DIFFERENCES BETWEEN THE HISTORIC REHABILITATION TAX CREDIT AND THE LOW-INCOME HOUSING TAX CREDIT

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1 DIFFERENCES BETWEEN THE HISTORIC REHABILITATION TAX CREDIT AND THE LOW-INCOME HOUSING TAX CREDIT Andrew S. Potts NIXON PEABODY LLP 401 Ninth Street NW Washington, D.C Forrest Milder NIXON PEABODY LLP 100 Summer Street Boston, Massachusetts (This article is derived from an earlier version written by Ken Alperin.)

2 -2- DIFFERENCES BETWEEN THE HISTORIC REHABILITATION TAX CREDIT AND THE LOW-INCOME HOUSING TAX CREDIT This article provides a summary of the principal differences between the historic rehabilitation tax credit provided for in Section 47 of the Internal Revenue Code ("HTC") and the low income housing tax credit provided for in Section 42 of the Internal Revenue Code ("LIHTC"). First, we should start with what the two credits have in common. They are both based on a percentage of certain capital expenditures; the amount of expenditures is determined at the time the project is placed in service (or up to the end of the following tax year); and both are subject to recapture if the project is disposed of, or if the interest of a partner or member of a partnership or LLC that owns the project is reduced. But, there are significant differences: 1. Eligible Properties. HTC is only available in connection with the qualified rehabilitation of (i) a building first placed in service before 1936, or (ii) a certified historic structure. A certified historic structure must be listed in the National Register of Historic Places or be of particular significance in a historic district. Acquisition of the building, and enlargement of a building, are not eligible. Residential projects are only eligible if the building is a certified historic structure. The LIHTC is available for all of (i) the acquisition of an existing building, (ii) the rehabilitation of an existing building, and (iii) the construction of a new building, provided the building is "rent restricted" and occupied by low-income tenants.

3 -3-2. Rate and Timing of Credits. The HTC is taken in one year, and it is equal to 10% of the amount of "qualified rehabilitation expenditures" in the case of pre buildings that are not certified historic structures, and 20% of such expenditures if the building is a certified historic structure. The LIHTC is taken for ten years, and each year, it is equal to approximately (A) 3.5 to 4% or (B) 8 to 9% of the amount of "qualified basis" in the property, determined at the end of the first year of the "credit period". The exact percentage for the LIHTC is determined based upon the month in which the property is placed in service (or the credit percentage may be "locked in" in an earlier month as a result of an election made by the taxpayer) and is announced by the IRS each month. In the remainder of this article, we'll refer to these credits as the "4% credit" and the "9% credit", although each is generally lower than that. Acquisitions of existing buildings and projects that have tax-exempt bond or below-market federal financing are eligible for the 4% credit, while rehabilitations and new construction that does not benefit from these kinds of loans are eligible for the 9% credit. 3. When to Start Claiming the Credit. The HTC can be claimed in the year in which qualified rehabilitation expenditures are placed in service, or even earlier if the taxpayer is eligible for and elects treatment under the qualified progress expenditure rules. The LIHTC does not commence until actual occupancy of the qualified low-income units.

4 -4-4. What's the Minimum Required Expenditure to Qualify? For the HTC, during a 24-month period, the owner must incur rehabilitation expenditures that are at least the greater of $5,000 or the adjusted basis of the building at the commencement of the 24-month period. The LIHTC is available without limitation for new construction. It is available for acquisitions and rehabilitations of existing buildings only if the expenditures incurred during a 24-month period are at least the greater of (i) $3,000 per dwelling unit or (ii) 10% of the adjusted basis of the building at the commencement of the 24- month period. 5. Government Approval Process. The HTC is not competitive, but in the case of the 20% credit, approvals are required from the Department of Interior with regard to the historic quality and character of the building and the rehabilitation of the building. The LIHTC is available when either (A) the project is chosen as part of a competitive process by which the state credit agency allocates a limited amount of available tax credits or (B) the project is financed with tax-exempt bonds that have been allocated "volume cap"; if 50% or more of the project is financed with such bonds, then as much as 100% of the costs of the project are eligible for credits; if the percentage is less than 50%, then only that percentage is eligible. 6. Amounts Included in Computing the Credit. The HTC is based upon the amount of qualified rehabilitation expenditures, which generally consist of improvements made to the building structure and interior which have a year depreciation period. No HTC is permitted for land costs, for enlargement

