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News, Analysis and Commentary On Affordable Housing, Community Development and Renewable Energy Tax Credits
July 2010, Volume I, Issue VII
Published by Novogradac & Company LLP
Why Prepaid Rent (Unfortunately)
Isn’t Nonqualified Financial Property
Part Two
By Douglas Banghart, Holland & Knight
O
ccasionally new markets tax credit (NMTC) transactions are structured such that the qualified active
low-income community business (QALICB) makes a
one-time, up-front, rent payment to its lessor. A frequently
raised issue is whether this prepayment could be reclassified by the Internal Revenue Service (IRS) or a court as a
loan, which presumably would make it a prohibited nonqualified financial property (NQFP). This article argues that
in the non-NMTC world, and even though many taxpayers
would prefer otherwise, prepaid rent is almost never classified as a loan. Given this, this article maintains that it is
extremely unlikely that the IRS could take the position that
prepaid rent is NQFP because it is simply contrary to the law
and would create enormous income tax deferral opportunities. Last month, part one of this two-part series on prepaid
rent explained the rules that existed before Congress and
the IRS got smart and started making our tax system take
into account the time value of money concepts. This month,
part two will deal with what happens under Section 467 of
the Internal Revenue Code (IRC).
Under Section 45D of the IRC, community development entities (CDEs) are authorized to designate investors’ equity
contributions into those CDEs as qualified equity investments (QEIs), entitling the investors to NMTCs. The CDEs
are then required to use such QEIs to make qualified lowincome community investments (QLICIs) in QALICBs during a seven-year compliance period. Section 45D(d)(2) of
the IRC sets forth the various tests that must be satisfied in
order for the borrower to be a QALICB, one of which is that
the adjusted basis of any NQFP held by the QALICB cannot
exceed 5 percent of the adjusted basis of all of the QALICB’s
assets. Loans are NQFP, as are stock, partnership interests,
options, futures contracts, forward contracts, warrants, notional principal contracts and annuities. The legislative history of the NMTC is sparse, but presumably the policy rationale of the NQFP prohibition is that Congress wants to
subsidize active business activity, not passive investing.
Last month’s article argued that the IRS would be unlikely
to argue under pre-IRC Section 467 law that prepaid rent
paid by a QALICB to its lessor would be a loan because of
the enormous deferral opportunities that position would create in non-NMTC transactions. Under pre-IRC Section 467,
those payments are income to the lessor, so they cannot also
be loans. If they are not loans, then they should not constitute
NQFP. This month, part two of this two-part series on prepaid rent, explains the rules that exist under IRC Section 467.
Section 467 Rental Agreements
IRC Section 467 applies to rental agreements. A “467 rental
agreement” includes rental agreements that contain “increasing or decreasing rents;” “deferred rents;” or “prepaid
rents.” Each of these terms has a peculiar definition. The peculiarity stems from the fact that the 467 regulations assume
that the rent schedules in most leases have three columns
rather than the two columns with which we are typically
familiar: the year and the amount to be paid in that year.
The strange new third column is labeled “rent allocation.”
In other words, the regulations assume (and permit, within
certain limitations) that the parties might decide to book
the tax consequences of the rent payments other than as
they are paid. For example, in a three-year lease, the parties
might pay even amounts of rent in each year, but book all
continued on page 2
NOVOGRADAC JOURNAL OF TAX CREDITS
continued from page 1
the income and deductions in the last year.
PUBLISHER
For purposes of analyzing prepaid rent, let’s say we have a 10year lease for $1 million, all of which is paid in the first year. Since
no rent is paid in the second year, it certainly sounds like we have
either decreasing rents or prepaid rent, either of which would
mean we have a 467 rental agreement that would be subject to the
complicated IRC Section 467 rules.
