Tax Credits can be either Federal Tax Credits, administered by the National Park Service (NPS), or State Tax Credits, administered by the state in question.  These are based on qualified rehabilitation expenditures (QREs). While State Tax Credits can be relatively straight forward, the Federal Tax Credit rules often dictate complex org chart structures and create confusion among developers and lenders alike.

After a new set of IRS tax guidelines applicable to HTCs in 2014 were issued, the outright upfront sale of HTCs was prohibited and instead the tax credit investor had to become an investor in the transaction.  The upfront payment was capped at 25% of the purchase price of the tax credits and the investor now had to have “skin in the game” throughout the construction period.

This resulted in two different structures:

  • The Single-Tier Structure – the structure whereby the tax investor is admitted as a partner of the property-owning entity and that entity is thus entitled to claim the HTCs.
  • The Master-Lease Structure – The property owner leases the property to an entity owned at least 99% by the tax investor. The master lessee in turn obtains a 10% stake in the property owner.  While the property owner funds the QREs, it is permitted to pass the HTCs to the master lessee and thus to the tax investor through its interest in the master lessee.

If it sounds complicated, it is because it is.  Even experienced lenders often balk at having to sign a subordination, non-disturbance and attornment agreement (SNDA) with the master-lease structure, claiming they will not subordinate to anyone.  However, this is a must for HTC transactions since the SNDA prevents the collapse of the master lease structure upon foreclosure and, in turn, protects the tax credit investor’s rights to the HTCs.  These tax credits can then be used by the investor over the five-year compliance period (20% per year) after obtaining Part 3 approval (the final NPS sign-off) post-construction. During this time, any take-out financing must also agree to sign a SNDA with the tax credit investor.

Another common point of confusion is how the HTCs can be used as a source of funding.  There are generally three ways to capitalize a project with Federal HTCs:

  • A tax credit investor invests through the Single-Tier Structure and as a partner is entitled to the HTCs. This is straightforward as this investor would come in as a traditional LP partner. That said, this is incredibly rare and is not the standard for HTC commercial real estate transactions.
  • A tax credit investor purchases the HTC’s with the Master-Lease Structure and funds 25% of the HTC purchase at closing. Generally, these investors pay between 80 and 95 cents on the dollar and then 25% of this number (about 20-23% of the total HTC’s) can be used as a source of funds in the developer’s sources and uses. The remainder will typically come in over the course of the development, commonly at C of O, with some small amount held back until the developer obtains Part 3 approval from the NPS (typically 6 months or so after C of O).
  • With a tax credit investor structure similar to #2 above, the developer can then also obtain a tax credit bridge loan secured by the remaining payment stream from the tax credit investor that can be monetized up front. The amount of proceeds on the remaining 75% of the tax credit purchase net of the capitalized interest reserve and points on the tax credit bridge loan can then be added as an additional source of funds.

While these transactions are complicated, HTCs do significantly reduce the effective cost basis of renovation deals and thus are a necessary evil.  Taking the time to properly understand the HTC structures can give developers a leg up on their competitors and lenders more deal flow and higher yields.  Additionally, adding qualified professionals that understand HTCs to the development team including mortgage brokers, real estate attorneys, and tax credit consultants is a must for any developer that wants to tackle the complexities involved with Historic Tax Credit transactions.