2006 Incentives of Historic Proportion Applying Federal Historic Preservation Tax Credits to Hotel Projects Matthew D. Melville, Consulting & Valuation Analyst HVS INTERNATIONAL NEW YORK 372 Willis Ave. Mineola, NY 11501 +1 516-248-8828 (ph) +1 516-742-3059 (fax) July 2006 New York San Francisco Boulder Denver Miami Dallas Chicago Washington, D.C. Weston, CT Phoenix Mt. Lakes, NJ Vancouver Toronto London Madrid New Delhi Singapore Hong Kong Sydney São Paulo Buenos Aires Newport, RI
Hotel development is a complicated and expensive undertaking. The process requires the effective management of materials, labor, and capital in an effort to control costs and remain within strict budgetary limits. The feasibility of any hotel development project hinges on the relationship between total construction cost and estimated market value. Simply stated, a proposed hotel project is deemed feasible if its net expected returns exceed total development cost. While this analysis is the clincher for most development decisions, historic hotel rehabilitation or conversion projects introduce additional economic and socioeconomic considerations into the decisionmaking process. Current trends such as historic preservation, urban redevelopment, and historic tourism can mean major financial incentives for well-informed investors. These incentives include income tax credits, property tax abatements, grants, and low interest loans, all of which exist to encourage rehabilitation of historic structures. Depending on the location of the project, incentive programs may be offered through federal, state, and local governments, and through for-profit and non-profit organizations. The ability to combine a variety of incentives can make a historic rehabilitation project economically attractive. While a variety of sources can be utilized to enhance the feasibility of a hotel redevelopment project, the most significant incentive programs are offered though the federal government in the form of tax credits. This article serves as an introduction to Federal Historic Preservation tax credit programs. According to Don Nimey, Senior Manager of Real Estate Consulting with Reznick Group, many hotel projects have lost eligibility for tax credits simply because an investor or developer is unaware that such incentives exist. A phenomenon we see is that hoteliers often do not know about the tax credits in advance of commencing a rehabilitation project. The owner either learns about the credits after the fact [have lost the value of the tax credits] or learns about the credits as construction is nearing completion [have to scramble to revise structures and risk not getting the correct ownership structures in place by Certificate of Occupancy]. When hoteliers understand the credit program and it is incorporated into the timeline and decision making upfront, there is no little additional impact on timing and a modest increase in budget for a large increase in low-cost equity. This article is not meant to provide hotel developers and investors with a comprehensive outline of all legal issues associated with obtaining tax credits, but rather a generalized overview of these programs, basic qualification requirements, and the applicability of Federal Historic Preservation tax credits to select hotel development projects. The unique nature of individual rehabilitation projects requires that investors and developers consider all inherent project-specific issues. Defining the Historic Hotel Various criteria such as architectural style, famous (and infamous) historical events, cultural significance, and age can be used to determine the historic importance of a structure. The National Trust for Historic Preservation s Historic Hotels of America division (HHA) defines a historic hotel as a building that is at least 50 years old and 2
listed in, or eligible for, the National Register of Historic Places or recognized locally as having historic significance. With a total of 211 member hotels, as of June 2006, HHA identifies quality hotels that have faithfully maintained their historic integrity, architecture, and ambiance. These hotels are promoted nationally and internationally to those who prefer historic settings for their leisure and business travel. Examples of member properties range from the eight-room American Hotel in Sag Harbor, New York, to the Waldorf-Astoria in New York City with 1,425 rooms. A directory of the lodging properties affiliated with Historic Hotels of America can be ordered or reviewed online at www.historichotels.org. While personal opinions on what aspects establish the historic significance of a structure vary, specific requirements apply to rehabilitation projects seeking Federal Historic Preservation Tax Credits. The requirements differ depending on the size of the tax credit, and other property specific factors such as age and use following rehabilitation. The Basics Federal Historic Preservation Tax Incentives are administered by the National Park Service (NPS) and designated State Historic Preservation Officers (SHPOs). Established in 1976 by the National Park Service in partnership with the Internal Revenue Service, the program is one