Earlier this fall, the National Park Service celebrated the 35th anniversary of the popular Federal Preservation Tax Incentives Program, which has helped in the preservation of historic structures across the U.S. and particularly in Ohio with its wealth of historic buildings. Because of the program’s numerous possible benefits and its important role in fueling economic growth in surrounding communities, property owners and developers should consider utilizing tax credits on applicable building projects.
But before making the leap, it’s helpful to better understand the requirements and limits of the program. Here are 10 key points to consider before you get started:
1. Your building needs to be historic.
First, you need the right kind of building. If it is on the National Register, or a contributing factor in a historic district, then you are all set. If it is not, you can get the building placed on the National Register or have the district expanded so as to include your building. In either case, this process will likely take a year. This is known as a Part 1 approval.
2. Your plans need approval from the state historic preservation office (SHPO).
Some say this may be the biggest disadvantage of using historic tax credits. SHPO needs to approve your plans, both inside and out. This is known as the Part 2 approval.
3. Your rehabilitation must be substantial.
In order to qualify for the federal historic tax credits, your rehabilitation plan must be substantial – in the eyes of the IRS, this means the rehabilitation costs must exceed your basis in the property.
4. You typically need a third-party investor.
There are two factors necessitating the need for a third party investor. First, the credit must offset a tax liability. Most individuals do not have a large enough liability, therefore, most of the investors are C-corporations. The second issue is created by the passive activity loss rules. Basically, only a full time real estate professional can use the credits against active income. C-corporations are not subject to the passive activity loss rules.
5. Historic Boardwalk has impacted how these deals are structured.
In the Historic Boardwalk case, the IRS successfully argued that the tax credit investor was not a real partner and therefore could not be allocated the credits. The IRS said that the investor must have real upside (not just from being allocated the credits) in the economics of the project (i.e., cash flow and appreciation) and real downside (i.e., the developer cannot completely indemnify the investor). The industry is waiting to hear from the IRS who has promised to issue a revenue procedure outlining a safe harbor for these investments.
6. Your building cannot be transferred for five years.
The Internal Revenue Code provides that the taxes offset by the credits are subject to a pro rata recapture if the property or a controlling interest in the owner is sold in the five-year period after the property has been placed in service. This makes it difficult to condominium-ize a project and investors will want to make sure you have a truly viable project so that they are not faced with the prospect of foreclosure.
7. Be careful when you work with a nonprofit.
Generally, the IRS does not allow a nonprofit to be involved either as a part owner or as a tenant of the building. Having the nonprofit form a subsidiary that elects to be taxed on its income can solve the issue. The use issue is trickier. Having the nonprofit use less than 50% of the space is the simplest way. If however, the nonprofit used the building before and will use more than 50% afterwards, you will need to contact a tax credit professional.
8. There are both federal and state historic credits.
The federal credit is equal to 20% of the qualified rehabilitation expense (QRE). Provided you comply with the NPS standards, the credits are available to a project. The state of Ohio also has a historic tax credit program. That credit is equal to 25% of the same QREs but is currently capped at $5 million. The state credit is subject to a very competitive allocation process. There is a scoring sheet where job creation and economic development rank very high. Unlike the federal credit, a portion of the “credit” can be a refund, up to $3 million.
9. What is included in a QRE?
A QRE is the base on which the credit is calculated. It includes all the hard costs of construction as well as soft costs, including developer fees, construction interest and professional fees. It does not include the acquisition price, enlargements, work outside the building or personal property expenditures.
10. You will need a bridge lender.
This is sometimes the most difficult part. Most of the investor’s equity comes in after construction and after the Part 3 has been obtained. The Part 3 is the final sign off by the SHPO that confirms that the project was completed in accordance with the approved Part 2. A bridge lender has to be comfortable assuming the risk that the project will be completed and the Part 3 will be obtained. Most lenders require either a guaranty from a deep pocket or outside collateral, in addition to a pledge of the capital contribution to be made.
As previously published In the November 2013 issue of Properties Magazine