historic rehabilitation tax credits: using tax incentives to develop and invest in historic...

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GrowSmart Maine Summit 2014:

October 21, 2014

Daniel Kolodner, Klein Hornig LLP

1

Key Federal and State Tax IncentivES

• Rehabilitation Tax Credit (IRC Section 47).

• Low-Income Housing Tax Credit (IRC Section 42).

• New Markets Tax Credit (IRC Section 45D).

• Qualified Conservation Contributions (IRC Section 170(h)).

• State Historic Rehabilitation Tax Credits

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There are Two Types of Federal HTC:

10% & 20% Credit

10% Credit 20% Credit

Qualification Building older than

1936 and neither

listed on National

Register of Historic

Places nor located in

Historic District and

contributing

Listed on National

Register of Historic

Places or located in

Historic District and

recognized as

contributing to district

Permitted Use Commercial, may not

have residential

rental

Commercial, may

have residential

rental

Requirements Must exceed $5,000

of qualified rehab

expenditure, or

building basis,

whichever is greater

Same


Important Dates in the History of the

Rehabilitation Tax Credits

• 1976: First federal tax incentives for historic preservation (accelerated depreciation/ amortization).

• 1978: First federal tax credit for rehab of historic buildings (10%).

• 1981: Three tiered tax credit (25%, 20% and 15%), including first credit for rehab of older, non-historic buildings.

• 1986: Current two tiered structure; passive loss limitations imposed.

• 2014: Revenue Procedure 2014-12 released by IRS, introducing “safe harbor” structure


The 20% Rehabilitation Tax Credit

Fundamentals

• Preservation aspects jointly administered by NPS and State Historic Pres. Offices (SHPOs).

• Tax Aspects Administered by the IRS.

• Tax Credits = dollar for dollar reduction in tax liability (contrast with deduction).

• RTC is the most important (in dollar volume) federal preservation program.


The 20% Rehabilitation Tax Credit Statistics

• 1020 projects approved by NPS in 2012*

• In 2011, roughly 47% of HTC projects were for multi-family housing, 21% for office space, 16% for commercial space, 16% for other uses*

• Of the 94.5% of Projects receiving Part 3 approvals that used other incentives or publicly supported financing, 48% used state historic tax credits*

• Top states ranked by Part 2 approvals: OH (123), LA (104), VA (82), MD (62), MO (60), MA (52), NC (39), PA 38, NY (36), MI (34) (FY2012)*

*Source: Annual Report for Fiscal Year 2012: Federal Tax Incentives for

Rehabilitating Historic Buildings National Park Service



Statistics (cont’d)

• More than $3.5 billion in private investment leveraged by up to $694 million in tax credits*

Federal HTCs leverage $5 of private investment for every $1 of public expenditure

*Source: Annual Report for Fiscal Year 2012: Federal Tax Incentives

for Rehabilitating Historic Buildings National Park Service


The NPS Rules: Parts 1, 2, and 3

• Historic Preservation Certification

Application

Part 1 - Evaluation of Significance

Part 2 - Description of Rehabilitation

Part 3 - Request for Certification of Completed Work


What Types of Buildings Qualify?

The NPS Rules: Certified Historic Structure Requirement

Part 1: Option #1

Building is listed in the National Register of

Historic Places.


Part 1: Option #2

Building is located in a registered historic district

and certified by the National Park Service as

being of historic significance to the historic

district.


The NPS Rules: Certified Historic Structure Requirement


The NPS Rules (cont’d)

Historic Preservation Certification Application Part 1 – Evaluation of Significance

• Part 1 required unless the building is individually listed on the National Register.

• Part 1 is submitted to SHPO. SHPO forwards to NPS.




Historic Preservation Certification Application Part 1 – Evaluation of Significance

Part 1 is used to establish that a building:

Does or does not contribute to significance of a

district; Has preliminarily been determined to be eligible for

National Register listing; and Contributes to proposed historic district.