of the federal government s most successful and cost-effective community revitalization initiatives. Historic preservation tax credit incentives reward private investment in the rehabilitation of historic, income-producing properties, such as hotels. Liz Creveling of the Heritage Preservation Office of the National Park Service notes that a total of 7,062 Federal Historic Preservation Tax Credit projects have been completed since October 1995. Of these projects, 506 had a hotel function at some point in time, before rehabilitation, after rehabilitation, or maintained throughout the property s lifetime. Of these 506 rehabilitation projects, 323 operated as hotels following rehabilitation. A total of 207 projects, or roundly 64% of the 323 hotel projects receiving Federal Historic Preservation Tax Credits, were newly created from historic buildings that were not previously hotels, such as office buildings and apartment complexes. These statistics illustrate that historic tax credits can be applied to the rehabilitation of existing historic hotels, as well as the conversion of historic structures to hotel use. While select developers have taken advantage of these credits for hotel projects, ample opportunity exists for others to utilize the program. As no limit is placed on the number of eligible projects approved for the federal program each year, hotel developers will continue to compete on their ability to find the most economically feasible rehabilitation projects, and not for the tax credits. As currently structured, the federal program offers tax credit incentives equal to 10% or 20% of qualified rehabilitation expenditures. In addition, approximately half of the states offer some form of historic preservation tax credit. These state credits can be claimed in addition to the federal credits. Interested developers should research the 3
requirements of state-level tax credits prior to the start of a rehabilitation project to ensure that a project captures all historic preservation tax credits it is eligible to receive. 10% Tax Credit A 10% tax credit is available for the rehabilitation of non-residential buildings built before 1936. For a hotel project to be eligible for the 10% tax credit, the original structure must have been built before 1936. In addition, the developer must satisfy structural retention requirements as outlined by the NPS. The following guidelines illustrate the requirements for designation as a qualified rehabilitated building. Guidelines for a Qualified Rehabilitated Building (10% Tax Credit) At least 50% of the existing external walls must be retained in place as external walls. At least 75% of the existing external walls must be retained as internal or external walls. At least 75% of the existing internal structural framework must be retained in place. The rehabilitations must be at the location where the building has been located since before 1936. Source: National Park Service The 10% federal historic preservation tax credit does not require that a property be designated a certified historic property. In fact, certified historic properties are not eligible for the 10% tax credit. The requirements of certified historic properties are outlined later in this article. In the Hurricane Katrina GO (Gulf Opportunity) Zone areas, the 10% tax credit has been increased to 13%. The application of Historic Preservation Tax Credits will be a major driver in the redevelopment and preservation of historic structures damaged during the 2005 hurricane season. 20% Tax Credit A 20% tax credit is available for the certified rehabilitation of certified historic structures. The 20% tax credit has more stringent guidelines than the 10% tax credit. The basic requirements that determine whether a hotel project will be eligible for the 20% tax credit are summarized as follows. 4
Requirements for the 20% Tax Credit The historic building must be listed in the National Register of Historic Places or be certified as contributing to the significance of a "registered historic district." After rehabilitation, the historic building must be used for an income-producing purpose for at least five years. Owner-occupied residential properties do not qualify for the federal rehabilitation tax credit. The project must meet the "substantial rehabilitation test." In brief, this means that the cost of the rehabilitation must exceed the pre-rehabilitation cost of the building. Generally, this test must be met within two years or within five years of a project completed in multiple phases. The rehabilitation work must be done according to the Secretary of the Interior's Standards for Rehabilitation. These are ten principles that, when followed, ensure the historic character of the building has been preserved in the rehabilitation. Source: National Park Service For developers and investors interested in applying the 20% Federal Historic Rehabilitation Tax Credit to a hotel project, the State Historic Preservation Officer (SHPO) is the first point of contact. Although the tax credit program is administered on the federal level through the National Park Service, developers must apply for the 20% tax credit incentive through the appropriate SHPO. The SHPO is determined by the location of the project, each state maintains a SHPO who assists developers in the process and submits the application to the National Park Service on behalf of the developer. NPS Approval Process 1. Determine the historic significance of a building if the property is not already included in the National Register of Historic Places or located in a NPS certified Historic District. 