Before December 30, 2013, a real estate developer rehabilitating a historic building in Virginia could have raised about 40% of his rehabilitation costs from outside parties. He accomplished this feat using a carefully structured limited liability company. Unfortunately, the Fourth Circuit Court of Appeals did not condone such a business structure in a case decided in early 2011 (Virginia Historic Credit Fund 2001 LP v. Commissioner). Before this case, a developer felt relatively comfortable that the federal government realized the virtues of rehabbing old buildings. The feds tended to overlook technical business structural issues and would allow developers to raise capital fairly unimpeded. I put together probably 50 or so of these combined federal and Virginia transactions and tried to give my investors real substance as a tax partner. The structure used in Virginia Historic was, admittedly, thin; it gave the credit investor very little indicia of being a tax partner. With bad facts come bad law.
The IRS could have solved the problem created by Virginia Historic and issued a workable safe harbor, but it issued Revenue Procedure 2014-12. Effectively, to come within the safe harbor and have his deal sanctioned, a developer must make the credit investor a true and substantial real estate partner. Many developers are unaware of this mess until they court a large investor in federal historic tax credits. Those investors are apparently insisting that the safe harbor be met. Some developers retreat to Virginia historic credit only deals, and that is a good move if the qualified rehabilitation expenditures will be less than $1,000,000. Above that threshold, a developer will have difficulty forfeiting $200,000 plus in potential federal tax credits. Why did the IRS insist on such a shallow and narrow safe harbor? Perhaps we will find out as this mess moves forward and causes real friction in historic rehabs. Please be careful out there.