the legal and financial facets of historic tax credits...• the ualified rehabilitation...

California Preservation Foundation

From Dollars & Cents to Success: Financial Incentive Programs for Historic Preservation February 10, 2016

Roy Chou, CPA

The Legal and Financial Facets of Historic Tax Credits

Background and Overview

Historic Rehabilitation Tax Credits • Historic Rehabilitation Tax Credit Rules under Internal Revenue

Code §47

• Credit is an indirect federal subsidy used to finance the rehabilitation of historic and pre-1936 buildings

• Dollar-for-dollar reduction of income tax liability to taxpayer

• Credit is claimed in the year the rehabilitation of the qualifying building is placed in service

• After the credit is claimed, the building must remain in productive use and the entity that owns the building, along with the owners of that entity, must not change for a period of five years from the date the rehabilitation expenditures are placed in service

• Generally, credit is available to any taxpayer this is liable for income taxes, including individuals. C corporations, estates and trusts

Rehabilitation Tax Credits 1.

2.

10% Tax Credit

Placed in service Pre-1936

Placed in service before 1936 (10% Credit)

Types of Historic Tax Credits


2.

20% Tax Credit

National Register

www/nps.gov/hr


Listed in National Register (20% Credit)

–OR–

Types of Historic Tax Credits

20% Tax Credit

Significant to district!

Secretary of the Interior

National Register

www/nps.gov/hr


2.



–OR–


2.



–OR–

Located in a Registered Historic District AND is listed as being of significance to that district (20% Credit)

Certified Historic Structure

20% Tax Credit


2.



–OR–

Located in a Registered Historic District AND is listed as being of significance to that district (20% Credit)

• Cannot be residential rental

• Internal/external wall preservation

Certified Rehabilitation

• In order for a building to qualify for the 20% credit, the building must be a certified historic structure and the rehabilitation must be a certified rehabilitation.

– Defined as “any rehabilitation of a certified historic structure which the Secretary of the Interior (NPS) has certified to the Secretary (of IRS) as being consistent to the historic character of such property or the district in which such property is located”

The Two Types of the HTC

• Which credit applies for certified rehabilitation?

– The NPS and SHPO determine if the project qualifies for the 20% credit

– If the project qualifies for the 20% credit, then either the 20% credit can be taken or no credit at all

• The 10% credit cannot be claimed on a certified historic structure under any circumstance

Qualified Rehabilitated Building (QRB)

There are 5 tests to determine if the building is a QRB:

1. Building must be “substantially rehabilitated”

2. Building must have been originally placed in service before the beginning of the rehabilitation

3. In the case of any building other than a certified historic structure, during the rehabilitation process: 1. 50 percent or more of the existing external walls of such building are retained in place

as external walls, 2. 75 percent or more of the existing walls of such building are retained in place as

internal or external walls, and 3. 75 percent or more of the existing internal structural framework of such building is

retained in place.

– There is no requirement regarding external walls for certified historic rehabilitations since they are subject to more stringent rehabilitation requirements imposed under the rules applicable to certified historic structures.

4. Depreciation must be allowable with respect to the building

5. The building must be located in the United States or in a territory of possession of the United States

Substantial Rehabilitation Test

24 mo. “Measurement Period”

QREs during Measurement

Period

Adj. Basis

24 mo. “Measurement Period”

1 1 2 0 1 2 2 0 1 3 2 0 1 4 2 0 1 5

Substantial Rehab Test

Rehab PIS Acquisition

QREs Tax credit % Tax credits

20%

x $20,670,000

$ 4,134,000

2014 Tax

Return

Substantial Rehabilitation Recap: • The qualified rehabilitation expenditures (QREs) during the

measurement period must exceed the greater of $5,000 or the adjusted basis of the property at the beginning of the measurement period

• The 24-month period must end within the tax year in which the qualified rehabilitation expenditures are placed in service

• If 10% credit is planned to be taken, adjusted basis will exclude post -1935 additions to the property

• Unless the rehabilitation qualifies as a “phased” rehabilitation, the entire building must be substantially rehabilitated

• For rehabilitations that are sufficiently large enough in scope that completion will require a greater amount of time than 24 months, a 60-month measuring period can be used

