The proposed tax legislation coming out of House Ways and Means addresses a long running dispute between sponsors of low income housing tax credit deals and investors. The legislation favors the sponsors. To understand the issue I need to briefly explain how the credit works.
Overview Of The Credit
The owner of the building, typically a partnership, receives a credit annually on the “qualified basis” of the building which reflects the portion of the building that is providing low-income units for 10 years.
The credit is currently pegged at 9% per year for projects with unsubsidized mortgages and 4% for projects with subsidized mortgages. Originally the credit was reset every month to assure that it would provide either 70% of the present value of the investment or 30% in the case of subsidized projects.
After the 10 years is up, the credit is subject to partial recapture for 5 years which makes for a 15 year “compliance period”. There remains a requirement to keep the project affordable for another fifteen years, but that is enforced by state housing authorities. The IRS is out of the picture.
In year 15 the project might be needing a makeover. And there is a provision in Section 42 that can allow a not-for-profit sponsor to take out an investor at a bargain price relative to the fair market value. Until relatively recently it was uncontroversial, but now there is a significant amount of litigation between limited partners, often not the original limited partners, and not-for-profit sponsors. The limited partners are resisting not-for-profits exercising a “right of first refusal” (ROFR) that is defined in Section 42. I have dug into the litigation a bit and you can read about it here, here, and here.
The Legal Issue
The not for profit sponsors have been operating on the assumption that the Section 42 ROFR is, in effect, an option. In their view, the project was underwritten to provide the investors with the credit and it is time for them to move on. The investors, on the other hand, believe they are entitled to consider the increased value of the property.
The problem that the sponsors have is that a common law right of first refusal is not the same thing as an option. So far the sponsors have won a couple of decisions in state courts, but when a federal case has been made out of it, the sponsors have lost.
The Proposed Change
The proposed change substitutes “an option” for “a right of 1st refusal”. That can affect how deals are designed going forward, but that won’t matter for another fifteen or more years. But there’s more:
‘‘For purposes of determining whether an option, including a right of first refusal, to purchase property or partnership interests holding (directly or indirectly) such property is described in the preceding sentence— ‘‘(i) such option or right of first refusal shall be exercisable with or without the approval of any owner of the project (including any partner, member, or affiliated organization of such an owner), and ‘‘(ii) a right of first refusal shall be exercisable in response to any offer to purchase the property or partnership interests, including an offer by a related party.’’.
That interpretation is retroactive and applies to existing deals.
Will It Work ?
What the legislation is doing is saying that a Section 42 ROFR was never a common law ROFR. And to be fair that is what a lot of people assumed. Federal courts, so far, have not agreed. But now maybe Congress is setting them straight on what it really meant over thirty years ago.
Another possibility is that the change might be an unconstitutional taking. That is what the Federalist Society argued about a similar proposal in 2019.
David Davenport, an attorney who represents sponsors in these disputes, wrote me:
Without commenting on what federal courts have ruled in certain instances, I would say that legislative branches (both federal and state) often times will amend laws in reaction to how courts interpreted those laws in order to ensure that what the legislature intends is what actually occurs if disputes arise in court. That, in my view, is not retroactive and as I understand the provision approved by the House Ways and Means Committee it expressly says that it would not supersede express language in existing deals (meaning this is prospective).
I’m just a CPA and on a good day, I call myself a writer, but I did read Antonin Scalia’s book about textualism. And I am skeptical about Congress being able to say that it meant something different thirty years ago when it used ROFR rather than option.
Reactions
Elizabeth Roehm has What Congress gets right in its Draft Housing Tax Credit Provisions in Texas Housers.
Using federal legislation is also the best way to get at issues with the current “qualified contract” system and Right of First Refusal, which are notoriously difficult to use in a way that preserves our national investment in LIHTC affordable housing over the long term. After a property is developed using LIHTC, which is indirectly a colossal infusion of public funds, the property may only provide affordable housing for 15 to 30 years before leaving the program and going up to market rate. These fixes proposed in the appropriations bill can close loopholes and make our collective investment more meaningful over the long haul.
LeadingAge has Housing Credit: Increase 60%, Fix Right of First Refusal & More.
LeadingAge helped sound the alarm about right of first refusal issues and is very pleased with the bill’s inclusion of this language.
Tax Credit Housing Management Insider has House Committee Includes LIHTC Provisions in Reconciliation Package.
The bill also makes several changes to keep third-party investors from using the right of first refusal provisions under the LIHTC program to keep mission-driven nonprofits from taking full ownership of LIHTC sites at year 15. The bill converts the right to purchase into a purchase option and it expands the definition of “property” to include the partnership assets. The option holder can exercise the right of first refusal without requiring the approval of an investor or requiring a bona fide third-party offer.