Volume 1, Number 3
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An Overview of Opportunities (and Pitfalls) in the Federal Historic Preservation Tax Credits Program
Since 1976, the Federal Historic Preservation Tax Incentives program has quietly played a major role in real estate development involving historic landmark properties. The IRS Code, at Sections 38 and 47, includes provisions for the “historic rehabilitation credit” which can be utilized in connection with “qualified rehabilitation expenses” for renovations of “certified historic structures.” This Historic Tax Credits program has spurred the redevelopment of more than 30,000 historic properties in the United States. Over $30 billion in rehabilitation dollars have been associated with these projects, providing approximately $6 billion in tax credits for investors.
In Seattle, recent historic rehabilitation projects have generated substantial Historic Tax Credits for the benefit of project developers, including the following:
● The Smith Tower renovations, with over $28 million in qualified expenses, creating the potential for approximately $5.6 million in tax credits;
● Pacific Medical Center (Amazon.com headquarters), with approximately $21 million in qualified expenses and $4.2 million in potential tax credits;
● The Seaboard Building, a mixed use office/retail/residential building in Downtown Seattle, including over $20 million in rehabilitation expenses and the potential for more than $4 million in tax credits generated for the benefit of investors.
In spite of these success stories, projects like these have not been widely replicated in Seattle. While the Historic Tax Credits program has been very prominent in other parts of the United States, Seattle area developers have not played a major role in using the credits. Part of this is explained by the sheer volume of qualified historic properties in cities such as New York, Chicago and San Francisco. Also, the tax credits rules and process can be complicated, the documentation can be extensive and the program is not well-suited to every project or development scenario. But this does not explain the whole story behind Seattle developers’ infrequent use of the tax credits, especially when you consider the fact that developers in Spokane (a city with a much smaller pool of historic properties) have surpassed Seattle developers in the use of the tax credit program in recent years.
This uneven use of the Historic Tax Credits in Seattle and other cities is due (at least in part) to a general lack of familiarity with the details of the program. And there are many intricacies and many traps for the unwary that must be avoided if Historic Tax Credits are to be fully realized for a project. Still, this particular tax credit (along with the affordable housing tax credit, discussed in the accompanying article by Joe McCarthy) presents one of the few significant tax credit advantages that remain available to real estate developers after the 1986 code changes eliminated most tax credits for real estate investors.
This article summarizes the basics of the Historic Tax Credits program, gives an overview of which redevelopment projects are eligible, how developers can take advantage of the program, and some recurring legal and tax challenges involved in using the credits.
II. Basic Parameters of the Historic Preservation Tax Credits Program
A. What is the Historic Tax Credits Program? This program, administered jointly by the U.S. Department of the Interior (through the National Park Service) and by the Department of the Treasury (through the IRS), makes tax credits available to developers that rehabilitate qualified historic buildings. As set forth in Internal Revenue Code (IRC) § 47(c)(3)(A), qualifying buildings must be “certified historic structures” defined as: (a) buildings listed on the National Register of Historic Places; or (b) buildings that contribute to a National Register Historic District or another qualifying local historic district. Treas. Reg. § 1.48-12(d). A tax credit equal to 20 percent of the “qualified expenditures” in the renovation of certified historic structures may be allocated to the developer entity. So if a developer entity spends $5 million on qualified expenditures for a project, there could be $1 million in tax credits available to directly offset income taxes owed by that entity or one or more of its members/partners.
B. Who Uses the Tax Credits? The Historic Tax Credits are used by owners (or long term lessees) of certified historic structures. Historic Tax Credit utilization by individuals is very limited, due in large measure to the passive activity loss provisions introduced in the Tax Reform Act of 1986. See IRC § 469 regarding passive activity provisions and phaseout of credits. However, taxable corporations regularly take advantage of the credits to reduce their income tax liabilities. A typical arrangement, then, is to bring a corporate tax credit investor entity into the development entity as a member and allocate the tax credits to that investor, in exchange for cash. The tax credit investors pay anywhere from 50 cents to 90 cents on the dollar for the tax credits, depending upon such variables as size of the deal, the local market, project parameters, etc. This arrangement can be extremely positive for the developer: the tax credit investor comes into the project early and contributes cash at a crucial point in the project. In exchange, the credits (which are typically not useful for the developer) are allocated to this corporate entity. Entities that are affiliates of lenders are common users of the credits, (although the single biggest user/investor involved with Historic Tax Credits today is Exxon Mobil Corporation).