Qualified Rehabilitation Expenditures

$1.5M

Qualified Rehabilitation Expenditures

Tax credit %

Tax Credits

Investor %

Price per credit

Equity

8,450,000

20%

1,690,000

99

0.90

1,505,790

$

x

$

x

x

$

Equity

Qualified Rehabilitation Expenditures (QREs)

17%

Total Costs

$9 Mil

• Only qualified rehabilitation expenditures (QREs) are includable in the basis used to calculate HTCs

150% DB

200% DB

Site work

Personal property

Land Land

SL Commercial bldg

QRE Eligible

Residential rental building

Site work

Personal property

150% DB

200% DB

SL

Excluded

Excluded

(Rehab portion)


QREs include amounts incurred by a taxpayer in connection with the rehabilitation of a QRB that are capitalized to the building and depreciated using either a 27.5 or 39 year recovery period.


– Generally includes: • Hard costs • Insurance premiums • Legal Costs • Development fees • Site survey fees • Architectural & engineering fees • Interior demolition • Construction period interest and taxes • “Additions” (refer to additional rehabilitation that does

not go beyond the physical planes of the original building)


• “Additions”

“Enlargements” vs. (Excluded) (Included)

New Floor


– Generally excludes: • Costs for personal-use property

• Acquisition costs • Amounts treated as expenses and deducted

• Capitalized interest for existing building and land

• New building construction (i.e. enlargements)

• Tax-Exempt Use Property

Tax Planning and Limitations

• Recapture of the credit occurs if, within five years of placing in service:

– ownership of the property changes, – the property ceases to be investment credit property, – sale of a partnership interest, or – reduction of a partner’s interest to less 2/3 of original ownership

interest

HTC Recapture

Basis Reduction Requirements For single tier/direct ownership structure: • Depreciable basis reduced by amount of tax credits

• Reduction in basis is treated as a reduction in

partners’ capital accounts

• Reduction in basis treated as accelerated depreciation for purposes of determining ordinary gain upon sale of property

The State HTC • Over 30 states have adopted a state historic tax

credit program

• Programs vary from state to state

• Problems with state programs – Annual Aggregate Caps or Individual Project Capping – Lack of Transferability (prevent pass thru or sale)

• Some states allow credit to be refundable

Other Tax Planning Issues and Limitations

• Housing and Economic Recovery Act of 2008 – HTCs can now reduce AMT for Qualified Rehabilitation Expenditures taken after December 31, 2007

• HTC is nonrefundable credit and can be carried back one year and forward for 20 years

• Disqualifying Uses of HTCs 1) Property located outside the United States 2) Property used for personal use lodging 3) Property used by (as opposed to leased to) governmental units

or foreign persons or entities 4) Property predominantly used by tax-exempt organizations

Using the Credits

Using the Credits

• Taxpayers that can use tax credits – C corporation – Individuals – Estates – Trusts

• Taxpayers that can’t use tax credits

– Tax-Exempt Entities – Real Estate Investment Trusts – Pass-Through Entities

DEBT

Investor Tax Liability

Developer/ Owner

• Partnership • LLC • S-Corp

Tax Liability

Equity

Yay!

Yippee! Hooray!

Cost to Rehab

10% and 20%

“Rehabilitation Tax Credit” Section 47

Rehab exp. Tax credit % Tax credits LP % Price Equity

X,XXX,XXX XX%

XXX,XXX 99.99%

0.XX XXX,XXX

$ x $ x x $

DEBT

Using the Credits

How Tax Credits Fit Into the Financial Picture of a Project

99% Profits & Capital Interest

P’ship

Investor Developer/ Owner

LP GP

Single-Tier Structure

• Pass-Through of Tax Credits to Lessee • QREs are incurred by Lessor/Owner • Lessor and lessee make an election to “Pass-

through” to the Lessee all or portion of the QREs – Lessee is deemed to have incurred QREs

Alternative Structure: Pass-Through Lease

Tenants


LLC

Investor

Developer/ Owner

MM

LLC

MM

Profits & Capital Interest

99% Profits & Capital Interest

Master Lessee/ Sublessor

Fee Owner/ Master Lessor

Master Lease Master Lease

• Requirements: – Must be IRC Section 38 property – Lessee must be original user of property – Lessor must make election to treat QRE’s as incurred by Lessee

• No mandatory basis reduction applies

• Lessee includes in gross income each year an amount equal to the HTC it received from the lessor ratably over the recovery period or tax depreciable life of the property in the hands of the lessor. – Generally, the HTC that will be required to be recognized as

income for residential property is 1/27.5th and for non-residential property is 1/39th