What Types of Rehabilitations Qualify?


Historic Preservation Certification Application Part 2 – Description of Rehabilitation

• Must be preceded or accompanied by Part 1.


• Description of proposed rehabilitation.

• Processing Fee of $500 to $2,500 (depending on size).




Historic Preservation Certification Application Part 3 – Request for Certification of

Completed Work

• Must be preceded or accompanied by Part 2.


• Part 3 must generally be received prior to the date that

is 30 months after the date of the tax return upon which

HTCs are claimed (the “30 Month Rule”) unless a

statement is filed with IRS prior to such date extending

the 3 year statute of limitations.



The IRS Rules: Depreciable Building

Requirement

• Must be a “building”. Building is defined as a

structure or edifice enclosing a space within its wall

and usually covered by a roof

• Building must be depreciable. Depreciable buildings

are generally those used for nonresidential (i.e.

commercial) or residential rental purposes. (See

Section 168(e))


What Kinds of Buildings Qualify?

• Almost Anything But a Personal Residence

Apartments

Hotels

Office Buildings

Warehouses

Distribution Facilities

Back-Office Support/Computer/Call Centers

Sports Facilities

Mixed Use of Any of the Above



The IRS Rules:

Substantial Rehabilitation Requirement

• The QREs incurred during any 24-month period** selected by the taxpayer and ending in the taxable year in which the building is placed in service must exceed the greater of:

$5,000, or The adjusted basis of the building. **A 60-month period may be used where written plans completed

before the rehab begins show that the rehab is expected to take place

in phases and is reasonably expected to take more than 24 months.



Definition of QREs

• “Qualified Rehabilitation Expenditures” (QREs) is the

tax term given to those development costs on which

rehabilitation tax credits can be claimed.

• QREs are any amounts chargeable to a capital

account made in connection with the renovation,

restoration or reconstruction of a qualified

rehabilitated building (including its structural

components), except as provided by law.



Definition of QREs

• QREs include costs related to:

• walls, partitions, floors,

ceilings;

• permanent coverings such as

paneling or tiling;

• windows and doors;

• air conditioning or heating

systems, plumbing and

plumbing fixtures;

• chimneys, stairs, elevators,

sprinkling systems, fire

escapes;



Definition of QREs (cont’d)

• QREs include costs related to:

• construction period interest and taxes;

• architect fees, engineering fees, construction

management costs;

• reasonable developer fees*

• The “Safe Harbor” Revenue Procedure highlights the concept of

“reasonable” developer fees. It is now important to get third party

back-up of all cash-flow based fees, including deferred developer

fees



What is Not a QRE?

• Land & Interest Carry on Land

• Building Acquisition & Interest Carry on Acquisition

• Acquisition-Related Costs

• Site Improvements & Landscaping

• Enlargements & Demolition

• Personal Property

• Tax Exempt Use Property


Sample Development Budget

Qualified Depreciable

Rehabilitation Non-Eligible Funded

Total Expenditures Basis Expense Other

Acquisition Costs-Land 40,000 - - - 40,000

Acquisition Cost- Building 120,000 - 120,000 - -

Construction Period Interest for Rehab 20,167 20,167 - -

Permanent/Construction Loan Fee 6,000 1,000 - 5,000 -

Achitectural, Engineering 28,000 28,000 - - -

Construction Contract 300,000 300,000 - - -

Site Improvements 5,000 - 5,000 - -

Contingency 35,000 35,000 - - -

Appliances 17,800 - 17,800 - -

Historic Tax Credit Application Fee 2,500 2,500 - - -

Professional Fees 15,000 15,000 - - -

Marketing & Leasing Reserves 20,000 - - - 20,000

Insurance and RE Taxes During Construction 15,000 15,000 - - -

Development Fee 124,893 83,333 41,560 - -

TOTAL APPLICATIONS: 749,360 500,000 184,360 5,000 60,000


Calculating the Credit

• QREs $ 500,000

• Credit Rate 20%*

• Credits $ 100,000

• Calculate the equity amount: $1.15 per credit multiplied by $100,000 credits = $115,000

* Credit Rate is sometimes 10%.



