IRS and Treasury Representatives Speak on LIHTC Topics

Representatives from the IRS and the U.S. Department of the Treasury recently spoke at the annual meeting of the American Bar Association Forum on Affordable Housing and Community Development. The representatives did not speak on behalf of their respective agencies, but rather provided personal observations and reflections.

One comment concerned the application of the nonprofit right of first refusal provision in Section 42(i)(7) of the Internal Revenue Code. IRC Section 42(i)(7) states that no tax benefits will be lost if certain persons, particularly a tenant, qualified nonprofit organization, or governmental agency, has a right of first refusal (“ROFR”) to buy a building after the end of the compliance period for a price that is no less than the building’s debt plus exit taxes. Congress included this ROFR provision to help housing nonprofits, low-income tenants, and governmental agencies acquire LIHTC projects, so as to assure their continued availability as affordable housing.

However, there have been disputes and even litigation among investors and the nonprofit general partners or sponsors over the inability of the nonprofit partner or sponsor to exercise such rights and secure ownership of the property at the permitted price. James Rider, General Attorney in the IRS Office of Chief Counsel, said that when considering the nonprofit right of first refusal under IRC 42(i)(7), an option to buy is different from a right of first refusal. He noted that as the statute was being drafted, the wording was initially stated to be an “option,” but later changed to use the term “right of first refusal.” This legislative history suggests that Congress intended for it to be a true right of first refusal, and not an option. Rider observed that under a right of first refusal, an owner must first choose to sell, whereas an option holder can compel a sale. However, Rider also observed that a third-party bona fide offer may not be required, as that doesn’t seem to have been Congress’s intent. Moreover, Rider suggested that a plan to sell the property would not necessarily require all partners to agree to that sale.

Another topic discussed was when a foreclosure is part of an arrangement to terminate an extended use agreement. The purpose of an extended use agreement is to provide continued affordability to tenants. The code provides that while most foreclosures would terminate an extended use agreement, Section 42(h)(6)(E)(i)(I) provides that a foreclosure won’t terminate an extended use agreement if the “Secretary determines that such acquisition is part of an arrangement with the taxpayer a purpose of which is to terminate such period.” Unfortunately, it’s not clear how the IRS would become aware of such an arrangement, or what tests it would apply to the particular facts.

Based on some recent activity within the industry, ABA representatives expressed concern that bad actors could engage in a scheme to remove the extended use agreement through a foreclosure involving related party debt after the end of the initial 15-year compliance period. Mike Novey from the Treasury Department observed that this situation is very troubling, and that the IRS has several options available to address the situation, including adding waiting periods and requiring that these transactions be classified as listed transactions subject to additional disclosure requirements.