2. Following the determination of historic significance, plans for renovation must be submitted to the SHPO for review and approval of the NPS. 3. Following approval of the plans, evidence of completed work and extent of rehabilitation must be submitted to the SHPO for review and approval of the NPS, to approve initial qualification for the 20% tax credit. Source: National Park Service As detailed in the above list, the NPS approval process for the 20% tax credit is determined in two or three steps, depending on whether or not the property in question is currently listed in the National Register of Historic Places, or located in an 5
NPS certified historic district. In comparison to the 10% tax credit, the 20% tax credit places more stringent restrictions on developers with regard to structural changes to an existing building. A developer must consider the scope of the changes necessary to an existing structure to ensure its functionality following rehabilitation. This is especially important for hotel rehabilitation projects, as the physical layout of a hotel is directly tied to operational efficiency and profitability. A historic building may require extensive structural changes to allow for hotel use. In such cases, the 10% historic preservation tax credit may be more appropriate. Buildings that are currently listed in the National Register of Historic Places or located in Registered Historic Districts are required to follow the certified rehabilitation requirements as established by the Secretary of the Interior. Secretary of the Interior s Standards for Certified Rehabilitation 1. A property shall be used for its historic purpose or be placed in a new use that requires minimal change to the defining characteristics of the building and its site environment. 2. The historic character of a property shall be retained and preserved. The removal of historic materials or alteration of features and spaces that characterize a property shall be avoided. 3. Each property shall be recognized as a physical record of its time, place, and use. Changes that create a false sense of historical development, such as adding conjectural features or architectural elements from other buildings, shall not be undertaken. 4. Most properties change over time; those changes that have acquired historic significance in their own right shall be retained and preserved. 5. Distinctive features, finishes, and construction techniques or examples of craftsmanship that characterize a historic property shall be preserved. 6. Deteriorated historic features shall be repaired rather than replaced. Where the severity of deterioration requires replacement of a distinctive feature, a new feature shall match the old in design, color, texture, and other visual qualities and, where possible, materials. Replacement of missing features shall be substantiated by documentary, physical, or pictorial evidence. 7. Chemical or physical treatments, such as sandblasting, that cause damage to historic materials shall not be used. The surface cleaning of structures, if appropriate, shall be undertaken using the gentlest means possible. 8. Significant archaeological resources affected by a project shall be protected and preserved. If such resources must be disturbed, mitigation measures shall be undertaken. 9. New additions, exterior alterations, or related new construction shall not destroy historic materials that characterize the property. The new work shall be differentiated from the old and shall be compatible with the massing, size, scale, and architectural features to protect the historic integrity of the property and its environment. 10. New additions and adjacent or related new construction shall be undertaken in such a manner that if removed in the future, the essential form and integrity of the historic property and its environment would be unimpaired. Source: National Park Service 6
Project Timing and Qualified Rehabilitation Expenditures (QRE) With both the 10% or 20% tax credit, specific timing requirements exist for the start and end of a rehabilitation project. Timing is a crucial factor for these projects, as a basis period must be established to determine a project s tax credit eligibility. In addition, rules regarding the transfer of ownership following a rehabilitation project are specific. In general, if the developer or initial investor plans to sell the property upon completion of a rehabilitation project, the property should not open (receive a certificate of occupancy) until after the new ownership is in place. In this way, the new ownership can legally claim the qualified rehabilitation expenditures made by the initial investor, allowing the new owner to claim a historic tax credit. Tax credits are calculated