Calculating the Allowable Credit

Credit equals 20% of all QREs incurred:

Prior to the start of the 24-month period selected (so

long as they were incurred “in connection with” the

rehab process that resulted in the substantial

rehabilitation of the building);

During the 24-month period; and

After the last day of the 24-month period but before

the last day of the tax year in which the measuring

period ends.



When is the Credit Allowed?

• Credit is generally allowed in the year in which the

building is placed in service (provided substantial

rehabilitation test has been met).

• “Placement in Service” means that the all or

identifiable portions of the building is placed in a

condition or state of readiness and availability for a

specifically assigned function.

• If you plan on monetizing the Credit, it is very

important to plan ahead and bring in any

partners/investors prior to the Placement in Service

date.



Who Can Claim the Credit?

• The Credits belong to the taxpayer(s) that owns title

to the property when the QREs are placed in service.

• A landlord that incurs QREs can elect to pass the

credit to its long-term tenants.

• When property owner is a pass through entity, the

Credits are allocated in accordance with taxable

profits.



How to Claim the Rehab Tax Credit

• Credits are claimed by filing IRS form 3468 along with

the tax return for the year in which the taxpayer claims

the credit.

• Part 3 Approval need not have already been obtained

(but generally must be obtained within 30 months of

tax return filing date)

Tax-Exempts and Historic Tax

Credits:

• Be aware of tax exempt use issues with Historic Tax

Credits

• Section 47 of the Code provides that QRE’s eligible

for Historic Credits do not include expenditures

allocable to the portion of the property which is (or

may reasonably be expected to be) “tax exempt use

property”.

• A tax exempt entity as an owner of or tenant in a

historic building can cause a loss of Historic Tax

Credits so careful structuring of any tax exempt

entity participation is required.

• Grants/donations to the owner of a historic building

can also cause tax issues and potential reduction of

Historic Tax Credits if not handled appropriately.


Tax-Exempts and Historic Tax Credits:

• Tax Exempt Ownership:

─ Who is a Tax Exempt entity?*

•Governmental/State entities

•Any organization exempt from income taxes

(such as a 501(c)(3))

•Any foreign person or entity

•Any Indian tribal government

─ Can the Tax Exempt (or its sub-entity) make a

168(h) election to be taxed as a for-profit entity?

─ Will the same Tax Exempt be the end-user of the

Building?

*IRC Section 168(h)(2)(A)


Tax-Exempts and Historic Tax Credits:

• Tax Exempt Use:

─ Specific limitations on Tax Exempt Use by end-

user tenants

─ 50% limitation (up from 35%)

What counts towards the limitation?

─ Qualified vs. Disqualified Leases to Tax Exempt

Entities

•Did the tax exempt participate in the financing?

• Is there a fixed purchase price/option to buy

under the Lease?

• Is the Lease term in excess of 20 years?

•Has there been a “sale/leaseback” with the Tax

Exempt



Recapture

• Credit previously allowed is recaptured if any portion

of the project which includes QREs is disposed of

prior to the fifth anniversary of placement in service.

• Amount subject to recapture decreases by 20%

during each year of the five year period.

• Disposition includes any sale, exchange, transfer, gift

or casualty. Subsequent rehabs that do not comply

with the Secretary’s Standards can trigger recapture.


Recapture Risks

Recapture Risks:

Building ceases to be investment credit property

Subsequent rehabilitation of the building that does

not meet National Park Service standards;

Building is otherwise converted to an improper

use, such as personal use or goes out of service

Over 50% of the Building is leased to a tax-exempt

entity


Recapture Risks

Recapture Risks:

Change of Ownership of owner/lessee

If the Investor sells more than 1/3 of its investment

in the entity claiming the credit (owner or lessee)

If the owner is claiming the credit and the building

is foreclosed on or sold, resulting in a change in

ownership of the building. For example, where the

tenants go dark and the general partner/developer

does not have funds to support the owner’s debt

service payments.

