Is Individual Participation in the NMTC Program a Passive Activity? Completing the Financing Puzzle NMTC Coalition Corner About Reznick Group
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and carried forward until they can be used to offset passive income or until the passive activity is disposed. Material participation, in general, is participation in an activity on a regular, continuous, and substantial basis during the year. Treasury Regulation 1.469-5T lists quantitative tests based on the hours of participation which, if met, provide a safe harbor that the taxpayer materially participated with respect to the activity. The passive activity rules apply to individuals, estates, trusts, closely
held C corporations, and personal service corporations. Prior to the Internal Revenue Service (IRS) issuing Revenue Ruling 2010-16 on June 8, 2010, it was unclear as to whether the New Markets Tax Credit (NMTC) was a passive activity credit. The NMTC is, under Section 469(d)(2)(A), subject to the passive activity rules and may be suspended if the NMTC arises in connection with the conduct of a passive activity. The IRS, through Revenue Ruling 2010-16, established
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tions unrelated to any public housing authority. One example involves the use of New Markets Tax Credits to provide working capital financing for a Kentucky nonprofit corporation that provides affordable housing and other housing services in low-income communities. In this situation, a conventional lender acted as investor and leveraged lender and no governmental funds were used. In another example, New Markets Tax Credits were used to finance the renovation of a building in Washington, D.C., owned by a nonprofit corporation for a mixed use facility with low-moderate income rental housing and commercial space leased to an early childhood development center. However, this challenging economic climate has offered new opportunities for public housing authorities to expand their participation in the New Markets Tax Credit program. Public housing authorities are not only lenders or developers but also are forming affiliates to act as community development entities. By forming affiliated community development entities, the public housing authority is able to launch its own New Markets Tax Credit programs as a way of expanding its arsenal of financing tools available to combat the lack of affordable housing in low-income communities. In one of the most exciting developments in 2010, a public housing authority in Illinois obtained formal HUD approval to act as lender and developer in a New Markets Tax Credit leveraged financing of an affordable housing project that involves the use of HUD public housing funds. Typically, mixed-finance development of affordable housing is financed with Low-Income Housing Tax Credits and HUD Hope VI capital and operating funds, tax exempt bond proceeds, Community Development Block Grant funds, and other types of federal, state, and local governmental funding. Although not intended as an affordable
housing development tool, this formal HUD approval has cleared the way for creative New Markets Tax Credit models to finance affordable housing projects. In this precedent-setting transaction, HUD has formally approved the use of public housing funds as the source of leveraged loan financing in a project involving the construction of a new senior citizen affordable housing facility with both public housing units and housing choice voucher units. The mixed-use facility will include a community center, office space for affiliates of the housing authority, a community health center, and retail. In addition, the facility will be LEED-certified with a rooftop garden. We represent the public housing authority and, as currently structured, the transaction integrates the HUD mixed finance development regulatory requirements into the New Markets Tax Credit 80/20 rule mixed-use leveraged financing structure. The type of governmental funding used in a leveraged New Markets Tax Credit transaction can present myriad legal issues depending on the program-specific requirements of the applicable government grant or loan program. In this case, we have embarked on a new adventure! Initially, we had to determine whether the public housing authority could act as the leveraged lender under its state authorizing legislation. This particular housing authority does not have the legal authority to make loans to for-profit entities. As a result, the financing model contemplates that the public housing authority will form a new 501(c)(3) taxexempt affiliate to act as leveraged lender and a new 501(c)(3) tax-exempt affiliate to act as the qualified active low-income community business. Based on HUD mixed finance regulatory guidance, a public housing authority affiliate is considered a third party contractor rather than an instrumen-
tality controlled by the public housing authority. To date, we have successfully obtained HUD approval of the public housing authoritys use of public housing funds as the source of leveraged loan proceeds as well as HUD approval of the public housing authoritys sole source procurement of the leveraged lender affiliate and the developer affiliate under HUDs mixed finance development regulations. In order to fund the leveraged loan, the public housing authority will make a loan to the leveraged lender affiliate. In addition, the public housing authority will use the HUD funds in conjunction with Illinois Tax Increment Financing dollars from the city. An intergovernmental agreement between the city and the public housing authority was recently approved by city council. Also, the public housing authority is seeking, among other sources of funds, Federal Home Loan Bank funds, Illinois Housing Development Authority Trust Funds, Illinois Energy Commission grant funds, and renewable energy tax credits. This transaction is scheduled to close in October 2010, and HUD approval of the transaction will be required prior to closing. Stay tuned!
