The Legal and Financial Facets of Historic Tax Credits

Transcription

1 California Preservation Foundation From Dollars & Cents to Success: Financial Incentive Programs for Historic Preservation February 10, 2016 The Legal and Financial Facets of Historic Tax Credits Roy Chou, CPA

2 Background and Overview

3 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

4 10% Tax Credit Types of Historic Tax Credits Placed in service Pre-1936 Rehabilitation Tax Credits 1. Placed in service before 1936 (10% Credit) 2.

5 20% Tax Credit Types of Historic Tax Credits www/nps.gov/hr National Register Rehabilitation Tax Credits 1. Placed in service before 1936 (10% Credit) 2. Listed in National Register (20% Credit) OR

6 20% Tax Credit Significant to district! www/nps.gov/hr National Register Secretary of the Interior Rehabilitation Tax Credits 1. Placed in service before 1936 (10% Credit) 2. Listed in National Register (20% Credit) OR

7 20% Tax Credit Certified Historic Structure Rehabilitation Tax Credits Placed in service before 1936 (10% Credit) Listed in National Register (20% Credit) OR Located in a Registered Historic District AND is listed as being of significance to that district (20% Credit)

8 Cannot be residential rental Internal/external wall preservation Rehabilitation Tax Credits Placed in service before 1936 (10% Credit) Listed in National Register (20% Credit) OR Located in a Registered Historic District AND is listed as being of significance to that district (20% Credit)

9 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

10 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

11 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: percent or more of the existing external walls of such building are retained in place as external walls, percent or more of the existing walls of such building are retained in place as internal or external walls, and 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

12 Substantial Rehabilitation Test

13 Substantial Rehab Test 24 mo. Measurement Period QREs Tax credit % Tax credits $20,670,000 x 20% $ 4,134, Tax Return Adj. Basis QREs during Measurement Period 24 mo. Measurement Period Acquisition Rehab PIS

14 Recap: Substantial Rehabilitation 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 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

15 Qualified Rehabilitation Expenditures

16 Qualified Rehabilitation Expenditures (QREs) Only qualified rehabilitation expenditures (QREs) are includable in the basis used to calculate HTCs $9 Mil Qualified Rehabilitation Expenditures $ 8,450,000 Tax credit % x 20% $1.5M Total Costs 17% Equity Tax Credits Investor % Price per credit $ x x 1,690, Equity $ 1,505,790

17 Qualified Rehabilitation Expenditures (QREs) 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. Land Excluded Commercial bldg SL Residential rental building SL QRE Eligible (Rehab portion) Site work Personal property 200% DB 150% DB Excluded

18 Qualified Rehabilitation Expenditures (QREs) 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)

19 Qualified Rehabilitation Expenditures (QREs) Additions (Included) vs. Enlargements (Excluded) New Floor

20 Qualified Rehabilitation Expenditures (QREs) 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

21 Tax Planning and Limitations

22 HTC Recapture 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

23 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

24 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

25 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

26 Using the Credits

27 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

28 10% and 20% Using the Credits Rehabilitation Section 47 Tax Credit Tax Liability Investor Partnership LLC S-Corp DEBT DEBT Equity Cost to Rehab Tax Liability Developer/ Owner Yippee! Yay! Hooray! Rehab exp. Tax credit % Tax credits LP % Price Equity $ x $ x x $ X,XXX,XXX XX% XXX,XXX 99.99% 0.XX XXX,XXX

29 How Tax Credits Fit Into the Financial Picture of a Project

30 Single-Tier Structure Developer/ Owner GP Investor LP 99% Profits & Capital Interest P ship

31 Alternative Structure: Pass-Through Lease Pass-Through of Tax Credits to Lessee QREs are incurred by Lessor/Owner Lessor and lessee make an election to Passthrough to the Lessee all or portion of the QREs Lessee is deemed to have incurred QREs

32 Alternative Structure: Pass-Through Lease Investor MM 99% Profits & Capital Interest Developer/ Owner MM Master Lease LLC Master Lessee/ Sublessor Profits & Capital Interest LLC Fee Owner/ Master Lessor Tenants

33 Alternative Structure: Pass-Through 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

34 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

35 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.

36 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.

37 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.

38 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

39 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

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

41 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

42 The Leveraged Structure ROI Loan Manager Equity Lender(s) 0.01% Investor(s) 99.99% Interest Fund 99.99% 99.99% NMTCs QEIs NMTCs Distribution QEIs CDE 0.01% Manager Interest QLICI Loan(s)

43 Combined NMTC/HTC Transaction Assumptions: $1M HTC at $1 per Credit $1M HTC Equity $500k NMTC Equity $1M Developer Equity $2.5M Other Debt Financing Federal Tax Credit Investor CDE Cash Distributions NMTCs generated = $585k HTCs generated = $1 million based on QREs of $5 million SMLLC Master Tenant (Disregarded for Federal Tax Purposes) Leases Tenants?? Equity?? Loan Master Lease Interest Payments/ Preferred Return Developer/ Managing Member $1M Developer Equity MM Interest/ Cash Distr. Owner (Rehabilitates Historic Building) $2.5M Other Debt Interest Payments Lender

44 Combined NMTC/HTC Transaction Pass-Through Lease Structure NMTC Federal Tax Credit Investor Cash Distributions CDE $ Loan Interest Payments HTC Federal Tax Credit Investor Preferred Returns Developer/ Managing Member $ Developer Equity MM Interest/ Cash Distr. Owner/QALICB (Rehabilitates Historic Building) Master Lease Master Tenant Leases Tenants

45 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.

46 Basic LIHTC Tiered Structure Investor(s) Equity 99.99% Syndicator 0.01% Fund Equity 99.99% Developer/ Owner 0.01% Operating P ship

47 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.

48 Example: Basis Reduction LIHTC: Acquisition basis $500,000 x 3.33% x 10 = $166,500 Eligible Basis Less: HTC x 9.0% x 10 = $ 4,000,000 $4,050,000 $4,500,000 QREs Tax credit % - $800,000 Tax credits $3,700,000 x 9.0% x 10 = x $ 20% 800,000 $3,330,000 LIHTC Credits HTC Credits Total Credits If it had been LIHTC only: $4,216,500 $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.

49 Basic LIHTC Tiered Structure with HTC Investor(s) Equity 99% Syndicator 1% Fund Equity 99% Developer/ Owner 1% Operating P ship

50 Federal Conservation Easements for Historic Preservation

51 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

52 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

53 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

54 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.

55 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

56 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

57 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