If the lessee is claiming the credit in a lease pass-

through, and the master lease is terminated.,

including where the tenants go dark as above.

Too much nonqualified non-recourse financing


Recapture Mitigants

Recapture Risk Mitigants:

The historic property owner contractually agrees to:

not alter the appearance of the building or convert it to an

improper use,

not take any actions or inactions that would cause recapture,

not alter the ownership structure of the property, or, if

applicable, terminate the master lease

BUT under the recent safe harbor, not able to guarantee

“structure risk”.

Historic consultant or architect monitor the rehabilitation, and

certify regarding the rehabilitation meeting NPS standards

Non-disturbance agreements are entered into by the lender so that

the lender is allowed to foreclose but must not interrupt the master

lease (unless in default).

Casualty insurance, including HTC insurance, alleviates liability for

destruction of the historic property.

Underwriting of tenants to assure rent payments and guarantees of

creditworthy developer or general partner.


Common Investment Structures

• Single Entity Structure.

• Master Lease/Credit Pass-Through Structure.


Single Entity Structure

Tenants

Rental

Payments

Tax Credit Investor

LLC

Construction/

Perm Lender

Managing Member

(Developer Affiliate)

Historic

Tax Credit

Equity

99% Credits,

Profits & Losses

and Cash Flow

Loan

Proceeds

Debt

Service

Payments

Tax Credit, LLC

(Property Owner)

Tax Credit Investor

1% Credits, Profits &

Losses, Fees and

Cash Flow

Developer

Equity

Developer Dev.

Fee


Historic Tax Credit Syndication

The Credit Pass-Through Structure

• Landlord LLC owns fee simple, undertakes rehab,

enters into Dev. Agreement, and earns the Historic

Tax Credit.

• Master Tenant, LLC leases the entire project from the

Landlord LLC for a fixed annual

rental payment.


Historic Tax Credit Syndication

The Credit Pass-Through Structure

• Master Tenant, LLC operates the property, subleases

to end users and enters into the Property

Management Contract.

• Landlord makes special tax election to pass

the Historic Tax Credit through to the Master

Tenant LLC.


Master Lease/Credit Pass-Through

Structure

Sub-Tenants/

End Users

Rental

Payments

Tax Credit Investor

LLC

Construction/

Perm Lender

Managing Member

(Developer Affiliate)

Historic

Tax Credit

Equity

99% Credits,

Profits & Losses,

and Cash Flow

Loan

Proceeds

Debt

Service

Payments

1% Credits, Profits &

Losses, Fees and

Cash Flow

Developer

Equity

Master Tenant, LLC

(Master Tenant)

Landlord, LLC

(Property Owner/Lessor)

90% Profits &

Losses, Fees and

Cash Flow

Pass-through of Historic

Tax Credits & Share of

Residual Lease Payment &

Equity Investment

10% Profits, Losses,

and Cash Flow


Sample Transaction

Calculating the HTC Equity

Qualified Rehab Expenditures 24,060,799

Credit Rate 20.00%

Total Calculated Credit 4,812,160

Tax Credit Investor Allocation 99.99%

Total Credit to Investors 4,811,679

Credit Price Per Each $1 of Credit 0.98

Equity Contributions by Investors 4,727,474


Recent Developments: Case Law

Virginia Historic Tax Credit Fund 2001 LP v. CIR (3/2011)

Tax Treatment of state tax credits

Fourth Circuit decision reverses Tax Court (12/2009)

Having major impact on state tax credit structuring

Consolidated Edison Company Inc. of New York v. United States,

No. 2012-5040,(Fed. Cir. January 9, 2013)