Running the Numbers

• In addition to the other financing a project has received (construction/permanent loans, government subsidies, etc), the HTC provides additional equity financing in the form of limited partner capital

Example

• You wish to buy a qualifying building in a distressed area of an inner-city community and turn it into a commercial office rental building. – Land & Building acquisition cost is $255,000 – You estimate rehabilitation costs of $8,745,000 (of

which $8,450,000 are QREs) – You have $255,000 is developer equity – You secure a $6 million construction loan with a

permanent loan commitment as a first mortgage – You also secure loans from the local government and

other private financing in the amount of $1,239,210.

Example (cont.)

– Given no other source of financing, this project would not be undertaken because the interim uses of funds outweigh the interim sources of funds.

– However, if the project owner structured the

rehabilitation as a certified historic tax credit project this would lead to a potential historic tax credit for the taxpayer of $1,690,000.

Example (cont.)

– The project owner could court an investor to purchase an interest in the entity, say a 99 percent interest, at a negotiated equity contribution based upon 90 cents for every $1 of historic tax credits the investor will receive.

– This equity contribution would amount to an additional source of $1,505,790 for the project.

Example (cont.)

HTC qualified rehabilitation expenditures HTC factor for historic structures Historic tax credit amount for year of PIS = Investor interest in entity Investor’s share of entity’s HTC = Equity Investor’s capital contribution amount =

$8,450,000 x 20% $1,690,000

x 99% $1,673,100

x .90 $1,505,790

Example (cont.)

Total Sources: Developer Equity Construction Loan Government and Other Private Financing HTC Equity Total Total Uses: Land and Building Acquisition Rehabilitation Costs Total

$255,000

$6,000,000 $1,239,210 $1,505,790 $9,000,000

$255,000 $8,745,000 $9,000,000

Combining Historic Credits with Low-Income Housing Tax Credits and the New Markets

Tax Credit

New Markets Tax Credit • The new markets tax credit (NMTC) is a credit to encourage

investment in low-income communities.

• Most businesses located in low-income communities could qualify for loans or equity investments using the NMTC. Typical firms could include: small technology firms, inner-city shopping centers, manufacturers, retail stores or micro-entrepreneurs. Residential rental property does not qualify as a qualified active low-income business.

• The taxpayer will be eligible to claim a tax credit equal to 5 percent of its equity investment for each of the first three years and a 6 percent credit for each of the next four years (39 percent total).

• The pairing of NMTCs with HTCs was expressly permitted by IRC Notice 2002-64

NMTCs

Investor(s)

CDE

QEIs

Fund

Lender(s)

QEIs

ROI

Loan Equity

The Leveraged Structure

NMTCs

Interest

Distribution

Interest

99.99%

QLICI Loan(s)

99.99%

99.99%

Manager 0.01%

Manager

0.01%

Combined NMTC/HTC Transaction

Federal Tax Credit Investor

Cash Distributions

CDE

Tenants

SMLLC Master Tenant

(Disregarded for Federal

Tax Purposes)

Leases

?? Equity ?? Loan

Interest Payments/ Preferred Return

Owner (Rehabilitates Historic

Building)

Master Lease

Developer/ Managing Member

$1M Developer Equity

MM Interest/ Cash Distr.

Assumptions:

$1M HTC at $1 per Credit

$1M HTC Equity

$500k NMTC Equity

$1M Developer Equity

$2.5M Other Debt Financing

NMTCs generated = $585k

HTCs generated = $1 million based on QREs of $5 million

Lender

$2.5M Other Debt

Interest Payments

Combined NMTC/HTC Transaction

NMTC Federal Tax Credit Investor

Cash Distributions

CDE

Tenants

Leases

$ Loan Interest Payments

Owner/QALICB (Rehabilitates Historic

Building)

Master Lease

Developer/ Managing Member

$ Developer Equity

MM Interest/ Cash Distr.

Pass-Through Lease Structure

Master Tenant

HTC Federal Tax Credit Investor

Preferred Returns

Low-Income Housing Tax Credit

• The low-income housing tax credit (LIHTC) is a credit for providing affordable rental housing for low-income individuals.

• It can be claimed on newly constructed residential rental buildings or acquired and rehabilitated existing buildings used for residential rental.

