Written by Eric Mittereder, Published by the Journal of Affordable Housing, Volume 22, Number 1
Since Congress created the Low Income Housing Tax Credit (LIHTC) more than twenty-five years ago, LIHTC has become the most important federal resource in financing the private development of affordable housing. Both for-profit and nonprofit organizations leverage LIHTC to attract private equity investments, in which a for-profit investor enters into a joint venture and provides critical equity financing to develop and operate the affordable housing project. In order to obtain the equity needed to make such projects financially viable, project sponsors are generally required to provide certain guarantees to their for-profit equity investors. However. when the project sponsor is a nonprofit entity whose charitable purpose is to develop affordable housing, guarantees to for-profit entities may raise questions as to the nonprofit's tax-exempt status.
Although the Internal Revenue Service (IRS) generally recognizes the development of affordable housing as a charitable activity, the IRS has also scrutinized engaging in charitable activities through a joint venture with a for-profit investor. A substantial body of IRS guidance and jurisprudence has developed to ensure that the nonprofit’s obligations do not overly benefit the private investor or place the nonprofit’s charitable assets at excessive risk in order to protect the private investment. To determine when such risk or private benefit becomes excessive, the IRS and several courts have emphasized the importance of terms reflecting an arm’s-length negotiation. This body of law provides general rules applicable to affordable housing. However, the IRS has issued its most recent and detailed criteria for evaluating specific guarantees from a tax-exempt entity to a for-profit entity in a LIHTC joint venture in the form of informal, nonbinding guidance, starting in 2006 with an internal memorandum to IRS staff that is commonly referred to as the Urban Memo. The Urban Memo’s approach represents a middle ground, recognizing that the existence of guarantees alone does not confer impermissible private benefit, but also imposing limits on certain guarantees in order to mitigate the risk to the tax-exempt entity’s charitable assets.
Seven years after the Urban Memo, this article explores the relevance of changing market conditions to evaluating whether specific negotiated guarantees confer impermissible benefit on private investors. Since the collapse of housing and financial markets in 2008, investors have increased demands for guarantees and security, shifting greater risk to project guarantors. Nonprofits must balance the demands of tax-exempt status with the demands of equity providers in the current financial market, in which nonprofits compete with for-profit developers that can provide stronger guarantees unburdened by IRS limitations. Under current market conditions, to the extent that nonprofits push for strict adherence to the guarantee limitations described in the Urban Memo, investors may compensate by reevaluating their underwriting criteria, possibly resulting in reduced equity pricing or a smaller pool of potential investors for projects involving tax-exempt entities. Even if the terms of certain guarantees diverge from the standards set forth in the Urban Memo, the transaction may not necessarily create an impermissible private benefit, particularly if such guarantees are truly negotiated at arm’s length and reflect prevailing industry practices. Indeed, if the nonprofit produces affordable housing and retains it long after the investor has exited the financing arrangement, these market requirements may be a reasonable exchange for the nonprofit to further its charitable purpose.
The first section of this article provides an overview of nonprofit participation in LIHTC partnerships and the need for certain guarantees, followed by the legal background for imposing limits on those nonprofit guarantees. After introducing the Urban Memo and other IRS guidance providing specific limitations on nonprofit guarantees, the first section analyzes this guidance’s impact on nonprofit organizations negotiating transactions in a shifting financial market. The discussion draws from industry perspectives comparing the standards in the IRS guidance to current industry practices, based on both publications and interviews with legal practitioners, who represent a variety of geographic markets and interests in their roles as counsel for developers, investors, and syndicators.
The second section of the article applies this discussion to the three most contested guarantees that nonprofits provide to for-profit investors in LIHTC partnerships: (1) tax credit guarantees, (2) operating deficit guarantees, and (3) interest repurchase guarantees. The section identifies the issues raised by each particular guarantee and gauges the extent to which current industry practices overlap and diverge from the limitations proposed in the IRS guidance. These three pressure points in negotiations have produced several nuances in the terms of these guarantees, which vary in the degree to which they adhere to the standards set forth in the informal IRS guidance, but may nonetheless provide alternative mechanisms to minimize the risk to charitable assets. Some of these examples may be valuable improvements in developing formal guidance, in order to alleviate IRS concerns while enhancing flexibility to make business arrangements that provide investors with necessary security.