Tax credit financing: Incentive for historic redevelopment

Although there are many cultural and aesthetic incentives for redevelopment, there are financial incentives as well.

One of the most significant incentives for developers and investors is the federal rehabilitation tax credit program. The federal government provides a 20 percent tax credit for qualified rehabilitation expenditures. Many states also have enacted similar programs.

Developers and investors use tax credit programs to bridge the gap between conventional financing sources and the actual cost to rehabilitate historic buildings.

Conventional lenders typically impose strict limits on funds for real estate, with limits tied to specific loan-to-value percentages or debt service coverage ratios. Complete financing from conventional sources is rare. Tax credits can fill the gap when converted into equity for construction.

For example, assume a certified historic building is purchased for $500,000, and the owner incurs an additional $1 million in qualified rehabilitation expenditures to rehabilitate the building into loft apartments and light retail space. The $1 million in qualified rehabilitation expenditures produces $200,000 in federal tax credits, and the owners may be able to use the credits on their federal tax returns to reduce federal income tax liability by $200,000.

Alternatively, the owner may find a syndicator or direct investor to acquire an interest in the project in exchange for cash equity based on the $200,000 in federal credits.

Some states have credits that can be used in a similar way with the state tax credit being as high as 25 percent of the qualified rehabilitation expenditures.

Qualifying for the tax credits

Only certified historic structures qualify for the 20 percent credit and must be listed in the National Register of Historic Places or in a registered historic district. Their historic significance also must be certified by the Secretary of the Interior.

A 10 percent federal credit also is available for buildings that were first placed in service before 1936, but developers typically look to qualify the building for the 20 percent credit. To qualify for the 20 percent federal rehabilitation credit, the project must generally meet these requirements:

• The building must be a certified historic structure.

• The project must meet a “substantial rehabilitation test.” A building is treated as having been substantially rehabilitated if the qualified rehabilitation expenditures incurred during a defined 24-month period exceed the greater of $5,000 or the adjusted basis of the building and its structural components at the beginning of the 24-month period.

• The building must be used for income-producing purposes or in a trade or business following rehabilitation. Loft apartments, offices or retail space, among others, also qualify. Some states allow credits on owner-occupied personal residences, but such use is not eligible for federal credits. Certain use by tax-exempt entities also fails to qualify.

• A structure must be rehabilitated according to the Secretary of the Interior’s Standards for Rehabilitation, which emphasize the importance of preserving historic materials, a structure’s distinctive features and important interior spaces.

• Only certain expenditures are eligible for the 20 percent credit – typically only those items that must be capitalized and depreciated as part of the building, including walls, floors, ceilings, windows, doors, air conditioning, plumbing, electrical, stairs, masonry, construction of period interest and other structural components of the building. Personal property is generally not eligible, and property outside the building also is excluded.

The certification process

Certification involves a three-part application. Buildings located in historic districts or those eligible for listing on the National Register must complete Part 1, an evaluation by the National Park Service of the building’s historical significance.

The NPS decides if the building is a certified historic structure. Buildings already listed in the National Register automatically qualify and do not need to complete Part 1.

Part 2 describes the proposed rehabilitation work to be done and is submitted to the NPS for approval. The proposed work must meet the criteria set by the Secretary of the Interior.

Part 3 requests certification of completed work. On completion, the NPS compares the completed project with the proposed rehabilitation work submitted in Part 2. When approved, the project becomes a certified rehabilitation eligible for the 20 percent credit. Many developers combine the rehabilitation credits with federal and state affordable housing credits to enhance the feasibility of affordable housing in historic neighborhoods.

John Cook is a partner with BKD LLP. He may be reached at jcook@bkd.com. Derek Smith is a supervisor with the firm. He may be reached at dsmith@bkd.com.[[In-content Ad]]