Federal 20 and 10 Percent Rehabilitation Tax Credits
What are Rehabilitation Tax Credits?
Through Section 47 of the Internal Revenue Code, the federal government offers rehabilitation tax credits (RTC's) to encourage the preservation and adaptive reuse of certified historic and older buildings. RTC's are a dollar-for-dollar reduction of federal income tax liability.
The dollar value of the credit is calculated as a percentage of the qualified rehabilitation expenditures (QRE's) to be incurred during the course of construction. For the rehabilitation of certified historic buildings, the percentage is equal to 20 percent of QRE's; for the rehabilitation of non-historic, non-residential buildings built before 1936, the percentage is 10 percent of QRE's. The credits become available to the building owner after the completed project is placed-in-service and taxes are filed with the Internal Revenue Service.
Why Use Tax Credits?
Tax credit equity investments can be an extremely valuable part of a historic rehabilitation financing plan. In the case of a nonprofit developer, such as a historic theatre foundation, the presence of tax credit equity can help with fundraising by leveraging additional revenue for the project. In many cases, tax credits have made the difference between a historic property being rehabilitated and being demolished.
How to Use Rehab Tax Credits
To qualify for either the 20 percent or the 10 percent rehabilitation tax credit, the rehabilitation must be defined as ?substantial?. A substantial rehabilitation means that a taxpayer's QRE's during a 24-month or 60-month measuring period (for a phased project) must exceed the "adjusted basis" of the building or $5,000, whichever is greater. The adjusted basis is generally defined as the purchase price, minus the cost of the land, plus the value of any capital improvements made since the building acquisition, minus any depreciation already taken. Eligible properties must be income-producing to qualify for rehabilitation tax credits; therefore, owner-occupied residences are not eligible.
To qualify for the 20 percent credit, the rehabilitation must also be certified as conforming to the Secretary?s Standards for Historic Rehabilitation. This entails completing a three-part application process which is reviewed first by the state historic preservation office (SHPO) and then by the National Park Service.
- Part 1 makes the case for National Register property listing or verifies that a property is a contributing structure in a National Register District;
- Part 2 summarizes the scope of the rehabilitation; and
- Part 3 documents that the work has been done as proposed in the approved Part 2.
Virtually all of the rules that apply to the 20 percent rehab credit apply to the 10 percent credit with a few notable exceptions. The 10 percent credit requires no design review at the state or federal level, but there is a ?wall test? requiring that three of the original four walls remain intact. The developer simply needs to attach Form 3468 to his/her tax return.
The compliance and recapture period for the federal rehabilitation credits is five years from the date the property is placed in service. Twenty percent of the recapture risk burns off every year.
How Nonprofit Groups Can Use Tax Credits
Nonprofit organizations and public agencies do not pay federal or state income taxes and therefore have no tax liability against which to apply rehabilitation tax credits. Also, many for-profit entities are not in a tax position to make full use of the value of the credit. Fortunately, it is possible to still tap into the value of the rehabilitation tax credit by transferring (or syndicating) the tax credit to a corporate investor who then uses the tax credit to offset some of its own tax liability.
How to Turn Tax Credits into Cash
Those building owners not able to fully utilize rehabilitation tax credits personally or who prefer cash during construction instead of a reduction in taxes owed, may choose to syndicate or sell a rehabilitation project?s credits. To do this, the building owner forms a limited partnership (LP) or a limited liability corporation (LLC) with a corporate tax credit investor through which the investor becomes (and must remain) one of the building owners for a 5-year period. (Section 47 of the IRC states that the credits can only be claimed by project owners.) The investor is then able to claim the federal tax credits generated by the project to defray its federal income tax liability. In return, the corporate investor makes an equity investment in the project.
The amount of the tax credit equity investment varies depending on the attractiveness of the transaction. ?Pricing? is usually in the range of $1.15-$1.30 cents on the tax credit dollar for the federal historic rehabilitation tax credits, $.75-.95 cents on the tax credit dollar for state historic tax credits, and $.85-1.05 cents on the tax credit dollar for New Markets Tax Credits. Often these investors are direct tax credit investors (i.e. banks and other widely held corporations who buy the credits to defray their corporation?s tax liability. Palm Tree Financial is an example of a tax credit ?consultancy or syndicate? which, on the other hand, does not buy the credits, but arrange for them to be purchased by another corporate entity with an appetite for tax credits. A fee is charged for this service which ranges between 6.0%-10.0% of the tax credit dollars procured.
