Column: Taking (Tax) Credit For Creativity
But it’s one thing to have the idea and quite another to get it financed and producing a positive cash flow, which is why it’s important to have an understanding of creative financing tools (ideally, the kind that don’t land you in jail).
For some projects, one of the most successful has been the historic tax credit program.
Offered at the state and federal level, the programs can return as much as 45 percent of rehabilitation costs to an investor. Simply, every dollar used for eligible rehabilitation expenditures on an income producing contributing structure within a historic district (or an individual property on the historic register) could return 45 cents — 25 cents from the state and 20 cents in federal credits. You may have noticed a lot of qualifying language in the previous paragraph and with good reason — the program is intricate — and specific requirements must be met to receive the credits. No promises have been made about the ease of the process, but for those who can successfully navigate the program, historic tax credits offer a creative way for commercial real estate investors to take advantage of significant benefits.
In the short term, they offer a way to save money on rehabilitation costs, increase cash flow, or take a developer’s fee. Over the long term, they have the potential to increase property value by generating new demand and commanding a premium for the space.
More altruistically, historic rehabilitation can serve to arrest downtown decay, creating revitalized and vibrant communities capable of pumping money back into local economies and creating jobs.
Scary language aside, you don’t have to go at it alone. Locally, there are terrific professionals, including real estate brokers, accountants, architects and nonprofits like Harrisonburg Downtown Renaissance and Historic Staunton Foundation that are experienced and can help you through the process of capitalizing on this largely untapped resource.
The Federal Program
The Federal Historic Tax Credit program permits a 20 percent tax credit for qualified rehabilitation expenditures on certified historic structures. A qualified rehabilitated building is generally defined as any building that has been substantially rehabilitated and is a certified historic structure or was placed in service before 1936.
Understanding this overview requires a firm grasp on three key definitions:
- Certified Historic Structure — A building can meet the definition if it is either listed in the National Register or is located within a historic district and is certified as being “of historic significance to the district,” sometimes referred to as contributing. Buildings placed in service before 1936, but not considered a contributing structure, may be eligible for a 10 percent credit.
- Qualified Rehabilitation Expenditure — These expenses must be related to the rehabilitation of the building and must be depreciable (roof, windows, flooring, etc). However, they exclude acquisition of the property, enlargement of the building, and certain demolition costs.
- Substantially Rehabilitated — A building is considered to have reached this threshold if during a 24-month period, or 60-month period under a phased approach, the qualified rehabilitation expenditures exceed the greater of the adjusted basis of the building or $5,000. In other words, you will likely need to spend an amount equal to the cost of the building to be eligible.
In addition, it is important to note the federal program allows only nonresidential property (apartments are considered commercial income producing property). Tax-exempt property is not eligible for the credits, and the basis of the property will be reduced by the amount of the credit taken.
Moreover, the investor must hold and operate the property for investment purposes for a period of at least five years. Failure to do so will trigger a recapture of the tax credits taken at 20 percent for each year below the threshold, which wouldn’t be a great time come April 15.
Virginia bases its historic tax credits program on the federal model. Both programs follow the Secretary of Interior Standards and Guidelines for Rehabilitation.
Staff at the Virginia Department of Historic Resources and the National Park Service must review your project for approval before you start work. Changes to historic buildings must be compatible with the guidelines and retain the historic character of the property.
While the rehabilitation approach is materially similar and the documentation process is very much the same; here are a few key differences:
- Larger Credit — Whereas the tax credit under the federal program is 20 percent, the state credit is 25 percent.
- Material Rehabilitation — Virginia is a little more generous with the credit amount and a little less demanding when it comes to the level of rehabilitation requiring the expenses be greater than, or equal to 50 percent of the prior year’s assessed value of the property. It’s even lower if the property is owner-occupied, in which case the eligible rehabilitation expenses must only cross the 25 percent threshold.
- Owner-Occupied, Residential Property, and Tax-Exempt Property — You may have noticed above, the credit applies to owner-occupied, residential property, and tax-exempt buildings, while the federal credit does not.
- No Recapture Provision — Whereas the federal program requires a recapture rate of 20 percent of the credit amount for each year less than five the property is not owned by the taxpayer or operating as an investment property, the Virginia credit contains no such provision.
Both the state and federal programs offer significant benefits to investors in the form of tax credits up to 45 percent of eligible expenditures, which can serve to substantially reduce the cost of rehabilitation, increase cash flow and serve as a developer’s fee. While the costs of rehabilitation may be larger than nonhistoric tax credit rehabilitation, they are generally worth the benefit.
Some savvy investors select to syndicate tax credits, which permits them to transfer the credits to an equity investor within an LLC in exchange of an equity (cash) investment. It’s far too complex to cover in this format — just know that the opportunity to convert tax credits to cash at a discounted rate exists.
While the program is complex and requires a great deal of care throughout the process, there are professionals with the skills and experience to guide you through the process.