Construction Insurance and Real Estate
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HISTORIC REHABILITATION TAX CREDITS
By: Dan Cofran

Missouri and Kansas cities and towns share our nation’s rich architectural heritage, including large numbers of “rock solid” commercial and other buildings built in the late 19th and first half of the 20th Centuries. These buildings feature architectural detail and form that would be cost prohibitive to build today.

These older buildings are underutilized today, but can be renovated and updated to modern occupancy standards to again provide decades of future service as popular “show place” commercial and residential structures.

Rehabilitation costs, of course, can be much higher than new construction costs. The federal and state governments have stepped in, however, to provide tax credits equal to as much as 45% of these costs (combined federal and state credits available in Missouri and Kansas), bridging the gap between new life as a Class A property and a trip to the demolition debris landfill.

These are “credits” against taxes due, not “deductions” against income, giving the taxpayer a “dollar-for-dollar” benefit.

The federal “Rehabilitation Credits” fall under Sec. 47 of the Internal Revenue Code. There are two types of federal credits: “20%” credits for nationally certified historic buildings and buildings in districts on the National Register of Historic Places; and “10%” credits for buildings built before 1936, even though not on the National Register.

Both credits are one-time credits, generally taken only the year rehabilitation is completed and the building placed in service. However, they can be carried to other years in the event they exceed that year’s income tax liability.

The federal credits pay for most hard and soft costs of rehabilitation, but not building acquisition, in the end meaning the federal government covers 20% or 10% of the rehabilitation tab. The Missouri and Kansas credits equal 25% of the rehabilitation costs for certified historic buildings, for a combined total of as much as 45% of the costs . . . a significant incentive for owners, developers, builders and lenders.

Qualifying Buildings
Certified historic structures include (1) buildings listed on the Secretary of Interior’s National Registry of Historic Places or (2) non-listed buildings if located within a national, state, or local historic district and certified by the Secretary of Interior as historically significant to the district.

Listing is not strictly limited to “historic” structures. The 1966 National Historic Preservation Act includes structures significant in history, architecture, archeology, engineering, and culture.

The Secretary of Interior, through the National Park Service, applies very strict standards to a rehabilitation project’s design and materials to assure historically accurate rehabilitation.

Pre-1936 buildings do not need to comply with these standards. However, to qualify for the tax credit, 50% or more of the exterior walls must be retained as external walls, 75% of the exterior walls must be retained as exterior or interior walls, and 75% or more of the internal structural framework must be retained.

Further, whether a certified historic or pre-1936 building, the credit applies only to “buildings,” meaning lesser structures like storage tanks, bins, silos, industrial furnaces, or other large machinery or equipment do not qualify.

Permitted Uses
The federal credit applies only to commercial, industrial, and rental residential property used for production of income or in a trade or business; it does not apply to owner occupied residential property. For pre-1936 buildings, however, it does not apply to “lodging,” including residential rental property and apartments (“lodging” does not include hotels and motels). The “lodging” exclusion, however, does not apply to certified historic buildings.

Further, the credit does not apply to most property used or owned by non-profits for non-profit purposes or governments. There is a very narrow exception for leases to non-profits that may not to exceed 35% of a building’s space. (This is unfortunate . . . while these users generally do not pay income tax and, therefore, would not benefit from credits, they otherwise could sell the credits to raise restoration funds, for example, churches).

Substantial Rehabilitation
For both certified historic and pre- 1936 buildings, a rehabilitation must be “substantial,” meaning it must materially extend the useful life of the building, significantly upgrade its usefulness, or preserve it in a way that significantly improves its condition or historic value. Rehabilitation limited to cosmetics won’t cut it.

A mathematical test was added in 1981 to require that the rehabilitation costs equal the greater of $5,000 or the owner’s basis* in the building (excluding land) and that these costs be measured by expenditures over a two-year period. Post-1936 additions to a building are not included in the owner’s basis.

The two-year period, of course, cancause problems if the rehabilitation project takes longer, as in the case of all-too-frequent unexpected delays, phased projects, or projects with later rehabilitation improvements to be done by tenants. The Code extends the period to five years for projects with identified phases. This technically does not apply to projects taking more than two years due to unexpected delays. However, this can be protected against if reasonably expected phases are identified at the beginning of the project to stretch the allowable time beyond the two years.

