By Jason Yots
In recent years, Buffalo's local media has been rich with stories about an investment vehicle known as historic tax credits (HTCs). Since New York instituted its version of the federal HTC program, everyone from developer Rocco Termini to Congressional candidate Chris Collins has used HTCs to resurrect buildings. But this momentum is threatened by the simple rule of supply and demand: at the moment, there seem to be more New York tax credits available than the investment market can absorb, and that disparity could threaten a number of pending projects. If this trend continues, the best chance for New York's program to survive legislative sunset in 2015 may be a not-so-simple tax tweak called "bifurcation". More on that in a minute.
The federal HTC program assumed its current form in 1986 amidst a sweeping overhaul of America's tax code. The federal program rewards capital investment in "certified historic structures," which are buildings eligible for listing in the National Register of Historic Places (or contributing to a listed or certified historic district). The "reward" comes in the form of a 20 percent federal tax credit to the building owner and/or tenant when the project is complete.
As mentioned, New York administers a companion HTC program. From 2007 through 2009, New York's program offered a modest credit, capped at $100,000 per project. Beginning in 2010, however, New York overhauled its HTC program, modeling its credit calculation after the federal program and expanding the per-project cap to $5 million.
To be eligible for federal (and therefore New York) HTCs, an owner must "substantially rehabilitate" a commercial building by spending more on capital improvements than its current depreciable basis. With a few notable exceptions, funds spent on the rehabilitation project are treated as "qualified rehabilitation expenditures" (QREs). QREs serve as the basis for calculating HTCs, and they typically include most "hard" and "soft" costs, along with a reasonable developer fee. To estimate your HTCs, multiply your QREs by the federal HTC rate of 20%. New York's program matches the federal program by offering 20% in state HTCs.
Twice the HTCs for the same investment? Well, in theory, yes, but in practice, not really. In many cases, HTCs are "syndicated" to outside investors in order to raise capital for a rehabilitation project. "Syndication" is a vehicle through which a project sponsor becomes partners with a passive investor, who then invests capital in the project in exchange for certain economic benefits, such as HTCs. And that's where "bifurcation" becomes relevant.
"Bifurcation" refers to the allocation of different tax benefits (such as federal and New York HTCs) to separate partners within an HTC partnership. Currently, New York's HTC program does not permit bifurcation; the partner that claims federal HTCs must also receive an equivalent amount of New York HTCs. This can deflate the value of New York HTCs for a few reasons.
First, most of us pay federal taxes at a higher rate than state taxes. $100 in income to a particular taxpayer might create $30 in federal tax liability, but only $8 in state taxes. Therefore, an investor's "appetite" for HTCs often will vary, depending on whether they are in the market for federal or state credits. The inability to separately allocate federal and New York HTCs exacerbates this demand problem because project sponsors can't nimbly redirect New York HTCs to an investor with commensurate appetite.
The second reason for lagging demand in New York HTCs relates to the state's overall economy, which no longer boasts as many tax shelter-seeking (i.e., profitable) companies as it once did. Other than a few local banks and regional insurance companies, the industry is not seeing consistent corporate participation in New York's HTC program. This lack of consistency is creating a great deal of uncertainty for both HTC developers and investors alike.
The third reason relates to federal tax rules known as "passive activity restrictions" (PARs). Practically speaking, PARs prohibit most individuals and closely-held companies from claiming HTCs within a reasonable period of time. When combined with otherwise spotty corporate demand, PARs can make it very difficult to find a qualified HTC investor with adequate appetite for both federal and New York HTCs, particularly without the option of bifurcation.
A legislative amendment permitting bifurcation would immediately provide HTC project sponsors with more options for leveraging New York HTCs, including simply claiming the credits themselves if a state investor doesn't materialize. Over the long-haul, a bifurcation amendment would prompt HTC syndicators to assemble investment funds consisting of New York HTC investors, which will increase demand and project yields.
To date, bifurcation has taken a legislative backseat to other changes to New York's program. Most recently, it was overlooked in favor of an increase in the per-project cap from $5 million to $12 million (I'm told this 2012 amendment has not yet been sent to Governor Cuomo for signature). While that increase certainly will aid a few large projects, it will do nothing to solve the supply-and-demand dilemma faced by many New York HTC projects. In fact, it may end up producing more of a commodity that has no discernable market.
One plausible argument against allowing bifurcation is the possibility for an increased administrative burden on an already over-taxed Department of Taxation and Finance. That may be a reality, but we need to at least evaluate that presumed cost in the context of the possible benefits from bifurcation. Otherwise, New Yorkers may never be able to have their tax credits and use them too.
Jason Yots is a tax credit attorney and President of Preservation Studios LLC, an historic preservation consulting firm with offices in Buffalo and Rochester, New York.
Entry Image courtesy of the Lofts at 136. Former Alling & Cory Building that utilized historic tax credits for the rehabilitation