Affordable Housing Alert: Tax Credit and Community Development Update

    View Authors May 2006

    On April 25, 2006, Joseph Urban, acting director of the Exempt Organizations Rulings and Agreement Division of the Internal Revenue Service (IRS) issued a long-awaited memorandum for managers in the exempt organizations section regarding approval of tax-exempt applications for tax-exempt participants in low-income housing tax credit-limited partnerships (Memorandum).

    The Memorandum sets forth a number of requirements for such partnerships and for limited liability companies (each a "project owner") in order for its general partner or managing member to obtain an exemption under Section 501(c)(3) or 501(c)(4) of the Internal Revenue Code. Several of these provisions limit the scope of the business deal between the nonprofit general partner or managing member and the for-profit investor. These provisions apply only to nonprofit participants who are newly formed for the purpose of acting as a general partner or managing member of a project owner, although they will likely form the basis for a number of negotiations for established nonprofit sponsors and developers.

    The IRS addressed a number of issues in the Memorandum:

    • The formative documents must require that (a) charitable purposes be advanced by specifying in the project owner's operative documents that the project owner will operate the housing that it owns in a manner that furthers the charitable purposes of the tax-exempt organization by providing decent, safe, sanitary and affordable housing for low-income persons and families and (b) that in the event of a conflict between the "duty to maximize profits for the limited partner or other members" and the charitable purposes contained in the operative documents, the charitable purpose must prevail;
    • The nonprofit applicant must provide written representations to the IRS that it will take, perform or limit certain actions as part of the final operative documents for the project owner and as part of the due diligence required to construct the low-income project, including:

      • A requirement that the nonprofit obtain and review Phase I environmental reports and minimize any potential environmental risk before agreeing to any environmental indemnification;
      • A requirement that the project owner will enter into a fixed price construction contract with a bonded contractor or that performance letters of credit and adequate personal guaranties are entered into instead;
      • Operating deficit guaranties cannot (i) extend for more than five years from the achievement of break-even operations (95-percent occupancy with revenues covering all operating costs for three months after constriction completion), or (ii) be for an amount greater than six months of operating expenses and debt service. The nonprofit will also have a duty to review market studies to confirm that break-even will occur within a timely period;
      • Any credit adjusters must be limited under each separate adjuster provision to an amount that "does not exceed the aggregate amount of developer and other fees (both payable and deferred) that the applicant (or any affiliate) is entitled to receive in connection with the project" and/or the documents must provide that any such payments will be treated as capital contributions or loans;
      • The nonprofit must be given a right of first refusal to acquire the project at the end of the compliance period;
      • Any repurchase of an investor's interest must be limited to the amount of capital contributions made by the investor (apparently excluding any payment of interest or other yield maintenance formula or of additional fees);
      • The documents must require that various investor consents (excluding day-to-day operations) cannot be unreasonably withheld, unless such action would be inconsistent with preserving the housing as low-income housing. These consents include those relating to sale or refinance of the project; admission of new partners or members to the project owner; acquisition of additional property transfer of the nonprofit's interest in the project owner; borrowing substantial additional funds; entering into affiliated contracts; amendments to the operative documents; changes in accountants or property managers; and approval of the annual budget; and
      • Any removal right regarding the nonprofit must be for cause (as defined in the operative documents) and must provide for written notice and a reasonable cure period.

    If you have any questions about how these provisions may affect your projects, including tax issues related to nonprofit participation, or if you would like a copy of the Memorandum, please contact one of our affordable housing and community development lawyers listed in this Squire Sanders Alert.