Qualified Expenditures
Most hard and soft rehabilitation expenditures can be included in the credit computation. The expenditures must be items that are charged to a project’s capital account (added to basis and not deducted the year of expense) and are depreciable.* This excludes personal property that might be part of rehabilitation like special lighting, false balconies, exterior ornamentation, signs, some floor coverings, ornamental fixtures, and movable partitions.

The credit is limited to the rehabilitation expenditures; the cost of acquiring the building may not be included.

Soft costs like professional fees for architects, engineers, surveyors, and attorneys, as well as insurance premiums, construction interest, taxes, and a development fee (20% maximum) are included as long as they are charged to the project’s capital account and added to its basis.

In addition, costs for updated mechanical equipment and related items such as new heating, air conditioning, ventilation, plumbing, electrical, and elevators may be included. The IRS, however, has excluded the costs of site improvements like walks, fencing, retaining walls, parking, and landscaping as not being “building” rehabilitation costs.

Expenditures for enlargement of an existing building, such as an addition, may not be included.

Demolition costs, particularly light interior demolition, may be included as long as the wall retention requirements are met for pre -1936 buildings and Secretary of Interior standards are met for certified historic structures.

In addition, for certified historic structure projects, all aspects of the rehabilitation must be approved by the National Park Service as part of a “certified rehabilitation plan.” Only “certified rehabilitation” expenditures qualify for the credit.

The National Park Service applies detailed Standards for Rehabilitation and Preservation Briefs addressing original use, adaptive reuse, historical design, contemporary design, additions, construction techniques, finishes, materials, repairs (favored) vs. replacement (not favored), surface cleaning, and archeological preservation.

Tax Credits for Tenants
A landlord is permitted to pass through its qualified rehabilitation expenditures to its tenant.

In addition, a long term tenant can qualify for the same credits for its rehabilitation expenditures as long as the same rehabilitation tax credit tests are met. However, to do so, the remainder of the tenant’s lease term (without renewals) upon completion of its work must be equal to or greater than the depreciation* period for the property, namely, 39 years for commercial or industrial property, or 27.5 years for rental residential property under the Internal Revenue Code.

A long-term tenant can also have a problem if the owner sells the building during the two (or up to five) year rehabilitation process. The tenant may have to use the new owner’s likely higher basis in the building. (The tenant should require a lease provision prohibiting sale during the rehabilitation period and record the lease).

“Placed in Service”
“Placed in service” is an important concept, generally meaning the date the completed project is put in use. The historic rehabilitation tax credit generally is taken the year the building is “placed in service” as selected by the owner.

In addition, a buyer to whom a project is sold can take the credit based on the seller’s rehabilitation expenditures aslong as the purchase is before the “placed in service” date.

Taking the Credit During Construction
While the credit normally cannot be taken until the end of the rehabilitation process when the building is placed in service (two to five years), the credits some times can be taken each year the rehabilitation expenditures are made for projects taking several years if approved in advance by the IRS.

If a building owner is doing the rehabilitation work itself with its own employees and purchases materials (must be at least one half the rehabilitation expenditures), it frequently can take the credits each year based on that year’s actual expenditures, providing annual cash flow relief.

Owners using outside contractors can do the same thing based on the percentage of progress made each year, again based on actual expenditures. The IRS may, however, not let the owner begin counting “progress expenditures” until the total spent exceeds the pre-rehabilitation basis in the building.

Basis Reduction and Credit Recapture
There are, of course, two important “catches.”

Basis Reduction. While the owner gets the 20% or 10% federal credit the year the building is placed in service, the tax basis* in the building must be reduced by the amount of the credits taken. This reduces the basis amount to be depreciated over the life of the building (“straight line” only), thereby reducing the depreciation deduction that may be taken each year, as well as increasing the capital gain* upon sale of the building.

Credit Recapture. If the owner takes the credits and then sells the building (or a partner sells its partnership interest) before five years has passed, all or a portion of the credits must be paid back, depending on how much time has passed. A series of 20% steps are applied. A full 100% of the credit is recaptured and must be repaid if the building is sold in Year One of ownership, 80% in Year Two, 60% in Year Three, 40% in Year Four, and 20% in Year Five.