Stephanie L. Franklin-Suber is a partner in the Business and Finance Department and contact partner for the New Markets Tax Credit practice team within the Tax Credits Group. Copyright 2010 by Ballard Spahr LLP www.ballardspahr.com All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the author and publisher.
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that the determination as to whether the NMTC was a passive activity credit was dependent upon whether the acquisition of the qualified equity investment (QEI) in a community development entity (CDE) arose in connection with the conduct of a passive activity. Revenue Ruling 2010-16 provides two scenarios as examples. In the first, an individual acquires a QEI in a CDE, and in the second, a partnership acquires a QEI in a CDE and allocates the NMTC to its partners. In both situations, the facts stipulate that the acquisition of the QEI is not in connection with the conduct of a trade or business. The Revenue Ruling states that the determination of whether the NMTC under Section 45D is disallowed under Section 469 does not depend on the taxpayers interest or extent of participation in the CDEs trade or business. To be a passive activity, the activity of acquiring a QEI in the CDE must be in connection with the conduct of a trade or business in which the person claiming the NMTC does not materially participate. The Revenue Ruling concludes that since the acquisition of the QEI is not a rental activity nor is the acquisition in connection with a trade or business, it would not be subject to the passive activity rules. If it was determined that the acquisition was in connection with conducting a trade or business of acquiring a QEI, the next determination would have to be whether the taxpayer materially participated in the activity of acquiring the QEI. If it is determined that the taxpayer materially participated with respect to the activity, then the credit would not be a passive activity credit. Revenue Ruling 2010-16 acknowledges that the term trade or business is not defined in either the code or the
regulations, and the determination of what constitutes a trade or business depends on the facts and circumstances of each case. Revenue Ruling 2010-16 cites a Supreme Court case, Commissioner v. Groetzinger, 480 U.S. 23 [59 AFTR 2d 87-532] that held that there are generally two requirements for an activity to constitute a trade or business: the activity must be conducted for income or profit and the activity must be engaged in with some regularity and continuity. The new ruling, however, does not provide an explanation as to why the taxpayers activity of acquiring the QEIs is not
connected with the conduct of a trade or business. Presumably, it is because the taxpayer is making the QEI acquisition as an investment to obtain the NMTC and is not in the business of making these investments on a regular and continual basis. While this new Revenue Ruling does not guarantee that the NMTC will not be a passive activity credit to all taxpayers subject to the Section 469 passive activity rules, it does provide guidance as to how to make the determination and should, in many cases, enable individual taxpayers to avail themselves of the NMTC benefits.
responded to the survey. Highlights of the survey findings include: Despite the worst economy in our lifetimes, Community Development Entities (CDEs) raised over $3 billion in Qualified Equity Investments (QEIs) in 2009. Since the start of the recession in 2008, CDEs have raised more than $6 billion for investments in low-income communities; Demand for the credit remains strong. Since 2003, over 1,800 CDEs have applied for more than $200 billion in credits; Investments in non real-estate businesses especially community facilities and charter schools are on the rise; and CDEs continue to target NMTC investments to the poorest communities in America especially those with high rates of unemployment and median incomes below 60% of area median. Save the Date 2010 NMTC Coalition Annual Conference in Early December Mark your calendars! The 2010 Annual NMTC Coalition Conference at the Hotel Monaco in Washington, D.C., will be Thursday and Friday, December 9 10. A complete conference agenda will be available soon on the NMTC Coalition website. The opening luncheon will begin at noon on December 9th and the Annual Membership Meeting and elections will begin at 8 a.m. the morning of December 10th with the conference set to adjourn at noon that day.