Tuesday, December 8, 2009

Caution: Historic Tax Credits Under Construction

In 1976, Congress enacted an early version of the federal historic tax credit program, and it was quickly pressed into service by the development and investment communities (see our lovely chart, right). By 1986, the IRS determined that the program was, perhaps, too successful, and Congress sought to close the more egregious loopholes in the sternly-named Tax Reform Act of 1986. Among those legislative changes were adjustments to passive activity rules that shrank the pool of investors eligible to claim historic tax credits. Not surprisingly, enthusiasm for the historic tax credit program waned until developers and investors were able to retool their programs under the new tax laws. Until last year, the 1986 version of the historic tax credit program remained relatively unchanged, enabling industry members to establish and maintain fairly effective syndication infrastructure for larger historic rehabilitation projects ("syndication" is the process through which tax credits are monetized to create a source of cash equity for a rehab project). However, while effective, the process for syndicating larger historic rehabs is by no means simple or inexpensive, and there remain few capital investment resources for smaller historic rehabs (say, those generating less than $1 million in federal historic tax credits).

Last year, nestled within the massive Housing and Economic Recovery Act 0f 2008, Congress made a pair of notable changes to the historic tax credit program. First, it eliminated the long-standing rule that historic tax credits cannot reduce a taxpayer's alternative minimum tax (aka, "AMT") liability. More simply - by tossing those AMT restrictions, Congress opened a new boulevard of potential investors for both large and small rehabs (more on that theme in a moment). The second change increased opportunities for charitable organizations to undertake historic tax credit projects (more on that below, as well).

This October, the optimistically-named Community Restoration and Revitalization Act (H.R. 3715, S. 1734) was introduced to Congress. If it becomes law, this bill will result in unprecedented changes to the historic tax credit program. Its eight proposed amendments fall into two primary categories: (a) no-brainer tweaks to the program and (b) changes that will promote sustainability and stimulate private investment in historic rehab projects.


10% Non-Historic Tax Credits - The 10% "non-historic" tax credit for "older buildings" is the subject of two of the proposed amendments. Under a 1986 tax amendment, a non-historic building can become eligible for the 10% credit if it was constructed prior to 1936 (at the time, this made sense - Congress simply applied the generally-accepted 50-year standard for historic eligibility). Unfortunately, Congress chose a static date (1936), rather than a 50-year sliding standard, which means that, with each passing year, the stock of eligible buildings shrinks. One of the proposed 2009 amendments would change the standard to "fifty years old or older".

A second tweak to the 10% credit would make it eligible for use in projects involving residential rental property. The current law to the contrary prohibits the use of the 10% credit housing projects, limiting its impact on places like historic downtown neighborhoods.

Non-Profit Projects

We mentioned above that the 2008 amendment increased opportunities for non-profit organizations to undertake historic rehab projects. Under a 1986 change, historic tax credits were were not available for "tax-exempt use property" resulting from a "disqualified lease." A non-profit disqualified lease arises in four situations: (1) the term of the lease exceeds 20 years, (2) the lease contains a purchase option in favor of the non-profit, (3) the project involves tax-exempt financing or (4) there is a sale/lease-back between the non-profit and a for-profit entity. Under the 1986 law, if more than 35% of the project was the subject of a disqualified lease, then that project was ineligible for historic tax credits. The 2008 amendment increased that threshold to 50%. The proposed 2009 amendment would eliminate items (1) - (3), leaving the sale/lease-back scenario as the sole trigger for a disqualified lease. Bottom line: if this amendment passes, non-profit organizations will be better able to enjoy the benefits of historic tax credit syndication.

Moderate Rehabs

The historic tax credit program is designed to incentivize "substantial rehabilitation" projects. With some exceptions, a taxpayer generally must incur, within a 24-month window, "qualified rehabilitation expenditures" equaling the greater of (1) $5,000 or (2) the taxpayer's adjusted basis in the building (generally, [acquisition price] minus [cost of land] plus [capital improvements] minus [depreciation]). In practical application, this rule can prohibit rehab projects where, for instance, the owner recently acquired an occupied building and proposes a "facelift" for the building, but the cost of the rehab work will not exceed her basis in the building. A proposed amendment would reduce the "adjusted basis" test to 50% of the taxpayer's adjusted basis, thereby increasing the availability of tax credits for certain moderate rehabs and for moderate and substantial rehabs in high-cost real estate markets.


Smaller Rehab Projects - As we mentioned briefly, smaller historic tax credit projects often lack the sort of access to private capital enjoyed by their larger counterparts. Syndication can be costly, and institutional investors often set minimum project sizes of $1 million (or more) in federal historic tax credits. There are some "small deal funds" serving smaller rehab projects, but they vary widely by jurisdiction and often provide net pricing far below that offered by conventional funds for larger rehabs. However, two pending amendments would improve the outlook for smaller rehab projects. For starters, there's an amendment to increase the current 20% federal historic tax credit to 30% of qualified project costs in deals with no more than $5 million of such costs. That credit boost likely would improve pricing for smaller rehab deals, thereby increasing the amount of equity available to pay project costs. A second amendment aims to improve syndication prospects for projects with a qualified costs of no more than $5 million. Under this amendment, a taxpayer undertaking a qualified rehab would be able to transfer her historic tax credits to another taxpayer in exchange for cash equity that can be used to pay project costs.

State Historic Tax Credits

Many states offer their own historic tax credits to supplement the federal program. Under current federal tax law, state tax credits generally are taxed as income to the taxpayer undertaking the rehab project. Under a proposed amendment, state credits no longer would be taxable as federal income, unless the taxpayer elects otherwise. The amendment also would exempt from federal recapture rules certain transfers of state credits (eg, for syndication purposes). Taken together, these provisions would increase the value of state historic tax credits by reducing a negative tax consequences resulting from claiming and syndicating them.


If you had to summarize historic preservation in a word, "sustainable" might be apt (as we're fond of repeating, "the greenest building is the one that's already built"). Perhaps appropriately, then, Congress also is considering an amendment that would provide graduated increases in the amount of federal historic tax credits available for projects that boast certain energy efficiency attributes.

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