State Rehabilitation Credits
Missouri and Kansas also provide significant historic rehabilitation credit against their state income taxes.

The Missouri credit applies only to certified buildings on the National Register; it cannot be used for non-listed pre- 1936 buildings. Unlike federal credits, however, the state credits can be used for owner occupied residential properties.

Kansas credits apply to buildings on the National Register or on the state’s register of historic buildings or places. More like the Missouri credits, Kansas credits are not limited to income producing properties.

In both Missouri and Kansas, the credit is equal to 25% of the rehabilitation expenditures, using the federal qualifying standards for the expenditures. In Missouri, total rehabilitation costs must equal or exceed one-half the owner’s basis in the building. In Kansas, rehabilitation expenditures must be at least $5,000.

In both states, rehabilitation work must meet Secretary of Interior standards.

Like the federal credits, the Missouri and Kansas credits are taken in only one year, but in both can be carried to other years in the event they exceed that year’s state income tax liability. In Missouri, the credits can be carried back three years and forward up to ten years. In Kansas, they can be carried forward up to ten years.

In addition, Missouri and Kansas explicitly permit sale of the credits to other taxpayers, so an owner can sell the credits (discounted basis, e.g., receive 80 to 85 cents on the dollar) for cash the year the project is completed and the building is placed in service. If sold to a third party (not a project partner) the proceeds from the state tax credits, however, are taxable income (federal income tax) to the seller.

Credits Translate Into Equity
The federal and state credits can also translate into equity for a developer because they can be made available to investors for cash, as much as 90 cents on the dollar. As a practical matter, the cash from the credits can provide the developer’s equity to finance the project. While federal historic rehabilitation credits cannot be sold outright like the Missouri and Kansas credits, developers structure their projects to include a tax partner to which the credits are allocated in return for cash to the developer partner upon project completion.

Economic Benefits to Developers
The purpose of the historic rehabilitation tax credit program is to provide an economic benefit to the developer to compensate it for the risk taken in developing an historic rehabilitation project. Because the credits can be sold or structured to raise equity, they reduce the mortgage indebtedness needed to do a project and maintain a fair development fee to a developer since the fee qualifies for the credit.

In a 20% federal historic rehabilitation tax redit project, the mortgage loan frequently is 75% to 80% of the total cost of the project, the balance of which can be allowance for the credits and the developer’s cash equity making a much better loan-to-value ratio for lenders. Many construction lenders, however, are not willing to treat the credits as equity since they are not allowed until project completion. If also using the Missouri or Kansas 25% credits, the mortgage loan can be a lower percentage of project costs for an even better loan-to-value ratio. The Missouri and Kansas credits can also be sold “up front” to raise cash equity.

Also, as a result of increased equity, interest costs and carrying charges for construction are significantly reduced. The equity can pay a significant amount of the up-front costs, allowing for a slower draw on the construction loan.

Benefits to Financial Institutions
There are economic, regulatory, and social benefits to a financial institution participating in a historic rehabilitation tax credit project.

Due to the relatively lower leverage and the recapture provisions for historic rehabilitation tax credit projects, the likelihood of default is less than in other projects. As stated above, if the project is disposed of prior to 5 years after placed in service, there is a recapture to the tax credit partner. The tax credit partner will be careful to make sure the debt is serviced so there is not a foreclosure and thus a recapture, at least for the first five years, frequently the toughest.

In addition, the project may qualify under the Community Reinvestment Act (“CRA”) since many older projects may be in CRA areas.

Another significant potential advantage to a financial institution is that it can acquire both the credits and make the loan. A financial institution can have a significant investment in a project. The investment is reduced significantly by the reduction in federal and state income taxes from the credits. When coupled with the loan, the total return on the investment can be increased appreciably.

Combining Historic Preservation Credits with Affordable Housing Credits
Greater savings can be achieved if a historic rehabilitation project is done with a building also qualifying for low income housing federal tax credits. These credits can equal 30% or 70% of a project’s costs.

Combined affordable housing and historic rehabilitation projects are limited to historically certified buildings, however - they can’t be combined for a pre-1936 building project. In addition, the amount of the affordable housing expenditures must be reduced by the amount of the historic rehabilitation credits. Still, significant overall tax savings can be achieved with a combined project.