C. What is a “Certified Rehabilitation” of a Historic Structure? As a prerequisite to utilizing historic tax credits, the proposed rehabilitation work must be certified by the Secretary of the Interior as being in conformance with the Secretary of the Interior’s standards for rehabilitation. See IRS § 47 (c)(2)(B) & (C); Treas. Reg. § 1.48-12(d). This certification and review process is administered through the National Park Service (NPS), in conjunction with the State Historic Preservation Officer (SHPO) in each State. Application for certification of a rehabilitation is made to the NPS through the SHPO. The SHPO reviews the applications for certification and forwards its comments and recommendations to the NPS for final approvals. In general, in order to be certified, the rehabilitation must be consistent with the historic character of the structure and/or the applicable historic district. The defining historic features and character of the structure must be maintained and not destroyed or compromised by the rehabilitation work.
D. Tax Basics.
1. “Substantial Rehabilitation.” In order to get a project into the Historic Tax Credit arena, the project must be “substantial.” “Substantial rehabilitation” is defined in Treas. Reg. section 1.48-12(b)(2)(i) and includes projects that involve qualified costs in excess of the larger of: (a) the adjusted basis of all owners of the building; or (b) $5,000. The adjusted basis is generally described as the property purchase price, less the costs of the land, less any depreciation taken to date, plus the cost of any improvements made since the purchase. These costs must be expended within any 24-month period ending with or within the tax year that the Historic Tax Credits are claimed.
2. “Qualified Expenditures” are defined in Treas. Reg. § 1.48-12 (c) and IRC § 47 (c) (2) (B) and can include a wide range of hard and soft costs associated with the building work. The total dollar value of the qualified expenditures is critical, because the total amount of tax credits is calculated as 20% of this value. Qualified expenditures can include costs of construction, along with certain developer fees, consultant fees (including legal, architectural and engineering fees), if added to the basis of the property. Costs that are not included in the qualified expenditures include property acquisition costs, new additions to the historic structure or other new buildings, parking and landscaping costs.
3. Building Uses. To qualify for the Historic Tax Credits, the building must be depreciable, so it must be income producing or used in a business. Rental housing, commercial and industrial uses all qualify. Owners of condominium housing units can utilize the tax credits provided that the unit is held for income or is used in a business or trade. An owner’s personal residence will not generate Historic Tax Credits. See IRC § 47 (c) (2) (A).
4. Building Users. There are also limitations on the types of users for the restored historic property. For example, tax exempt entities cannot lease more than 35% of the rentable area in a rehabilitated building unless the lease terms are limited in length and there are no purchase options at the end of the term. There are also restrictions on sale and leaseback arrangements with tax exempt entities. The tax exempt user rules are complex and must be analyzed carefully on a project by project basis. IRC § 47 (c) (2) (B) (v); Treas. Reg. § 1.48-12(c) (7); IRC § 168 (h).
5. Claiming the Credit. The Historic Tax Credits are generally claimed in the taxable year that the rehabilitated building is “placed in service,” which essentially means the date that the rehabilitation work has been completed such that a certificate of occupancy has been issued. For projects that have never been removed from service, this would be the date that the project work is completed. Any excess credit not claimed in the initial tax credit claim can be carried forward for up to 20 years and carried back 1 year. IRC § 47 (b); Treas. Reg. § 1.48-12(f)(2); Treas. Reg. § 1.48-12(c) (3) and (6).
6. Transferring or Allocating the Credits. Historic Tax Credits cannot be “sold” without selling the corresponding interest in the real estate. Only owners of the real property (or long term lessees; see below) can be allocated tax credits. But in practice the use of the Historic Tax Credits are often allocated differently to one or more members of the ownership entity (such as an LLC), so long as the percentage allocation of the tax credits matches the members’ interests in profits for tax purposes.
7. How Long Must the Tax Credit User Own the Property? An owner that claims the Historic Tax Credits must retain ownership of the property for at least five years after the date the project was placed in service, or the tax credits will be subject to recapture.
8. Recapture of the Credits. Historic Tax Credits can be recaptured if the project is sold before the end of the minimum five year holding period or if the property ceases to be income-producing. These recapture rules are laid out in IRC section 50(a). Recapture can also take place if the project ceases to comply with other transfer or leasing restrictions imposed under the program or if the project is physically altered such that it no longer complies with the approved rehabilitation improvements. See also Treas. Reg. § 1.48-12(f)(3). The amount of the credit recapture is calculated on a sliding scale based on how much of the minimum five year holding period has elapsed at the time of noncompliance.