Tax Credit Tips
You should allow at least 120 days from the date of application for the state and federal approval of Parts 1 and 2. Developers typically hire historic preservation consultants or an experienced preservation architect to complete this application. Palm Tree Financial tax credit purchase will not close on a tax credit investment without an approved Part 2. It is highly recommended that you obtain an approved Part 2 before beginning construction. It is also advised that you use an architect who has prior experience with meeting the Secretary?s Standards. Failure to obtain a Part 3 approval triggers a tax credit recapture.
To examine in more detail the federal tax credit rules and regulations as they may apply to you and your property, refer to the Rehabilitation Tax Credit Guide. The Guide provides a step-by-step, interactive format for determining whether a project will be able to qualify, earn and redeem the federal rehabilitation tax credits.
State Historic Tax Credits
Recognizing the success of the federal program, over 30 states have adopted legislation establishing state historic tax credits. Most are capped and do not provide significant capital for large-scale projects. However, there are a handful of states with credit statutes that provide substantial additional equity when combined with the federal credit. They include: Missouri, Michigan, North Carolina, Maryland, Rhode Island, Virginia, West Virginia and Oklahoma.
Every year, statewide historic preservation advocacy groups amend existing credits and add new states to the list.
For up to the minute information, contact your state historic preservation office.
New Markets Tax Credits
What are New Markets Tax Credits?
The New Markets Tax Credit (NMTC) is a 39 percent credit on an equity investment to a Community Development Entity (CDE), that is claimed over a 7-year compliance period (5 percent over the first 3 years and 6 percent over the last 4 years). The CDE must then make a Qualified Equity Investment or loan to a Qualified Business in a Qualified Low-Income Community (LIC's). Most Commercial and mixed-use real estate development projects located in LIC's are Qualified Businesses. (Residential projects without a commercial component do not qualify.) The New Markets program is designed to encourage investments in LIC's that traditionally have had poor access to debt and equity capital.
How do they Work in Conjunction with the Historic Tax Credit?
The New Markets Tax Credit and the historic tax credit are natural allies. LIC's are defined as U.S. census tracts with a 20 percent poverty rate or household incomes at or below 80 percent of the area or statewide median, whichever is greater. Due to this liberal definition, 40 percent of all U.S. and most central business district census tracts qualify for the NMTC's. Because most old buildings are found in disinvested parts of any city or town, and most rehab tax credit projects are located in central business districts, in 2005 sixty-eight percent of all HTC Part 3 approvals were granted for properties in qualified NMTC census tracts. The IRS has provided specific guidance that allows for the twinning of the HTC and NMTC.
Unlike the federal Rehabilitation Tax Credits, the annual dollar volume of New Markets Tax Credits allocated by the U.S. government is capped. That means that CDE's must compete against each other to receive an allocation of New Markets Credits during each annual funding round. Once a CDE wins an allocation, it partners with an investor who is attracted by the tax benefits offered by the New Markets Tax Credit. In order to claim the credit, the investor must make an equity investment in a CDE.
For example: consider this hypothetical investment partnership between a CDE and a Tax Credit Purchaser (TCP). The CDE wins a $50 million New Markets allocation in 2007. The TCP provides equity to the CDE's Trust Community Investment Fund which it invests in an historic commercial rehabilitation project that is eligible, by virtue of its location in an LIC, for both the federal historic tax credit (HTC) and the New Markets Tax Credit (NMTC). In exchange, the project transfers its historic and New Markets tax credits to CDE's Trust Community Investment Fund and ultimately, TCP. In addition to its usual investment return on the historic tax credit, the TCP is also earning 39 cents (the value of the NMTC) on the dollar amount of its initial RTC equity investment. The TCP is therefore willing to make a higher aggregate equity investment to reflect the value of both credits. This so-called ?twinning? of rehabilitation and New Markets Tax Credits on the same real estate transaction has a net effect of adding 25-30 percent more equity to the transaction. This equity boost helps offset the more difficult economics of developing historic properties in disinvested communities
LOW-INCOME TAX CREDITS (LITC'S)
The Low-Income Housing Tax Credit
Since 1986, Section 42 of the Internal Revenue Code has provided low-income housing tax credits for new construction and acquisition/rehabilitation of low-income housing. These are some of the key elements of the Credit:
? The Credit, generally, is designed to be equal to 70 percent of the costs of constructing new low-income housing or 30 percent of the costs of acquiring existing housing.
? The Low-Income Housing Tax Credit is available for 10 years starting with the first year in which the property is placed in service. A taxpayer can also elect to begin this credit period in the succeeding year.
? The Credit produces a dollar-for-dollar reduction of the taxpayer's tax liability.
