PJ Mechanisms to Preserve Affordability
PJs need to think about three things as they contemplate structuring the deal in a manner to preserve long-term affordability and maintain enforcement of the HOME requirements:
- If the investors want to exit after 15 years, what mechanisms can help to ensure that a successor sympathetic to maintaining affordability can purchase the property?
- What terms of the HOME investment can help to induce the successor to maintain affordability?
- How can the financing needed to buy out the investors and make needed improvements to the units be achieved, especially if the HOME affordability period prevents additional HOME investment?
Mechanisms for Controlling Changes of Ownership
When the HOME affordability period extends beyond the 15-year LIHTC compliance period, at a minimum, the PJ should require the LIHTC project owner to notify it when certain actions are taken or milestones are reached, including exit or change of ownership.
However, there are additional protections the PJ can put into place to strengthen its ability to enforce the HOME affordability restrictions during the remaining years of the affordability period if a change of ownership is required, including:
- Right of First Refusal
- Sale of units to tenant-occupants
- Option to purchase.
Right of First Refusal
The Code allows the sale of LIHTC projects to certain qualified groups at a bargain price, known as the “Qualified Contract” price through a Right of First Refusal. In this scenario, the Right of First Refusal gives the qualified group the right to purchase the property from the investor before the investor can sell the property to another party. The Code permits LIHTC project owners to offer the Right of First Refusal to the following groups:
- Government agencies
- Qualified nonprofit organizations
- Resident management corporations.
If the investor plans to give a Right of First Refusal to a qualified nonprofit, the PJ should secure an agreement with that nonprofit regarding any HOME affordability that extends beyond the LIHTC expiring use agreement. If the investor has not identified a qualified nonprofit to act as owner of the project, the PJ should consider requesting a Right of First Refusal itself so it can ensure continued HOME compliance.
If a PJ or a qualified nonprofit elects to enter into an agreement that provides them with the Right of First Refusal, the bargain price imposed by the Code is the total debt on the project plus any exit taxes.
“Exit taxes” are the investor’s tax liability in the event that the cumulative tax losses on the project exceed the investor’s investment of capital in the project, resulting in the investor having a “negative basis.” For example, if an investor made an original capital contribution of $1 million, received $100,000 in cash distributions over 15 years, and recognized $1.3 million in losses over 15 years, that investor’s tax basis would be negative $400,000 at year 15. If this investor donated its limited partner position to a charity, or sold its investment for a penny, or lost its investment to foreclosure, the investor would have $400,000 of taxable income and, in a 35 percent tax bracket, would owe $140,000 of income taxes. This “exit tax” ($140,000 in this example) creates a barrier to preservation, because it makes the investor reluctant to relinquish its partnership interest, even though selling may otherwise be the optimum strategy.
Tenants are also able to purchase their units under a Right of First Refusal. Some tax credit deals are designed as longer term lease-purchase programs, whereby the initial tenants rent their units with the understanding that at the time the LIHTCs expire, they will have the option to purchase.
The long-term lease-purchase option is not what is contemplated under the HOME Program lease-purchase requirements; HOME requires that the tenant/buyer purchase the property within 36 months of signing the lease-purchase agreement. However, the HOME Program does permit a rental property owner to sell or otherwise convey rental units to existing income-eligible tenants under 24 CFR 92.255. To do this, the length of time that remains on the HOME affordability period for the rental property would be imposed on the tenant/buyer, and the tenant/buyer would be subject to the HOME homeownership requirements of 24 CFR 92.254. (If the tenant/buyer were provided additional HOME funds, the affordability period would be redetermined to include these funds.) Therefore, tenant purchase is possible even when the HOME affordability period extends beyond the 15-year tax credit compliance period.
This strategy is risky, however, since the investor will not be able to convey HOME-assisted units to any tenant whose income has increased above 80 percent of AMI. There may be opportunities to use this strategy in properties with only a percentage of HOME-assisted units. PJs should work with the owners and their legal counsel to see if it is appropriate to invest HOME funds in projects with this type of exit strategy.
Option to Purchase
Another expiring use strategy is an “Option to Purchase” the investor’s ownership interest in the project. This option provides the General Partner in the ownership entity the right to buy out the investor’s limited partnership interest at the time the requirements of the LIHTC expire. Since the ownership of the real estate remains the same, there are no sale transaction costs.
While the IRS at-risk rules do not permit a fixed price set in advance, up-front negotiation of formula approaches to sales price are permitted, and usually incorporate one or both of the following amounts:
- Fair market value of the partnership interest
- Investor’s unpaid benefits plus any exit taxes.
To protect the HOME affordability period, a PJ should require notification and the right to approve any change in ownership of both the property and the owner of the property prior to the transaction.
A variation on the Option to Purchase is what is referred to as a “Put, ” which requires the General Partner to acquire the investor’s interest in the project. The price to acquire the interest is agreed to on the front-end by the parties. A PJ should know that this is part of the ownership structure prior to committing HOME funds to the project. If the PJ approves this arrangement, it should include a notification clause in the HOME agreement.
Terms of the HOME Investment
When making decisions about the investment of HOME funds in a HOME-LIHTC project, PJs need to think about the potential exit of the investors and how to best invest the funds to ensure long-term affordability.
First, as said in other parts of this guide, the deed, covenant, or other mechanism should be recorded ahead of liens, as the restructuring of the financing will be required as part of the recapitalization or buyout of the investors, and the use restrictions need to survive the refinancing or sale.
Second, the HOME financing will need to be recorded as debt (through note and mortgage or deed of trust) to ensure that the PJ has a claim on the actual HOME funds in any restructuring of foreclosure that could trigger repayment. The lien position is an important consideration.
Third, the HOME debt is likely to be structured on a cash flow basis so that it can be included in the tax credit basis, and the accrual of debt increases the leverage of the HOME agency to influence the sale.
Fourth, the HOME debt should be due on sale, but assignable to an approved buyer, such as a nonprofit, that will continue to preserve affordability.
And, finally, if the use of some or all of the HOME funds might be directed toward acquisition of land, providing the funding to a land trust or nonprofit and a land lease keeps the ownership of the land in the hands of the nonprofit and removes land appreciation from the buyout price.
Financing the Sale and Preservation
Refinancing is typically part of most exit or recapitalization strategies. Depending on the original loan terms and current lending market conditions, refinancing of the original debt may create some additional debt capacity, which is needed to raise funds for the required exit payment to the investors and for current rehabilitation needs.
After 15 years of operation, a project may require large capital outlays to replace or repair major building systems such as the roof or the heating and air conditioning system. If replacement reserves are distributed to the original investor as part of its exit strategy, and there are no funds in a reserve account to replace them, the existing general partner or new owner will need to find ways to fund the repairs or the property may fall into a state of disrepair. The property may not be able to support additional bank debt to pay for the repairs or rehabilitation.
Depending on the partnership agreement, the operating and replacement reserves in the project may be part of the distribution to the original owners at the time of sale or transfer of ownership. This is not in the interest of the project, as those reserves are needed for the project going forward.
Re-syndication is another option available to owners to raise capital for their project.
During the HOME affordability period, the PJ is not permitted to provide additional HOME funds, so the PJ and new owner will need to identify other sources of capital for these projects. Note that if the HOME affordability period has expired, PJs may make a new commitment of HOME funds, subject to the HOME requirements.
PJs should be open to refinancing or recapitalization strategies that preserve affordability and HOME compliance, including re-subordination of new debt, assumption of the HOME debt by a new owner, and addition of new sources that enable the buyout and necessary rehabilitation.
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