Rights of first refusal under Section 42(i)(7) Internal Revenue Code of 1986, as amended (Code), have, in recent years, been the subject of significant dispute and controversy in the low-income housing tax credit industry. Section 42(i)(7) permits certain tenants, residential management corporations, qualified nonprofit organizations, and government agencies to hold a right to acquire qualified low-income buildings for an amount that may be less than the building’s fair market value. Ordinarily such a right would call into question who, for tax purposes, should be respected as the true owner of the building. Section 42(i)(7) creates a safe harbor that prevents the Internal Revenue Service from denying any federal income tax benefit merely by reason of having granted a right of first refusal that complies with the requirements of Section 42(i)(7). But the safe harbor only applies if, in substance, the right granted is in fact a “right of first refusal.”
The Sixth Circuit’s analysis creates uncertainty as to the proper distinction between a right of first refusal, which is eligible for safe harbor treatment under Section 42(i)(7), and a purchase option, which is not. The decision also includes statements about the role of investors in low-income housing tax credit transactions that are inconsistent with industry practice in structuring low-income housing tax credit investments as well as current, prevailing business considerations of tax credit investors. Both of these aspects of the decision may create additional uncertainty and lead to further disputes and controversy among industry participants.
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