Q: We developed a low-income housing tax credit (LIHTC) project that was placed in service a few years ago. We completed the project reasonably close to budget and with a deferred development fee approximately equal to the amount included in the original projection. Unfortunately, rents have not grown as anticipated, and we are not seeing the cash flow necessary to repay the deferred developer fee within the time period allowed in the project’s partnership agreement.
If the deferred fee is not paid off within the allowed time period, a general partner guarantee will require us to make a capital contribution in an amount necessary to retire this obligation. A potential payment under this guarantee is several years away; however, rents will need to increase significantly to avoid our obligation under the guarantee. Are there any planning opportunities available to mitigate this looming issue?
A: First, congratulations for having the foresight to think ahead. Second, this problem is not unique to your project. The payment of a capital contribution by a general partner does not create a deduction for the general partner entity. The payment of the deferred development fee by the partnership creates ordinary income for the developer entity. Assuming the owner of the general partner entity and the developer entity are related parties, the tax result of the above is phantom income. You will have written yourself a check, and that check represents taxable income.
There may be a potential solution for this problem; however, it will require the cooperation of your investor limited partner and may require amending partnership documents. Additionally, both the general partner entity and the developer entity must be flow-through entities that ultimately flow to the same taxpayer.
The first step of the process is to update your original projection based on actual development numbers and current operating results. Your accountant can help with this step. This will allow you to accurately analyze future capital accounts and potential Internal Revenue Code (IRC) §704(b) reallocations. Deferred development fees are one of the primary causes of such reallocations. This revised projection should give you a good indicator of the time period remaining to pay off the deferred development fee and to develop a reasonable repayment schedule. In general, the goal is to repay the deferred development fee prior to exhausting the investor limited partner’s positive capital account.
Next, documents may need to be amended. The partnership agreement will need to provide that operating deficits funded by the general partner are specially allocated to the general partner. The partnership agreement already may contain this provision. The partnership agreement and/or the development fee agreement also will need to be modified to require payment of the deferred development fee based on the above determined repayment schedule. In effect, you are converting a cash flow item to a mustpay item.
Additionally, the definition of operating deficits in the partnership agreement may need to be modified to include payments made based on the above determined repayment schedule. Preferably, these payments should be required to be made prior to the payment of other operating expenses.Finally, the partnership agreement will need to contain a general partner Deficit Restoration Obligation if the general partner’s capital account goes negative while the limited partner has a positive capital account. This may also already be in the partnership agreement.
Given an appropriate repayment horizon, the above should result in the general partner being allocated losses equal to any required funding of the balance of the deferred development fee. As long as the losses and income both wind up with the same taxpayer, the net effect should be tax neutral.
Q: Why would my investor limited partner agree to the restructuring?
A: They do not have to agree to the restructuring. However, there is a compelling economic argument for requesting the restructuring. In your original question, you stated the actual deferred fee is approximately equal to the projected deferred fee.
Additionally, you stated that flat rents are the reason the deferred fee is not being retired as originally anticipated. If the original projection showed the deferred development fee would be repaid within the required time period, the projection must have shown positive net operating income (NOI) at least equal to the deferred development fee.
The payment of the deferred development fee does not create a deduction. Therefore, the investor limited partner made its investment decision expecting taxable losses factoring in the positive NOI. In effect, the actual NOI has been less than projected. The result of this is your investor limited partner has received losses to date in excess of what they originally projected.
Investor limited partners make investment decisions based on a project’s projected benefit schedule. The amount and timing of their invested equity is based on an internal rate of return (IRR) calculation that incorporates the projected delivery of LIHTCs and tax losses. Assuming the LIHTCs were delivered as projected, the investor limited partner’s return is now in excess of the original projection due to the excess tax losses. Requesting a reallocation of tax losses equal to the remaining balance of the deferred fee should be IRR neutral to your investor limited partner.
As previously stated, unpaid deferred development fees are one of the primary causes of IRC §704(b) reallocations. LIHTC allocations follow depreciation deduction allocations. An IRC §704(b) reallocation of LIHTCs away from the investor limited partner would reduce their actual IRR. The fact that you had the foresight to identify the problem and offer a solution should weigh heavily in your favor.
The information presented here is intended solely for informational purposes and should not be construed as accounting advice from the author or Reznick Group. Reznick Responds is published four times a year, so be sure to send accounting questions that you would like to have addressed in this column to firstname.lastname@example.org.
Reznick Group has more than 25 years of experience providing accounting, tax, and business advisory services to clients nationwide. The expertise of the firm is broad, ranging from real estate and management advisory services to auditing and tax preparation. Ranked among the top 20 public accounting firms in the nation, Reznick Group is on the move—continuing to grow nationally, expanding its services, and building upon its leadership as industry experts.
Terence Kimm, CPA, is a principal with Reznick Group and co-head of the Real Estate Consulting Group in the Bethesda, Md., office, where he works with developers and syndicators in structuring low-income housing, historic, and New Markets tax credit transactions.