FEATURE ARTICLE, JANUARY 2005

THE BEST WAY OUT
Like-kind exchange as an exit strategy for investors in affordable housing.
Jeffrey W. Sacks, Forrest D. Milder and Jonathan C. Black

One important challenge facing the affordable housing industry is meeting the needs of individuals who invested more than 15 years ago in affordable-housing projects that involved tax credits. Finding a good exit strategy for these individual investors is a thorny problem that confronts syndicated limited partnerships owning these older affordable housing properties. The exit strategy issue affects the individuals who originally invested in the limited partnerships and it impacts the partnerships’ general partners, potential buyers and developers of the properties, and, indirectly, tenants and companies that do work related to the affordable housing in question.

The Haunting Effects of Phantom Income

Originally, individual investors in these limited partnerships received tax benefits from their affordable housing investments through depreciation deductions. But by now — some 15 years later — those tax benefits have been exhausted, and the individual investors are often left with the resulting “phantom income.” Projects generate phantom income when they are creating taxable income without yielding comparable cash flow, typically because all or part of the operating income is used to make pay-down debt principal payments on the project’s debt, which, unlike most interest payments, are not tax-deductible. Thus an investor owes tax on this income, but he or she isn’t receiving any cash to help pay the tax.

The phantom income leads investors to seek a solution that will alleviate their tax burden. However, it is difficult to find a solution that will satisfy all stakeholders. Most limited partners with negative capital accounts look to defer this huge tax problem without current tax liability. At the same time, other investors do not face this tax burden, because they have carried forward passive losses or because they have inherited their partnership interest (along with stepped-up basis), and therefore, are willing to be bought out and bring their investment to an end.

Definition of Terms • “Basis” is what an investor pays for a property. • “Adjusted basis” is that amount less depreciation deductions taken over the years. • “Stepped-up basis” is an adjustment to the basis in the property which happens when an owner sells the property, or he dies, and another person inherits the property. • “Phantom income” is the situation that occurs when rental income is being used for something that is not deductible (for example, making principal payments on the building’s financing), and the partnership (and therefore, its investors) have taxable income, but they do not have any cash to pay the resulting tax liability. — Forrest Milder, Brown Rudnick Berlack Israels LLP

Both scenarios have inherent problems. Holding on to affordable-housing projects that generate phantom income may yield tax costs for the individual investors who make up the limited partnership. But, in many cases, direct sales of the projects can generate depreciation recapture and capital gains tax liabilities for those individual investors.

One solution is to combine a careful restructuring of the limited partnership with a tax-free “like-kind exchange,” using leveraged properties leased to investment-grade tenants with properly structured financing. This enables partners who formerly had phantom income to remain in the partnership; but they now hold an interest in an investment-grade net-leased property with restructured debt, allowing them to benefit from a significant deferral of taxable income. At the same time, the program can allow the other partners, who have stepped-up basis, to be bought out from their investment, satisfying the needs of all constituents.

Finding out which strategy — holding, selling, or using a like-kind exchange — is right for a given set of limited partnership investors requires a “Goldilocks-style” approach, in which various options are examined to find out which is most appropriate for a given project and set of limited partners.

The Credit-Tenant Solution – Just Right

The concept of tax-deferred, like-kind exchanges under Section 1031 of the Internal Revenue code is, of course, not new. But, it has always been difficult to find the right kind of properties to match the needs of investors in tax-credit properties and to make a like-kind exchange feasible. However, there is now an emerging trend that involves the trading of investment-grade credit-tenant commercial properties. These credit-tenant properties have 20- to 30-year triple-net leases with established, investment-grade tenant companies — such as large retailers or Fortune 500 corporations — that have sold and leased back their headquarters buildings. In a triple-net lease, the building tenant bears the responsibilities for operational costs, such as upkeep, maintenance and taxes, for the duration of the lease.

When a like-kind exchange is made between an affordable-housing project and a credit-tenant commercial property, the debt on the credit-tenant property is structured to limit or eliminate the phantom income problem the individual investors in the partnership previously faced, and to defer their tax liabilities for up to 20 years. Because many of the individual investors involved in these older affordable housing limited partnerships are by now themselves older individuals, a 20-year deferral of tax liabilities may mean that, by the time any tax is due, their interests in the partnership will have been transferred to heirs, with the step up in basis that such a transfer entails. For the individual investors, such a like-kind exchange should be viewed as deferring virtually all tax liability for 20 years or more, but also adding a modest risk of immediate tax liability, with no cash available, if the credit tenant files for bankruptcy during the duration of the lease.

An Exchange that Works for Everyone

How does such a like-kind exchange work in practice? Typically, a like-kind exchange does not literally involve a swap of one property for another. Instead, under the IRS regulations, a holder of property can get tax-free treatment when it sells that property, has the sales proceeds delivered to a qualified intermediary (QI), and then instructs the QI to use the proceeds to buy a different or “replacement” property which is deeded directly back to the holder. For example, where the original property is an affordable housing project, it could be transferred to a housing developer that wishes to renovate it, and who may, as the new owner, receive tax-credit benefits for doing so. That developer will pay the cash portion of the purchase price to the QI, who will hold the cash until the new credit-tenant commercial property has been identified for acquisition by the limited partnership, and then it will use the proceeds from the sale of the housing project to purchase a credit-tenant property, which is transferred to the partnership that previously owned the housing project. The result: the individual investors in that partnership, which now owns the credit-tenant property, are put in a more favorable tax position; the affordable housing project is recapitalized with new debt and is renovated by its new owners; and those new owners, in turn, get both low-income housing tax credits and depreciation benefits. (Note that many technical rules apply to limit the availability of the tax credit to the new owner of the project. For example, under Section 42 of the Internal Revenue code, the new developer can qualify for “acquisition” tax credits only if no more than 10 percent of the partnership interests are common to both the new partnership and the partnership that previously owned the project.)

This type of like-kind exchange is most optimal for housing projects that have large negative capital accounts, low basis (i.e., their original cost, reduced by the depreciation deductions taken) and low net value. A careful review of regulatory restrictions, project financing restrictions, and the limited partnership agreement is necessary to determine if a like-kind exchange makes sense for a given affordable housing property.

Jeffrey W. Sacks is a partner at Brown Rudnick Berlack Israels LLP. Forrest D. Milder is the Chair of Brown Rudnick’s Tax Practice Group, and practices principally in the areas of federal and state taxation. Jonathan C. Black is a partner at Brown Rudnick Berlack Israels LLP.

The Real Estate Group at Brown Rudnick Berlack Israels works in conjunction with Net Lease Capital Advisors, which specializes in solutions to complex real estate and tax issues.


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