based on qualified rehabilitation expenditures (QREs). More specifically, the total QREs must be greater than the purchase price attributable to the existing structure, prior to rehabilitation. Examples of qualified and non-qualified expenditures are detailed as follows. Qualified Rehabilitation Expenditures Yes Any amount that is: Properly chargeable to a capital account Incurred by the tax payer after December 31, 1981 For Depreciable Real Property Made in connection with the rehabilitation of a qualified rehabilitated building No Land and Interest Carry on Land Building Acquisition and Interest Carry on Acquisition Acquisition-Related Costs Site Improvements and Landscaping Enlargements and Demolition Personal Property Tax Exempt Use Property Sources: National Park Service & Reznick Group Federal Historic Preservation Tax Credits in Action The following is a fictitious case study illustrating the impact of Federal Historic Preservation Tax Credits. The scenario provides a simplified analysis of the calculation of Federal Historic Preservation tax credits and does not explicitly describe all legal requirements for tax credit qualification. A developer recently purchased a former textile factory located in the southeastern United States. The purchase price for the building was 7
$750,000, including the land, which was valued at $300,000. The developer has plans to redevelop and rehabilitate the property into a 50-room boutique hotel. Built in 1915, the factory was the areas major employer though the late-1950s, before other industries moved in the area. The structure has remained vacant since 1975, when the factory closed. If the developer was unaware of the Federal Historic Preservation tax credits, he would complete a rehabilitation and conversion of the building without the benefit of the 10% or 20% tax credit. Land $300,000 Existing Structure 450,000 Total Purchase Price 750,000 Rehabilaiton Expenses $700,000 Total Investment $1,450,000 Tax Credit Percentage 0% Total Tax Credit $0.00 The developer investor could consider the 10% historic tax credit because the structure was built before 1936 and he plans to retain enough of the building s original structure to meet NPS standards. The developer is not required to have the structure added to the national register of historic buildings, or to have the renovation plans approved by the NPS. The following table shows the development scenario with the 10% tax credit applied. Land $300,000 Existing Structure 450,000 Total Purchase Price $750,000 Qualified Rehabilitation Expenditures $700,000 Total Investment $1,450,000 Tax Credit Percentage 10% Total Tax Credit $70,000 The project is eligible for the 10% federal tax credit, which equals 10% of the QREs, or $70,000. 8
The developer has the option to apply for the 20% Federal Historic Preservation tax credit. As previously discussed, the developer would contact the State Historic Preservation Officer to begin the process of having the building added to the National Register of Historic Places. Considering the importance of the factory in the history of the local community, the building has a strong chance of being approved. Assuming that the building is certified as a historic structure by the NPS, the developer would then be required to provide plans for rehabilitation that follow the Secretary of the Interior s Standards for Rehabilitation. Following an approval of the rehabilitation plan, the owner would submit information on the final results of the project to receive certification of the rehabilitation resulting in qualification for the 20% tax credit. Land $ 300,000 Existing Structure 450,000 Total Purchase Price 750,000 Qualified Rehabilitation Expenditures 700,000 Total Investment $ 1,450,000 Tax Credit Percentage 20% Total Tax Credit $140,000 The property s qualified rehabilitation expenditures (QREs) exceed the total price of the existing structure; therefore the project is eligible to receive the 20% tax credit, which equals 20% of the QREs, or $140,000. Historic hotel renovation and conversion projects have become increasingly important to urban redevelopment initiatives nationwide. Developers and investors considering such projects must educate themselves on the available federal tax credit incentives in order to ensure that the process is followed correctly, and to maximize the value of these programs. Project-specific factors must be analyzed to determine the most appropriate and feasible tax credit level. While the complicated nature of hotel development projects may not be lessened through the application of Federal Historic Preservation tax credits, the program offers attractive incentives to developers and investors willing to embark on rehabilitation projects. About the Author Matthew D. Melville is a Consulting and Valuation Analyst with HVS International s New York Office, specializing in Hotel Valuations, Market Studies, Feasibility Reports, and Investment Counseling. The author can be reached via e-mail: mmelville@hvsinternational.com Special thanks to Don Nimey of Reznick Group for his invaluable expertise and assistance. Mr. Nimey can be reached via e-mail: don.nimey@reznickgroup.com. 9