III. Challenges/Opportunities in Using the Credits
A. The Tax Credit Investor. A recurring challenge in using the tax credits is in identifying the partner entity that can utilize the credits and joining that entity with the developer in a partnership arrangement (usually an LLC). But this is a challenge that can also present real opportunities. For example, lenders have substantial tax liabilities that can be reduced by using the tax credits. An affiliated entity of a lender can act as a member in a development LLC and can be allocated the tax credits. An affiliate of that same lender can provide loans for the development project, perhaps on more favorable terms than another lender that does not have the tax credit incentive to lend on the project. This investor is typically interested primarily in taking advantage of the tax credits and in getting out of the project as soon as possible, with as little risk as possible.
B. Choice of Development Entity Type. The pass-through tax scheme of limited liability companies make the LLC the typical entity of choice for Historic Tax Credit developers, allowing the tax credit advantages to flow to individual members. The single entity structure is the most common structure for simpler projects, where the “developer” entity and the tax credit investor entity are members of a single LLC. In larger, more complex projects, a master tenant lease structure has also been used, where the owner/developer will pass through the tax benefits to a master tenant entity that leases the entire building from the owner/developer.
C. Put/Call Provisions. As mentioned above, an owner that is allocated the tax credits must remain in title for at least five years after the project is placed in service. To accommodate this five year window, the development agreement will typically include put/call (buy/sell) provisions that set out a mechanism for the developer to buy out the tax credit investor. Caution is required in drafting these agreements to avoid an IRS characterization of these arrangements as a disguised sale, thus potentially invalidating the tax credit allocation.
D. Allocation of the Tax Credits. There are also potential pitfalls involving the allocation of the tax credits by the investor party. In general, the percentage allocation of the tax credits should match the profits interests of the parties. If one party is allocated all of the tax credits over the five year period that the tax credit investor remains an owner in the project, then that investor will be allocated all or nearly all of the profits interests. To accommodate this, and to compensate the developer partner for its participation in the project, the company will typically pay development fees or other distributions to the developer entity. Cash flows do not necessarily match the profit/loss allocation percentages. At the end of the five-year tax credit recapture period, profit/loss ratios are typically revised to allocate greater profits to the developer.
E. Leasing to Tax Exempt Entities. As mentioned above, leasing space in a certified historic structure to tax exempt entities is possible so long as the lease does not fall into the category of “disqualified leases” as defined in the IRC § 168(h)(1). There are several factors in that code section that must be analyzed for each individual situation, including requirements that the lease term be less than 20 years, the lease cannot occur after a sale of the property from the lessee to lessor, the lease cannot include an option to purchase or a fixed or determinable purchase price for the property, along with limits on financing involving tax exempt financing. These limits are generally not applicable if in the aggregate no more than 35% of the rentable floor area in the historic building is leased to tax exempt entities.
F. Leasing to Taxable Entities. Taxable lessees may be eligible to claim Historic Tax Credits provided that the lease term is at least as long as the recovery period under IRC § 168(c), currently 39 years for non-residential property and 27.5 years for rental residential real property. See also IRC § 47 (c)(2)(B). If the lease term is less than this minimum recovery period, the full tax credit is not available but is instead reduced prorata based on a formula tied to the length of the lease as compared with the recovery period and based on the fair market value of the rehabilitated lease property. See Treas. Reg. § 1,48-4(c)(3).
V. Are the Historic Tax Credits Worth the Effort? Not all historic property redevelopment projects are natural candidates for tax credit utilization. If for whatever reason the developer cannot or will not endure the designation and certification process, or the project does not fit the tax credit criteria, or if the developer cannot structure the deal to bring in the tax credits investor, then the project will not work as a tax credit venture. Also, if the project does not involve at least $1 million in qualified rehabilitation expenditures, the transactions costs involved will likely make it infeasible as a tax credit project. But for those projects that involve certified or certifiable historic structures (and this category is broader than one might think, and getting broader every year), where the development strategy can be flexible, where the rehabilitation is substantial and where the tax credits investor can be identified that fits with the specific development strategy for the project, the historic tax credits can make the difference between a project that will pencil and one that won’t.
VI. A Note of Caution. The Historic Tax Credits rules are complicated and involve many interrelated parts. This brief summary is intended only as a general introduction to the subject. Project developers and investors should seek ongoing advice and counsel from experienced legal and tax advisors for any Historic Tax Credits project.
The National Park Service web site at www.nps.gov includes numerous links to sites that include information on the various stages of the National Register process and Historic Tax Credits program. The IRS web site at www.irs.gov also has links to sites that focus specifically on tax aspects of the program. Stephen Mathison is also a great source of information as the administrator of the Federal Investment Tax Credit Program for the State of Washington, through the Office of Archeology and Historic Preservation.