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American Bar Association - Defending Liberty, Pursuing Justice

FALL 2010

Vol. 7, No. 1



Found Money or Lost Opportunity? Still Too Few Take Advantage of the Federal Historic Tax Credits Program

By Stephen J. Day, AIA

Part 2: Project Requirements

This is the second of a two-part series on the Federal Rehabilitation Tax Credit Program. Part I explained the basic parameters of this program that allows developers and owners to attract cash investments for their historic properties redevelopment projects. Part 2 describes more detailed aspects of the RTC program and application to typical development projects.

Since the 1970s, the federal Rehabilitation Tax Credits (RTC) program has spurred the redevelopment of more than 35,000 historic buildings in the United States, providing substantial support to projects through tax credit investors’ cash infusions. The program has made projects economically viable that otherwise would not have been realized. This installment gives an overview of which redevelopment projects are eligible and outlines some of the recurring challenges in using the credits.

Key Requirements Under the RTC Program

“Substantial Rehabilitation”
In order for a project to qualify for the RTC program, 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 can generally be described as the un-rehabilitated property purchase price, less the costs of the land, less any depreciation taken to date, plus the cost of any improvements made since the latest purchase. These costs must be expended within any 24-month period ending with or within the tax year that the tax credits are claimed.

“Qualified Expenditures”
These 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 for historic structures (or 10% for non-historic structures). 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.

Building Uses
To qualify for the RTCs, 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 RTC. See IRC § 47 (c) (2) (A).

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 50% 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).

Claiming the Credit
The RTCs 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, for example, 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).

Transferring or Allocating the Credits
RTCs 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 RTCs 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 and losses for tax purposes.

How Long Must the Tax Credit User Own the Property?
An owner that claims the RTCs 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.

Recapture of the Credits
RTCs can be recaptured if the owner claiming the credit (or passing the credit through to a long term lessee) sells the building before the end of the minimum five year holding period, or if the property ceases to be income-producing. Recapture can also occur 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. These recapture rules are laid out in IRC section 50(a). See also Treas. Reg. § 1.48-12(f)(3). The amount of the credit recapture is based on how much of the minimum five year holding period has elapsed at the time of noncompliance.
Challenges/Opportunities in Using the Credits
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 can also present 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 primarily interested in taking advantage of the tax credits and in getting out of the project as soon as possible, with as little risk as possible.

Choice of Development Entity Type
The pass-through tax capability of limited liability companies make the LLC the typical entity of choice for RTC developers, allowing the tax credit advantages to flow to members. The single entity structure is more commonly used for smaller 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 is commonly 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 through a qualifying long term lease.

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.

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 and origination of the project, the company will typically pay development or management fees or other distributions to the developer entity. Payments to members 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.

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 less than 50% of the rentable floor area in the historic building is leased to tax exempt entities.

Leasing to Taxable Entities
Taxable lessees may be eligible to claim RTCs 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).

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 can make a tax credit project very challenging. But for those projects that involve qualifying 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 rehabilitation tax credits can produce significant cash investments to developers and can make the difference between a project that will pencil and one that won’t.

A Note of Caution
The RTC rules are complicated and involve many interrelated parts. This brief summary is intended only as a very general introduction to the subject and should not be taken as tax advice. Project developers and investors must seek ongoing advice and counsel from experienced legal and tax advisors for any specific project.

The National Park Service web site at includes numerous links to sites that include information on the various stages of the National Register process and the RTC program. The IRS web site at also has links to sites that focus specifically on tax aspects of the RTC program.

Stephen J. Day is both an architect and attorney. He has collaborated with a variety of clients and colleagues in real estate development projects over the past twenty years, focusing on the redevelopment of landmark historic properties. For more information on the tax credit projects he has been associated with, go to and Stephen can be reached at (206) 625-1511.


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