Michael J. Novogradac, CPA
MANAGING EDITOR
Alex Ruiz
EDITOR
Jane Bowar Zastrow
TECHNICAL EDITORS
Increasing or decreasing rents exist if the “annualized fixed rent”
allocated to any “rental period” exceeds the annualized fixed
rent allocated to any other rental period in the lease term. Annualized fixed rent is determined by multiplying the “fixed rent”
“allocated to the rental period” by the number of periods of the
rental period’s length in a calendar year. Fixed rent is any rent
to the extent its amount and the time at which it is required to
be paid are fixed and determinable. Importantly, the taxpayer in
determining what constitutes fixed rent is specifically required
to ignore the possibility of default under the rental agreement, as
well as the possibility that one of the parties may be insolvent. See
Treas. Reg. § 1.467-1(h)(1) & (2).
How is this fixed rent allocated to the rental period? If the rental
agreement specifically allocates (a) for periods no longer than a
year, an amount of rent for which the lessee becomes liable on
account of the lease during that period, and (b) the total amount
(for all periods), so specified totals the total amount due under
the lease, then the amount “allocated to each rental period” will
be whatever is specified on the rent schedule.
www.novoco.comJuly 2010
2
Novogradac Journal of Tax Credits
Editorial Board
So do we have increasing or decreasing rents and therefore a 467
rental agreement? That depends on how we allocate the rent for
tax purposes on the rent schedule in the third column discussed
above. Let’s take two scenarios based on our $1 million prepayment example above: in the first, assume we spread the $1 million
rent allocation over the 10-year term, such that $100,000 is allocated to each year; in the second, assume that we simply allocate
the $1 million just as we paid it: i.e. the full $1 million in the fi rst
year. Note in both instances the total rent allocated equals the
total amount paid.
In the first scenario, because the rental amount allocated to each
year is the same, the annualized fixed rent allocated to any rental
period obviously can’t exceed the annualized fixed rent allocated
to any other period, so we have don’t have increasing or decreasing
rents. In the second scenario, because the annualized fixed rent allocated to the first year exceeds the annualized fixed rent allocated
to the second year (and every year thereafter), we have increasing
or decreasing rents and therefore have a 467 rental agreement.
Because, under the second scenario, we have a 467 rental agreecontinued on page 3
Robert S. Thesman, CPA
James R. Kroger, CPA
Owen P. Gray, CPA
Thomas Boccia, CPA
Daniel J. Smith, CPA
STAFF WRITERS
Jennifer Dockery
Jennifer Hill
CONTRIBUTING WRITERS
Douglas Banghart
Kelly Beigle
Tom Boccia, CPA
Jerome Breed
Brandi Day
Brad Elphick, CPA
Jenny Ho, CPA
Jim Kroger, CPA
John Leith-Tetrault
Forrest David Milder
Donna Rodney
Buzz Roberts
Daniel J. Smith, CPA
Annette Stevenson, CPA
PRODUCTION
Jesse Barredo
James Matuszak
Novogradac Journal of Tax Credits
Information
Address all correspondence and
editorial submissions to:
Alex Ruiz/ 415.356.8088
Address inquiries regarding
advertising opportunities to:
Emil Bagalso / 415.356.8037
Editorial material in this publication is for informational
purposes only and should not be construed otherwise.
Advice and interpretation regarding the low-income
housing tax credit or any other material covered in this
publication can only be obtained from your tax advisor.
© Novogradac & Company LLP
2010 All rights reserved.
ISSN 2152-646X
Reproduction of this publication in whole or in part in any
form without written permission from the publisher is
prohibited by law.
LOW-INCOME HOUSING TAX CREDITS
Bud Clarke
BOSTON FINANCIAL INVESTMENT MANAGEMENT
Jana Cohen Barbe
SONNENSCHEIN NATH & ROSENTHAL LLP
Tom Dixon
BOSTON CAPITAL
Valerie White
STANDARD & POOR’S CORPORATION
Rick Edson
HOUSING CAPITAL ADVISORS INC.
Richard Gerwitz
CITI COMMUNITY CAPITAL
Rochelle Lento
U.S. BANCORP COMMUNITY DEV. CORP.