? Owners of a project generally also receive deductions for tax losses associated with the project.
? The housing must meet certain requirements during a 15-year Compliance Period and rents on the housing must generally remain affordable to low-income persons for 30 years or more.
? For investors/owners other than C Corporations, passive activity limitations on losses do apply and the credit is not available for use against the alternative minimum tax.
? To be entitled to the Credit, the taxpayer must be an owner of the housing - generally this is accomplished by an investor being a limited partner of a partnership which owns the housing.
Use of the Credit
Typically, private investors form limited partnerships with nonprofit and for-profit developers of low-income housing. The investor limited partners generally take a 99.9 percent interest in the partnership. The profits, losses and Credits from the housing development flow through to the investors. Those who find the Credit most attractive are those with a likelihood of taxable income over the 10-year Compliance Period.
Widely held corporations with anticipated taxable income may find this kind of investment attractive. Because a widely held corporation is not subject to the passive loss rules, the corporation is likely to have a greater opportunity to make use of the Credit. Since 1995, the Emerging Issues Task Force of FASB has had recommended procedures for accounting for the tax benefits associated with the Credit. Tax advisors for investor corporations may wish to review EITF Issue No. 94-1.
Credit Eligibility and Approval
The Credit is available only for housing that is part of a "qualified low-income housing project." Such a project is one which meets either the "20/50 test" or the "40/60 test." That is, at least 20 percent of the residential units must be rent-restricted and occupied by families having incomes which are 50 percent or less of area median income, or at least 40 percent of the residential units must be occupied by families that have incomes which are 60 percent or less of the area median income. This minimum set aside must be accomplished within 12 months of the project being "placed in service" and has to be maintained for 15 years from the beginning of the year in which the Credit is first taken. Since 1990, projects are eligible for the credit only if they are subject to an extended use agreement which requires the project to remain in low-income use for an additional 15 years. There are certain restrictions on transfer that also apply. Under certain circumstances, a low-income unit will remain eligible for the credit even if a tenant's income increases to the point that it exceeds 50 or 60 percent of median.
Qualified low-income units must also have restricted rents. Gross rents (including utilities other than telephone) must not exceed 30 percent of the tenant's imputed income (50% or 60% of area median) for a unit of a particular size. Other limitations apply as well. For instance, the initial lease term for a tenant usually must be at least 6 months (although there are some limited exceptions for transitional housing), tenants cannot be full-time students (there are exceptions here as well), and the units must be available to the general public.
Generally, for a building to be eligible for the Low-Income Housing Tax Credit, by the analogous agency in your state, must allocate a portion of its credit authority to the building no later than the end of the year during which the building is placed in service.
However, a state allocation isn't necessary where more than 50 percent of the land and improvements of a project are financed using tax exempt bonds which are subject to the state's volume cap.
How Much is the Credit Worth?
The Credit is intended to equal 70 percent of the costs of constructing new low-income housing or 30 percent of the costs of acquiring existing housing. To accomplish this result, the Credit provides tax benefits each year for 10 years that are equal to approximately 9 percent of the project cost for new housing or 4 percent of the acquisition cost for existing housing.
The 9 percent credit is available for new construction or substantial rehabilitation of existing units so long as tax-exempt bonds, below-market federal loans or other federal subsidies are not used to finance the project. ("Substantial" rehabilitation is $3,000 per unit or 10% of the unadjusted basis of the building--whichever is greater.) The 4 percent credit is available for new construction or substantial rehabilitation of units where tax-exempt bonds, or other federally subsidized dollars, are used. The 4 percent credit is also available for the acquisition of existing units. Just what percentage will apply to any given project will depend on: (1) whether the project is for new construction or rehabilitation work, (2) whether there are other federal subsidies supporting the project, and (3) whether the taxpayer elects to fix the percentage rate as of the date a credit reservation agreement is entered into with the state or the date on which the project is placed in service.
There are several other tax credits other than the credits mentioned above, for example Solar Tax Credits, local Tax Increment Funding (TIF), and many other energy credits. Palm Tree Financial seeks to arrange tax credits for real estate developers and investors between CDE's and tax credit purchasers. The success and or syndicating fees to arrange tax credits range between 6.0%-10.0% of the tax credit dollars procured. Palm Tree Financial is not a CDE, tax credit purchaser, certified public account (CPA), accounting firm, tax credit attorney, or a tax law firm, we act solely in a consultancy role. We recommend that developers and investors considering tax credit(s) to engage the services and advice of a accounting firm and legal firm specializing in the tax credit industry, in-conjuncture with our consultancy services.
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