5 -5- of a building, for personal property or for building acquisition costs. The LIHTC is computed based upon eligible basis which includes substantially all the costs of constructing or rehabilitating a building, including personal property, plus some site improvements, but only to the extent that the building is used to provide affordable rental housing. No LIHTC is permitted for land costs. In addition, the acquisition costs of a building can be included for purposes of the LIHTC, but only for the 4% credit provided that certain requirements are met, in particular, the acquisition is only eligible if it has not been placed in service within the last 10 years and a substantial rehabilitation (as described above) is undertaken in connection with the acquisition of the building. 7. Participation of Tax Exempt Entities. The HTC is generally not available with respect to tax-exempt use property, which includes property owned by, or leased to, a tax-exempt entity, governmental entity or a foreign entity under a disqualified lease. Disqualified leases generally include leases in excess of 20 years, leases with "fixed or determinable" purchase options and other designated types of leases. There are a number of exceptions to these rules. The LIHTC is not subject to the tax-exempt use property rules. 8. Restrictions on Use. Other than the tax-exempt use rules and the requirement that a residential project must be a certified historic structure to qualify for the HTC, each as described above, there are no use or tenancy restrictions for a property to qualify for the HTC. For the LIHTC, the tenants must be residential, they must meet certain maximum income limitations, and

6 -6- the maximum rents charged to the low income tenants must be limited. Students generally are not eligible tenants. 9. Long Term Commitments with Respect to the Property. A building which is entitled to the HTC is not subject to any commitment as to future use. A building entitled to the LIHTC is required to enter into an extended use commitment which requires that the building be dedicated to affordable housing for a period of not less than 30 years. 10. Pass-Through Election. Under certain circumstances, the owner of an HTC building can elect to pass through the HTC to a lessee. When the lessee claims the credit, the depreciation deductions stay with the landlord. No such election is possible for the LIHTC. Instead, all credits and depreciation go to the owner of the residential building. 11. Increase in Credits for Projects in Certain Areas. Computation of the LIHTC is eligible for a 30% increase if the building is located in either a qualified census tract (an area with a high concentration of low income residents) or in a difficult to develop area (an area where development costs are exceptionally high). Lists of these areas are published by HUD. There is no comparable adjustment to the 10% and 20% HTCs. 12. Basis Reduction. The basis of a project that qualifies for the HTC is generally reduced by the amount of the HTC. Thus, if a project qualifies for both the LIHTC and the HTC, the "qualified basis" for computing the LIHTC is reduced, as are the LIHTCs themselves. Note that this reduction does not apply if the

7 -7- HTCs are claimed by the tenant in a lease pass through structure, although the tenant will instead have taxable income that is effectively "antidepreciation". By comparison, the amount of the HTC is not affected by the LIHTC. 13. Affect of Federal Grants. General rules related to federal grants can cause the basis of any project (and therefore, the HTC and the LIHTC, which are based on that basis) to be reduced if the project receives a federal grant with respect to the development of the project. However, it may be possible to take such a grant into income, and thereby avoid the basis reduction. The law in this area is quite unclear. On the other hand, the law is clear that if a federal grant is utilized to subsidize operations of a building, there will not be a reduction in the amount of basis eligible for the HTC. By comparison, LIHTC eligible basis must be reduced by the amount of any federal grant received during the 15-year compliance period of the building which is utilized with respect to the building or the operation thereof, regardless of whether the amount of the grant has been taken into income. 14. Below Market Federal Loans. Receipt of a federal subsidy in the form of a below-market interest rate loan or the use of tax-exempt bonds does not reduce the amount of the HTC. Receipt of a federal subsidy of this type must either result in the use of the 4% (instead of the 9%) LIHTC or the taxpayer must elect to reduce the eligible basis of its building by the amount of federally subsidized financing.