Phillip Melton
GRANDBRIDGE REAL ESTATE CAPITAL
Thomas Morton
PILLSBURY WINTHROP SHAW PITTMAN LLP
Stephen Ryan
COX, CASTLE & NICHOLSON LLP
Arnold Schuster
SONNENSCHEIN NATH & ROSENTHAL LLP
Rob Wasserman
U.S. BANCORP COMMUNITY DEV. CORP.
PROPERTY COMPLIANCE
Rose Guerrero
CALIFORNIA TAX CREDIT ALLOCATION COMMITTEE
Sharon Jackman
SIG SERVICES LLC
Michael Kotin
KAY KAY REALTY
Patricia Murphy
Mardi Roberts
TEXAS DEPT. OF HOUSING & COMM. AFFAIRS
WASHINGTON STATE HOUSING FINANCE COMMISSION
Michael Snowdon
SOLARI ENTERPRISES
Ruth Theobald Probst
Kimberly Taylor
THEOPRO COMPLIANCE & CONSULT. INC.
HOMESTEAD CAPITAL
HOUSING AND URBAN DEVELOPMENT
Sheldon Schreiberg
Monica Sussman
PEPPER HAMILTON LLP
COMMUNITY REINVESTMENT FUND
Bruce Bonjour
PERKINS COIE LLC
Neil Kimmelfield
SONNENSCHEIN NATH & ROSENTHAL LLP
Ruth Sparrow
FUTURES UNLIMITED LAW PC
NIXON PEABODY LLP
Mary Tingerthal
HOUSING PARTNERSHIP NETWORK
Tom Tracy
HUNTER CHASE & COMPANY
Joseph Wesolowski
ENTERPRISE COMMUNITY INVESTMENT INC.
HISTORIC TAX CREDITS
Don Holm
FARRIS BOBANGO BRANAN PLC
John Leith-Tetrault
NATIONAL TRUST COMM. INVESTMENT CORP.
MACROSTIE HISTORIC ADVISORS LLC
BRYAN CAVE LLP
HERITAGE CONSULTING GROUP
RENEWABLE ENERGY TAX CREDITS
MILBANK, TWEED, HADLEY & MCCLOY LLP
Michael Hall
BORREGO SOLAR SYSTEMS
Jim Howard
DUDLEY VENTURES
Given this, whether we apply the second or the third method
turns on whether we have adequate stated interest with respect
to the 467 rental agreement. A 467 rental agreement provides adequate stated interest if, among other things, it does not contain
prepaid rent.
One could reasonably conclude we have prepaid rent given we
are paying all the rent in the first year. However, for these purposes prepaid rent exists only if the cumulative amount of rent
payable at the end of a year exceeds the cumulative amount of
rent allocated as of the close of the succeeding calendar year. The
rent payable under our lease is all paid in the first year and, under our second example, the allocated rents and payable rents are
identical since the allocated rent is also being booked in year one.
Given this, the cumulative amount of rent payable as of the close
of the first year cannot exceed the cumulative amount allocated as
of the close of the succeeding year, because there is no rent paid or
continued on page 3
www.novoco.comJuly 2010
Herb Stevens
Ed Feo
The third method, called “Section 467 rental accrual,” applies if
the 467 rental agreement does provide adequate stated interest on
fixed rent. If this method applies, then the fixed rent for the rental
period is whatever is written on the rent schedule.
LANE POWELL
Scott Lindquist
John Tess
The second method, called “proportional rental accrual,” applies
if the constant rental accrual method above does not apply (and
we concluded above it doesn’t) and the 467 rental agreement does
not provide “adequate stated interest on fixed rent.” When proportional rental accrual applies, then the fixed rent for a rental
period is the “proportional rent amount.”