• The LIHTC is generally a credit that is claimed for a 10-year period, and is calculated from eligible basis, or costs that are eligible to be included in the basis under IRC section 42.

Operating P’ship

Investor(s)

Basic LIHTC Tiered Structure

Developer/ Owner

0.01%

Fund

99.99%

99.99%

Syndicator

0.01%

Equity

Equity

The HTC and the LIHTC

• Since the HTC is a rehabilitation credit, only existing buildings that are rehabilitated have the potential to claim both credits

• No 10 percent rehabilitation credit buildings will be able to couple with the LIHTC.

• The main disadvantage in coupling the HTC with the LIHTC is the mandatory basis reduction required under IRC section 50(c). This basis reduction applies to rehab eligible basis for purposes of calculating the LIHTC.

Example: Basis Reduction LIHTC: Acquisition basis Eligible Basis Less: HTC LIHTC Credits HTC Credits Total Credits

$500,000 x 3.33% x 10 = $4,500,000 - $800,000 $3,700,000 x 9.0% x 10 =

$166,500

$3,330,000

$3,496,500 + $800,000

$4,296,500

By coupling with the HTC, the project is losing eligible basis to calculate the annual LIHTC amount. However, the loss of LIHTC is mitigated by more total credits, the entire HTC portion of which is taken upfront in the year the project is placed in service.

x 9.0% x 10 = $4,050,000

$4,216,500

If it had been LIHTC only:

QREs Tax credit % Tax credits

4,000,000 20%

800,000

$ x $

Basic LIHTC Tiered Structure with HTC

Operating P’ship

Investor(s)

Developer/ Owner

1%

Fund

99%

99%

Syndicator

1%

Equity

Equity

Federal Conservation Easements for Historic Preservation

General Overview • Historic Preservation Easement

– A voluntary legal agreement/arrangement between a property owner and a qualified organization which permanently protects a historic property’s conservation and preservation values significant historic property

– Typically in the form of a deed – Restricts changes to historic character of the property – Once recorded, binds granting owner and all subsequent

owners – Also referred to as “preservation covenants”, “preservation

restrictions” or “equitable servitudes” – Specific terms and requirements may vary depending

upon a particular state’s law or “enabling law”

Properties that Qualify • A building, structure, or land area individually

listed in the National Register Historic Places

• Building certified by the National Park Service as “contributing” to a registered historic district – Must be certified by NPS either by the time of the

easement transfer or due date for federal income tax return filing for year of transfer

Donor & Receiver Roles • Donor (Property Owner)

– Property owner places restrictions on development of, or changes to, the property

– Property owner can be individual or entity – Donor of easement may be eligible for one or more forms of tax

benefits

• Receiver (Qualified Organization) • Restrictions are transferred to a qualified organization • Must be a qualified organization

– May include governmental units or certain nonprofit charitable organizations – Has preservation mission/purpose – Has resources to manage or enforce easement restrictions or commitment

to enforce

• Has right to inspect property to ensure compliance of easement terms

• May require “stewardship fee” or “endowment contribution”

Benefits of Easements • Allows property owner to retain private ownership of the

property while preserving historic character of the property

• Property owner may be eligible for a federal income tax deduction for the value of the easement

• Federal taxes may be reduced

• Many states provide tax benefits for preservation easement donations

• Donations an historic preservation easement may be eligible for one or more forms of tax benefits.

Easement Value Calculations • Value of easement is generally the difference

between the appraised fair value of the property prior and after conveying easement (Before and After Method)

Before After Easement Value

$10,000,000 $8,000,000

$2,000,000

Appraisal and Other Considerations

• Valuation of an easement must be determined through a qualified appraisal – Needs to consider the specific terms of the

easement and the specific nature of restrictions imposed by existing local land use or similar laws

• Recent Developments – IRS is claiming preservation easements have

no value – Historic Tax Credit Coalition is fighting claims

Combining Easements with Other Incentives

• Can have a historic preservation easement on a historic building that qualifies for HTCs

• Issues to consider – If donation takes place prior to placing QREs in

service, basis for HTC purposes must by reduced by donation amount

– If donation takes place within five-year recapture period, recapture is required on that amount of HTCs associated with the basis reduction due to donation

the legal and financial facets of historic tax credits...• the ualified rehabilitation...

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