Jeff Adams is a partner with AGG and co-chair of the firm’s Affordable Housing and Community Development Practice Group.

When a nonprofit entity is a participating owner in a low income housing project that generates low-income housing credits (“LIHTCs”), it is common to grant the nonprofit entity, or another affiliated nonprofit entity, a right of first refusal to purchase the project after the end of the 15 year compliance period (the “Compliance Period”) provided for in the Internal Revenue Code (the “Code”).  The terms of the right of first refusal are dictated, in part, by Section 42(i)(7)(A) of the Code.  Such section provides that “no Federal income tax benefit shall fail to be allowable…merely by reason of” a right of first refusal in favor of qualified nonprofit organizations with regard to qualified low-income buildings financed with LIHTCs.  The low-income housing projects may only be purchased by a nonprofit entity for “a price which is not less than the minimum purchase price.”  The Code provides that the minimum purchase price is “the principal amount of outstanding indebtedness secured by the building (other than indebtedness incurred within the 5 year period ending on the date of the sale…)” and “all Federal, State, and local taxes attributable to such sale.”

The term “right of first refusal” is not defined in the Code, nor is sufficient IRS guidance available to shed light on the mechanics of exercising a right of first refusal.  Because of this lack of specificity within Code Section 42(i)(7) and the lack of IRS guidance, there has been some uncertainty in the industry as to how and under what specific circumstances a right of first refusal can be exercised by a qualified nonprofit entity.

Some of the questions that persist in the industry include:

1. Whether a third party “bona fide” offer to acquire the project is required before a right of first refusal can be exercised;
2. What does “bona fide” offer mean in the context of a Code Section 42(i)(7) right of first refusal;
3. Should the right of first refusal be triggered merely by the property owner putting the project up for sale?

This uncertainty, and the existence of a large amount of LIHTC projects nearing the end of the Compliance Period, has apparently resulted in a growing number of disputes between nonprofit sponsors and investor limited partners regarding the exercise of rights of first refusal.

A 2016 Massachusetts Superior Court case addressed the issue of the right of a nonprofit sponsor to exercise a right of first refusal in connection with a LIHTC project.  In Homeowner’s Rehab, Inc. and Memorial Drive Housing, Inc. v. Related Corporate V SLP, L.P. and Centerline Corporate Partners V, L.P., the court granted summary judgment and concluded that the nonprofit sponsor properly triggered a right of first refusal to acquire the project for the minimum purchase price as set forth in Code Section 42(i)(7). The partnership documents granted the nonprofit sponsor a right of first refusal, as well as an option, to purchase the property.  The investor limited partner argued that the nonprofit’s attempt to exercise the right of first refusal without having first obtained the investor’s consent  was invalid and also that there had not been a bona fide third party offer to trigger the right of first refusal.  The court rejected these arguments and held for the nonprofit.

Although the Superior Court’s ruling is under appeal (and also would not necessarily be binding on courts outside its jurisdiction), that lower court in Homeowner’s Rehab, Inc. made some important findings regarding the Code Section 42(i)(7)(A) right of first refusal:

1. “Section 42 explicitly envisions that qualified nonprofit . . . sponsors may be granted a right of first refusal . . . for a minimal purchase price.”
2. “A transfer of the [right of first refusal] at the Section 42 price . . . contributes to the overall goal of promoting the continuing availability of affordable housing.”
3. The Section 42 right of first refusal is “designed to allow nonprofit entities to buy back property at the end of the 15 Year Compliance Period at a preset price which . . . is substantially below fair market value.”  While a third party offer may be necessary to trigger it, any such offer need only be enforceable and submitted in accordance with the terms of the partnership agreement and Section 42 (i)(7) to trigger the right, all of which is in line with the intent of Congress and the policy goals of Section 42.

Again, very little guidance currently exists (either from the IRS or pursuant to case law) concerning Code Section 42(i)(7)(A).It is worth noting that early versions of the Cantwell–Hatch tax credit reform legislation that has been introduced in Congress proposed to convert existing rights of first refusal into options to purchase the property or the partnership interests of the project partnership.It is not clear how the mechanics of such a conversion would work, and of course, it is entirely unknown if any of the proposed legislation would be passed.In the meantime, nonprofit sponsors with projects that are nearing the end of the Compliance Period should carefully review their existing right of first refusal and related partnership agreements.Also, for parties currently negotiating partnership and right of first refusal agreements, careful and concise drafting of those agreements is vital to protecting the nonprofit’s interest and helping to avoid conflicts in the future when exercising those rights.