Health care bonds.

Alan F. Wohlstetter, Jr. is a member of the Philadelphia-based law firm of Cozen and O'Connor and chair of its public finance group. Bridget A. Brennan is an associate in the firm's tax group.

Sell assisted living facilities while retaining management

It's another beautiful Friday morning and your mind starts to wander to your 3 o'clock tee-off time. Line one lights up: it's some health care analyst from New York who has been panning your assisted living company's stock since the first of the year. "I'll call back," you say icily. Line two is your best friend from last year--your REIT lender. He wants to know if you want to buy back any of the properties he has in his REIT. He's got no money--something about problems in the Far East, he says. You take a deep breath and place a call to the not-for-profit that offered to buy some of your assisted living facilities using tax-exempt bonds.

In certain situations, not-for-profit organizations may issue tax-exempt bonds on a non-recourse basis for 30 years, with an interest rate of about 7 percent, to finance the purchase of an assisted living facility. We will refer to these bonds as health care bonds. With only a 10 percent equity requirement, a seller can maximize the sales price while retaining management of the facility's day-to-day affairs.

Kitchens are key to eligibility. If any of the facility's units has one, you might have to look elsewhere for financing. Under the tax laws, health care bonds may be used to buy an ALF if its units do not contain "separate and complete facilities for living, sleeping, eating, cooking, and sanitation." Although many assisted living units (particularly Alzheimer's units) are designed without full kitchens for the safety of the residents. the IRS considers even something as minimal as a small refrigerator, sink, and mounted microwave to be a "separate cooking facility."

Even if the units contain separate facilities for living, sleeping, eating, cooking, or sanitation, the facility may still qualify for health care bonds if it provides frequent or continual nursing, medical, or psychiatric services, with at least 12 hours of RN coverage and 24-hour coverage by licensed practical nurses and licensed nursing aides each day.

But even if the facility has separate cooking facilities and does not provide frequent or continual nursing, medical or psychiatric care, don't give up the ship: Tax-exempt bonds may be used if the facility meets low-income set-aside requirements. Under this scenario, at least 20 percent of the units must be rented to individuals with incomes of 50 percent or less of area median gross income, or at least 40 percent to people with incomes of 60 percent or less of area median gross income. Elderly residents often meet these requirements because they apply only to income, not assets.

Purchasers are generally one of two types. The prime buyer is a not-for-profit health system in your service area that wants to add another, virtually all private pay, level of care. It is advisable for the purchaser to be an empty corporation with no assets other than the facility to be purchased so that the bonds can be marketed based on the facility's credit alone.

This new corporation can be formed if the system has a group exemption letter from the IRS allowing subordinate entities to be formed under the parent not-for-profit. Alternatively, the parent may be able to form a single-member limited liability company without having such a letter. The LLC shares the parent's tax-exempt status for federal tax purposes, but is a separate corporation for state law purposes.

A second potential purchaser is an independent 501(c)(3) organization that has been approved by the IRS to purchase ALFs or has applied to be so approved. A streamlined process with the IRS permits such an entity to get approval in about three months.

In either case, the purchaser may not be controlled by any officers, shareholders, or employees of the seller and the sale must be at arm's length.

Limitations on the selling price and the management fee are important to keep in mind. The selling price may not exceed the facility's appraised fair market value, to ensure that the bonds are not being issued to benefit a private party. As a practical matter, the sales price will be further limited by the fact that the bond market requires the facility to project a maximum annual debt service coverage ratio on the bonds of at least 1.40 at stabilization.

In addition, the IRS generally permits a management contract between purchaser and seller-manager of up to 15 years, provided at least 95 percent of the management fee is a fixed dollar amount for each year of the contract. The balance may float based on a performance indicator other than net profits of the facility (e.g., 5 percent of gross revenues). Certain contracts may also include a onetime incentive fee payable upon the achievement of a gross revenue or expense target.

For shorter-term contracts, the IRS permits a larger portion of the management fee to be floating. For example, up to 50 percent of the fee may float in a 5-year contract. Whatever the contract's term, it needs to be negotiated at arm's length with an unrelated party at market rates. It is advisable for the purchaser to have two other documented offers to manage the facility at comparable levels.

Health care bonds enable a for-profit assisted living company to sell an existing facility to a not-for-profit corporation for cash while maintaining management of the facility for up to fifteen years. Interest rates for the purchasers of such facilities are at historic lows, and health care bonds allow the for-profit company to remove the asset (and its associated liability) from its balance sheet and replace it with cash and a management fee income stream.