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In an apparent decision of first impression, an appellate court has held that a low income housing tax credit (“LIHTC”) borrower cannot use the bankruptcy process as a tool to strip the value of the LIHTCs from the lender’s secured claim, therefore paving the way for a cram-down plan at a significantly reduced valuation. On June 29, 2012, the Bankruptcy Appellate Panel for the Sixth Circuit held that the value of LIHTCs must be considered in the valuation of a debtor's property for purposes of determining a creditor's secured claim under Section 506(a) of the Bankruptcy Code. The impact of this decision is significant for LIHTC-lenders who may be at risk of a cram-down in the event of a low-income housing project borrower’s bankruptcy if the value of LIHTCs awarded to the project is not considered for purposes of valuing the secured claim.

In Creekside Senior Apartments, LP, 2012 Fed App. 0008P (6th Cir. B.A.P. June 29, 2012), each of five debtors was a Kentucky limited partnership whose sole asset was a low-income housing development. Bank of America, N.A. (“Bank of America”) was the debtors’ senior secured lender. Each project was developed pursuant to the federal Low-Income Housing Tax Credit Program, under which the residential properties were subject to certain rent restrictions evidenced by land use restriction agreements between the debtor, the Kentucky Housing Corporation and Bank of America. In turn, the debtors received LIHTCs, which were syndicated to the debtors’ investor-limited partners under the terms of the debtors’ partnership agreements.

In October of 2010, the debtors filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Eastern District of Kentucky. In the cases, Bank of America filed proofs of claim asserting fully secured claims based on a valuation of the properties that included an upward adjustment for the value of the tax credits. The debtors disputed the bank’s claims, asserted that the claims were undersecured and sought to have the properties valued pursuant to Section 506(a) of the Bankruptcy Code, without taking into account the value of the tax credits or the impact of the tax credits on the value of the project.

The debtors argued that the bank's claims were undersecured because the proper fair market value should not include the value of the tax credits. Specifically, the debtors made three principal arguments in support of their contention: (i) that the credits were not part of the real estate and therefore should not be included in its valuation; (ii) that the credits were not property of the debtors’ estate at all because they had been transferred to the debtors' limited partners; and (iii) that Bank of America's security interest did not cover the tax credits and, therefore, the credits could not be considered collateral for purposes of the valuation.

Bank of America argued that the tax credits must be included in a determination of the fair market value of the property because the ownership of the tax credits, pursuant to the Internal Revenue Code (“IRC”), was tied to ownership of the properties. Bank of America further argued that the tax credits would factor into any willing buyer's calculation of its offer price and, therefore, could not be ignored by the debtors in an attempt to cram down Bank of America's claims.

The Bankruptcy Court agreed with Bank of America. The court applied the rule under Section 506(a) of the Code that the value of a debtor’s property "is the price a willing buyer in the debtor's trade, business, or situation would pay to obtain like property from a willing Seller," and held that the value of the tax credits must be included in the overall property valuation. The debtors appealed to the Bankruptcy Appellate Panel for the Sixth Circuit.

On appeal, the Bankruptcy Appellate Panel affirmed the Bankruptcy Court's decision. The Panel held that the tax credits must be included in the valuation of the property because the LIHTCs were inextricably linked to the properties themselves, citing the relevant IRC provisions under which the LIHTCs are awarded and the individual restrictive agreements between the parties. Both the IRC and the restrictive agreements specifically note that ownership of the credits is tied to ownership of the property. Among other things, the Court noted that upon a sale of an LIHTC project, the purchaser is entitled to claim the remaining tax credits. The court also looked to non-bankruptcy real estate tax assessment cases in which courts held that tax credits must be included in the valuation of real estate for tax purposes. Ultimately, since a willing purchaser would take into account such intangible restrictions associated with real estate, i.e., the rent limitations arising from the restrictive agreements − the willing purchaser must also take into account the benefits, i.e., the tax credits associated with the property.

The Bankruptcy Appellant Panel rejected the debtors' argument that a security interest could not attach to the credits. The Panel found that the argument was irrelevant – the question was not whether a security interest attached to the credits; it was whether the credits increased the value of the property. Moreover, although the debtors were entitled to allocate the use of the tax credits to its limited partners, it was not permitted to transfer ownership of those credits, which at all times were owned by the partnerships, tied to the property and subject to recapture if they were improperly used by a limited partner.

The Creekside Senior Apartments decision is significant for LIHTC-lenders who provide financing to low income housing borrowers. LIHTCs are designed to enhance the value of a low income housing development and are considered by lenders in underwriting the financing of such projects. The Creekside opinion is consistent with the expectations of LIHTC lenders that the value of the tax credits can be captured by and realized upon by the lender in the event of a foreclosure or bankruptcy.