8 Placement in Service. For purposes of the HTC, qualified rehabilitation expenditures are placed in service at the time that they are ready and available for their assigned use. This typically means that placement in service occurs when a certificate of occupancy is obtained for the building, although, in certain cases, a mathematical test may delay this placement in service. For purposes of the LIHTC, a new building is placed in service when a certificate of occupancy is received for at least one dwelling unit in the building, and a rehabilitated building is placed in service on a date selected by the taxpayer, provided that, on such date, the taxpayer has met the 24-month test described earlier for qualifying the building as a substantially rehabilitated building. 16.At-RiskRules. While both the HTC and the LIHTC are subject to at-risk rules, the HTC is subject to more stringent at-risk rules. In particular, for those taxpayers subject to the at-risk rules (typically individuals and closely held corporations), the amount of nonrecourse financing with respect to qualified rehabilitation expenditures (even if the financing otherwise constitutes qualified commercial financing) cannot exceed 80% of the credit base of the qualified rehabilitation expenditures. 17. Passive Activity Rules. Individuals who invest in property eligible for the HTC or LIHTC, and who do not materially participate in the real estate activity (for example, if they are limited partners), are generally subject to the passive activity limitations with respect to either credit. However, the passive activity limitation exception is different for the two credits. Individuals are entitled to

9 - 9 - utilize LIHTC to offset the tax attributable to up to $25,000 of taxable income without regard to the amount of their taxable income. The ability to use the HTC is more limited. An individual can utilize the HTC to offset the tax attributable to up to $25,000 of his taxable income subject to a phase-out as such individual's adjusted gross income increases from $200,000 to $250, Ability to Transfer the Property and Have the New Owner Claim Credits. The HTC is available only to the owner of the building (or partners in a partnership which is the owner of a building) at the time the qualified rehabilitation expenditures are placed in service. If the building is transferred after that date, the new owner does not get any credits, and the prior owner may suffer "recapture". The LIHTC is available over a 10-year period to whoever is the owner of the building for each separate month in which the building is occupied by qualified tenants. Section 42(d)(7) specifically provides for a "step into the shoes" rule permitting the transfer of a LIHTC eligible building once tax credits have been allowed. The seller of an LIHTC project may have to post a bond or Treasury Securities to avoid recapture of previously taken credits. 19. Allocation Among Partners. The HTC is allocated among partners of a partnership or members of an LLC based on their shares of the profits of the partnership or LLC. The LIHTC is allocated among partners or members based upon their shares of depreciation deductions attributable to the expenditures producing the LIHTC.

10 Profit Motive. The IRS has not yet ruled on whether a participant in an HTC transaction must have a profit motive, that is, a reasonable expectation of earning a pre-tax profit. Most HTC transactions are structured to demonstrate a profit motive, by showing the possibility of a "cash on cash" return for the investor. By comparison, a Treasury Regulation states that a profit motive is not required in order to claim the LIHTC. Of course, the transaction must not be a "sham" and the person or entity claiming the LIHTC must have a bona fide ownership interest in the property. In addition, the grant of a right of first refusal to certain tax-exempt or governmental entities to purchase the property at the close of its 15-year compliance period at a formula price which may be below fair market value is specifically authorized in the Code. 21. Credit Recapture. The HTC is subject to recapture if the building is disposed of or converted to tax-exempt use during the five-year period commencing on the date it is placed in service, or if the ownership interest of a partner in. the partnership owning the building is reduced during that period to less than 2/3 of what it was previously. The amount of recapture is reduced by 20% for each full year that has passed since the property was placed in service. The LIHTC is also subject to recapture, but the computation is quite different. Recapture is computed by comparing the credit taken to the amount that would have been allowed had it been taken over a 15-year period, and it can apply to a disposition or to a change to a disqualifying use. Recapture can be avoided by posting a surety bond or U. S. Treasury securities as collateral

11 -11- provided the project is expected to continue to qualify for the credit following the disposition. Circular 230 Notice. As required by Treasury Regulations, we hereby inform you that this article presents a generalized overview of the issues set forth, and should not be relied upon as definitive tax advice, but merely as a starting point for the analysis of these issues. Any tax advice is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the internal revenue code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.