NIXON PEABODY LLP
NEW MARKETS TAX CREDITS
Frank Altman
ment, we have to determine how to allocate the rent. There are
three methods of doing this, which are mandated to be applied
and are not optional. The first, “constant rental accrual,” requires
that the Commissioner affirmatively determine that because of
a tax avoidance purpose, the agreement should be treated as a
“long term lease” or a “disqualified leaseback.” If the lessor and
the lessee’s marginal tax rates do not differ by more than 10 percent, there is what amounts to a “no tax avoidance purpose” safe
harbor and constant rental accrual should not apply. See Treas.
Reg. § 1.467-3(c)(2)(ii). For our purposes, we will assume the lessor and lessee have the same tax rates.
MCA HOUSING PARTNERS
Gianna Solari
Donna Rodney
If the rental agreement specifically allocates (a) for periods no longer than a year, an amount of rent for which
the lessee becomes liable on account of the lease during that period, and (b) the total amount (for all periods),
so specified totals the total amount due under the lease,
then the amount “allocated to each rental period” will be
whatever is specified on the rent schedule.
DYKEMA GOSSETT PLLC
John Lisella
Bill MacRostie
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NOVOGRADAC JOURNAL OF TAX CREDITS
Novogradac Journal of Tax Credits
Advisory Board
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NOVOGRADAC JOURNAL OF TAX CREDITS
continued from page 3
allocated in the second year. The same rationale applies
for all the remaining years. Given this, we do not have
prepaid rent, so we have adequate stated interest, and
we are therefore required to use the Section 467 rental
accrual method.
Note however, that in the first example in which we prepaid all the rent but spread the allocation out over the
entire lease, then we would have prepaid rent because
the million dollars paid in the first year would exceed the
$200,000 allocated by the end of the second year. If we
had prepaid rent, we would have a 467 rental agreement
but would not have adequate stated interest, so the proportional rental accrual method would apply. But making proportional rental not apply is generally as simple as
booking the rent payments as they are actually paid.
Conclusion
The bottom line is that so long as you book the tax consequences of rent payments in the years in which they
are paid, and as long as the lessor and the lessee’s marginal rates are not expected to differ by more than 10
percent during the term of the lease, you will never have
prepaid rent or deferred rent for purposes of Section
467, even if the rent is prepaid or deferred in common
parlance. If you don’t have prepaid rent or deferred rent
for purposes of Section 467, then the rent allocations are
simply those stated on the rent schedule: no complicated
interest calculations are required. Complicated calculations which could raise NQFP issues will generally only
arise if the parties are trying to book the rent allocations
other than as they are being paid. Given this, under both
Section 467 and the authority that existed before Section
467, none of the rent is required (or, indeed, permitted)
to be recharacterized as a loan. If none of it is a loan,
none of it should be NQFP.
Douglas R. Banghart is a partner in the Boston office of Holland & Knight. He practices in the area of state and federal
tax credit syndication, partnership taxation and not-for-profit
organizations. He represents major institutional investors,
developers, local governments, CDEs and not-for-profit organizations, primarily in real estate redevelopment projects. He
has extensive experience in closing new markets tax credit leverage fund transactions, including acting as lead attorney on
the largest new markets transaction ever closed, and twinned
historic and new markets tax credit transactions.
This article first appeared in the July 2010 issue of the Novogradac Journal of Tax Credits.
© Novogradac & Company LLP 2010 - All Rights Reserved
Notice pursuant to IRS regulations: Any U.S. federal tax advice contained in this article is not intended to be used, and cannot
be used, by any taxpayer for the purpose of avoiding penalties under the Internal Revenue Code; nor is any such advice intended
to be used to support the promotion or marketing of a transaction. Any advice expressed in this article is limited to the federal
tax issues addressed in it. Additional issues may exist outside the limited scope of any advice provided – any such advice does
not consider or provide a conclusion with respect to any additional issues. Taxpayers contemplating undertaking a transaction
should seek advice based on their particular circumstances.
www.novoco.comJuly 2010
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This editorial material is for informational purposes only and should not be construed otherwise. Advice and interpretation regarding property compliance or any other material covered in this article can only be obtained from your tax advisor. For further
information visit www.novoco.com.