Sixth Circuit Issues Decision on Rights of First Refusal in Low-Income Housing Tax Credit Transactions

Facts and Holding

The case involves the attempted exercise by Presbyterian Village North (Presbyterian) of a right of first refusal to acquire a qualified low-income project. An affiliate of Presbyterian and another party (Pathway of Pontiac, Inc.) were co-general partners of a partnership that owned the project. The Investor was a limited partner in the partnership. Under the terms of the partnership agreement, Presbyterian held a right of first refusal to purchase the project for an amount based on the statutory minimum purchase price set forth in Section 42(i)(7). A condition to Presbyterian’s ability to exercise of its right of first refusal was that the partnership had to have received a “bona fide offer” to purchase the project.

In 2019, two separate offers were made to purchase the project. At least one of the offers had been solicited by one of the general partners of the partnership. Correspondence between one of the general partners and one of the offerors suggested that the terms of the offer be tailored so as to trigger Presbyterian’s ability to exercise its right of first refusal.  Upon receiving these offers, Presbyterian sought to exercise its right of first refusal. The Investor objected and brought claims against the general partners and Presbyterian for, among other things, a breach of the terms of the partnership agreement and a breach of the general partners’ fiduciary duty to the Investor. The district court granted the Investor summary judgment on both the breach of contract and breach of fiduciary duty claims. The district court concluded that Presbyterian’s ability to exercise its right of first refusal was conditioned on both the partnership’s having received a bona fide offer to purchase the project and the general partners’ having manifested a true intention to sell the project, neither of which had been satisfied, according to the court.

The Sixth Circuit reversed the district court’s grant of summary judgment and remanded the case for further proceedings. The Sixth Circuit found that the district court, which had relied on a common law understanding of what a “bona fide third party offer” means, had improperly interpreted the requirement in the context of the unique, statutorily-specified rights under Section 42(i)(7) of the Code.

The “Intent to Sell Generally” Standard

The Sixth Circuit’s decision acknowledges that in drafting the Section 42(i)(7) safe harbor, Congress intended to draw on common law distinctions between purchase options (which the holder may unilaterally exercise) and rights of refusal (which cannot be unilaterally exercised). But the court also states that the only statutory precondition for the exercise of a right of first refusal under Section 42(i)(7) is that the owner of the subject building possesses an “intent to sell generally.” According to the court, this condition need not be evidenced by the receipt of a bona fide third party offer.

The court’s decision provides little guidance as to how parties are to substantiate the existence of an “intent to sell generally” — particularly in a way that meaningfully distinguishes a right of first refusal from a purchase option. Given the importance of this distinction to the ability of taxpayers to rely on the safe harbor found in Section 42(i)(7), this ambiguous standard is likely to introduce additional controversy and dispute in the negotiation and drafting of rights of first refusal in low-income housing transactions.

Other Dicta Regarding Investors’ Role in Low-Income Housing Tax Credit Transactions

In reaching its conclusion, the Sixth Circuit also included, in dicta, a number of broad and conclusory statements about the role of investors in low-income housing tax credit transactions and the purpose of a right of first refusal under Section 42(i)(7). Among other things, the court suggested the following:

• An investor that holds its interest in a partnership as a passive limited partner and that agrees to a right of first refusal is expecting to receive only federal low-income housing tax credits and has otherwise bargained away its right to participate in the long-term appreciation of the project.
• Facilitating the exit of investors from low-income housing projects after the expiration of the 15-year low-income housing tax credit compliance period is “crucial to the efficacy of the [low-income housing tax credit] program.”
• Section 42(i)(7) was intended to avoid a “serious risk of an ownership battle” after the end of the 15-year low-income housing tax credit compliance period.

These statements are inconsistent with standard assumptions that are relied on in structuring low-income housing tax credit syndications through partnerships. They are also inconsistent with current, prevailing business considerations of many tax credit investors. In making these statements, the Sixth Circuit appears to have given little or no consideration to, among other things, the requirements for investors in low-income housing tax credit transactions to be respected as partners in the partnerships that develop and operate low-income housing projects¹; the requirements to avoid the application of partnership anti-abuse rules, or the requirement to structure transactions in a manner that imbues the transaction with economic substance and avoids challenges under the doctrine of substance over form. The court’s statements regarding the role of investors in low-income housing transactions and the mechanics for how tax credit syndications are intended to operate may therefore introduce additional uncertainty and lead to further disputes among industry participants and their tax counsel in matters unrelated to rights of first refusal.

Conclusion

The Sixth Circuit’s decision may introduce new areas of uncertainty as to the negotiation and proper drafting of rights of first refusal as well as other aspects of low-income housing tax credit transactions. This may lead to additional disputes and controversy among industry participants, making it more costly to successfully negotiate and close low-income housing tax credit investments. 

Investors and nonprofit sponsors have a shared interest in structuring rights of first refusal in a manner that permits the parties to rely on the safe harbor in Section 42(i)(7).  Failure to satisfy the safe harbor jeopardizes the ability of investors to claim low-income housing tax credits and could, in some circumstances, obligate a nonprofit sponsor to make substantial payments to an investor as a result of the investor’s inability to claim credits. 

Practitioners in the low-income housing tax credit industry must balance the important policy objectives that motivated the enactment of the Section 42(i)(7) safe harbor with the obligation to structure low-income housing tax credit transactions in a manner that complies with all applicable requirements of federal income tax law. The Sixth Circuit’s decision may make this balancing act more challenging. In recent years, Congress has considered legislation that would modify Section 42(i)(7) to bring clarity to this issue. The Sixth Circuit’s decision and the uncertainty it will create highlight the need for such legislative action.