Historic Tax Credits
Andy Smith, Tax Principal
This article was originally published in the April 3, 2015 issue of the MSCPA’s Friday@Five.
New England is filled with beautiful old buildings. Many once proudly served as things like textile mills, warehouses or military barracks, but were neglected when those uses ended. Lately, forward thinking developers have transformed many of those structures into trendy apartments, retail space, hotels, or office space. The particularly astute developers utilize federal and state tax credits to attract investors and maximize investments, and this article will discuss some of those alternatives.
The Federal Historic Preservation Tax Incentive program provided by Internal Revenue Code (IRC) Section 47 allows owners to claim a 20% federal tax credit for the certified rehabilitation of historic structures. The structure and rehab must be approved by the Secretary of the Interior, through the National Park Service, in order to claim the credit. A lesser 10% credit is available for non-historic structures that were placed in service prior to 1936 and are rehabilitated for non-residential use. Formal certification is required to ensure the characteristics that make the building historically significant will survive the rehabilitation.
This Historic Tax Credit (HTC) is based on the amount of qualifying expenses. Cost of acquisition, personal property and footprint enlargement do not qualify. Some other requirements to claim the credit are:
- Rehabilitation expenditures must exceed the greater of the adjusted basis of the building or $5,000. With some exceptions, this is measured over a 24 month, taxpayer-selected period.
- The building must be depreciable (i.e. used in a trade or business).
- It must be located in the United States.
- Property must be placed in service, with some exceptions for rehabilitation periods exceeding 24 months.
- Building must be certified as completed by the National Park Service.
Generally, the entire federal credit is claimed for the tax year the property is placed in service. However, longer projects may generate partial credits in earlier years.
The HTC is one of the general business credits under IRC §38. Therefore, it is non-refundable (cannot reduce tax below zero) and only offsets income taxes. It may even offset the Alternative Minimum Tax (AMT) if the qualified expenditures were incurred after 2007. Like other general business credits, any HTC that is not utilized entirely in the year generated is carried back one year and then forward 20 years.
The depreciable basis of the structure is reduced by the amount of the credit claimed and only the person or the entity that holds title to the property may claim the credit. However, there is an election available under Treasury Regulation § 1.48-4 that allows a non tax-exempt lessor to pass the HTC through to the lessee under certain circumstances. This structure is often referred to as a master lease or inverted lease structure and is extremely common in HTC projects as a way of attracting outside investment dollars.
Under the master lease structure, two separate partnerships are created. One partnership holds the legal title to the property and the other partnership operates the building as the tenant. This essentially allows the depreciation benefits of ownership to be isolated from the tax credit benefits. Outside investors are typically sought as a financing mechanism using the attraction of the passed through tax credits. Investors, often C Corporations with significant taxable income, make capital contributions to the project in exchange for the allocation of the tax credits. This often reduces or eliminates the amount of cash down payment required by a developer’s lender.
The Historic Boardwalk Hall, LLC v. Comm’r case, in 2011 caused a huge stir in the industry when the IRS successfully challenged the allocation of tax credits by the partnership to certain “investor-members.” In Boardwalk, the investor who was claiming 100% of the tax credits was brought into the deal late in the rehabilitation process with a guaranteed rate of return. The IRS convinced the Third Circuit Court of Appeals that the allocation was erroneous since the investor was not a true “partner” based on their late entry into the project and various contractual provisions, warranties, and indemnifications that guaranteed a preferred return and eliminated downside risk. This landmark decision served as the proverbial bucket of cold water to HTC projects everywhere. Many companies waited for additional guidance from the IRS before they would commit to new projects.
That guidance arrived in early 2014 with IRS Revenue Procedure 2014-12, which created a list of “safe harbor” requirements that must be met for a project to qualify as a historic rehabilitation project. Some key highlights of these complex rules are:
- The Investor must maintain a minimum ownership percentage equal to 5% of the Investor’s largest share of gain, loss, deductions, and credits.
- 75% of Investor’s total capital contribution must be fixed before the building is placed in service.
- 20% of the Investor’s total expected capital contribution must be made prior to the building being placed in service and maintained throughout the investor’s membership in the partnership, without protection or guarantee from loss.
- Investor must have a bona fide equity investment in the partnership and their return must be based on the operations of the partnership and not fixed.
- Investor cannot borrow the funds to make its capital contributions from any of the related partnerships or Developers related to the project.
- Only “unfunded” guarantees are permitted.
- Guarantees of the Investor’s ability to claim the credit or to pay the Investor’s costs associated with an IRS challenge to the credit are prohibited, as are guaranteed cash-on-cash returns.
- Investor is allowed to have a put right to sell their partnership interest as long as the put price does not exceed fair market value at the time of the exercise.
- Call rights to acquire the investor’s interest are not permitted.
With Rev. Proc. 2014-12 now a year old, practitioners have seen a renewed interest in Historic Rehab Projects. Investors and developers are more comfortable with the new playing field, and structure agreements that while not free from risk, have fairly well defined economic and tax outcomes.
Not to be left behind, Connecticut, Maine, Massachusetts, Rhode Island, and Vermont all have programs in place designed to incentivize redevelopment of historic properties. Each state’s rules are unique and separate from the federal credit, but most use similar criteria to determine eligible properties and expenses.
Connecticut has a 25% state tax credit (30% if it includes an affordable housing component) with a project credit cap of $4.5 Million. The credit may be utilized only by C Corporations against Connecticut income tax and contains a five year carryforward period. Since it may only be utilized by C Corporations, Connecticut allows the credit to be assigned or transferred.
Maine also has a 25% state tax credit that may be increased to 30% if the project includes an affordable housing component. Maine’s credit is refundable and recognized over a 4 year period starting with the year of completion.
Massachusetts may award a state tax credit of up to 20% of the certified rehabilitation expenditures. The state has committed $50 Million annually to the program through December 31, 2017. Since projects often take 2 plus years from proposal to completion, developers need to be mindful of this deadline. Due to the annual cap, awards are made via a competitive application process with preference given to projects that provide maximum public and preservation benefit. The credit is nonrefundable and may be carried forward for 5 years. It may also be sold. After the tax credit is awarded, the entity may also choose what year the credit is actually claimed though it cannot be claimed in a year prior to the building being placed in service.
Rhode Island provides for a tax credit of 20% for housing projects and 25% for trade or business space. The entire credit is claimed in the year of completion and is non-refundable, but the unused portion may be carried forward for 10 years. A fee equal to 3% of the qualified rehabilitation expenditures must be paid when the tax credit contract is signed.
Vermont provides a nonrefundable credit equal to 10% of the qualified rehabilitation expenditures. There are some additional credits and incentives for projects in a downtown or village district setting as well.
Many historic rehab projects provide long term economic benefits to the community by bringing buildings back to life. This generates increased property tax revenue for municipalities, creates jobs, and in some cases provides affordable housing. For this reason, many tax breaks accompany these projects. Despite the benefits, as governments fight to balance their budgets, these programs often find themselves in the crosshairs. Developers and their advisors should be sure to monitor the status of the incentives at the federal and state level to maximize the benefits available.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.