While not a historic tax credit case, the case changes how

put options are evaluated

Historic Boardwalk Hall, LLC v. Commissioner, No. 11-1832 (3rd

Cir., August 27, 2012)

Case appealed to 3rd Circuit, and 3rd Circuit reversed the Tax

Court


Historic Boardwalk Hall: Conclusions

• The appeals court decision was primarily decided on the investor not being a partner in the transaction

• The decision did NOT provide any “bright line” guidance to restructure transactions, nor did it spell out any actions that could be taken by an investor to be deemed a partner

• It is possible to draw some preliminary conclusions and/or recommendations based on the decision, but the tax credit industry is still in flux months later

• Post HBH, historic tax credit deal structuring is being changed to maximize the potential for the investor being a partner in the transaction with a focus on downside risk and upside potential.

• IRS Guidance (Revenue Procedure 2014-12) released in early 2014

• Most deals now are being structured to comply with the safe harbor featured in the Revenue Procedure


Revenue Procedure 2014-12

• Establishes a “safe harbor” for structuring transactions

• Does not address other tax credits

• By following the terms of the Guidance, developers can be certain that the HTC generated by an investment will be allocated to the Investor and that Investor will be respected as a Partner

• No minimum amount of cash needs to be distributed to the Investor (and recent discussions with Treasury confirm this approach), therefore economic substance issues are now less important

• Investor must receive reasonably anticipated value, exclusive of tax benefits, commensurate with the Investor’s percentage interest in the Partnership



• “Commensurate” being interpreted to mean that cash flow and

residual distributions in accordance with the % interest of the

Investor (99% interest then 99% distributions)

• But a “Flip” of interests is allowed after year 5

• At least a 5% interest must be maintained, but possible to “flip”

the investor from a 99% interest to a 5% interest

• BUT economic value of the Investor’s Interest must not be reduced

through fees, lease terms or other arrangements that are

“unreasonable” compared to non-HTC projects

• This will require additional underwriting and review

• Subleases are directly challenged

• Developer Fees and Incentive Management Fees are also at issue if they are cash flow based fees

• Investor preferred returns are permitted, but they can’t be guaranteed



Downside Risk

• At least 20% of investor equity must be contributed prior to placement in service

• At least 75% of the Investor’s total expected capital contributions must be fixed before placement in service

• But this 75% portion may be subject to conditions such as placement

in service, stabilization or receipt of Part 3 approval

• Guaranties:

• Funded guaranties not allowed (including minimum net worth)

• Impermissible guaranties include:

• Guaranty of partnership distributions or economic returns

• Tax structure risk or other disallowance or recapture events not

due to an act or omission of the Developer

• Can’t pay costs of audit

• 100% structure risk now on the Investor (likely to create an

incentive for investors to meet the guidance)



• The Investor may hold an option to put its interest to the developer at an amount not to exceed FMV

• Developer may not have a call right at FMV, but because of the ability to structure a “flip” in interests after the compliance period, there is some ability to structure around this issue

• The Investor is now going to receive additional cash flow during the compliance period, and the exit will be less certain.

• Guidance effective as of December 30, 2013. Should deals that have closed but not yet placed in service restructure?


Next Steps

• Due to HBH, a limited investor market has become smaller. It is unclear if the guidance will change that dynamic.

• Meeting the Safe Harbor effectively means the investor is treated as a partner in the transaction.

• Difficult to structure “sandwich lease” transactions due to lack of upside potential, and requirement of sublease being mandated by a 3rd party

• Many investors are requiring a “Fairness Opinion/Report” regarding certain fees (developer fees, management fees, lease payments)

• Potential investment pricing considerations:

• More risk = lower tax credit equity

• More Cash Flow to Investor = More tax credit equity

• Issue of Treatment of Section 50(d) income in HTC Pass-Through Transaction


Thank You

Daniel J. Kolodner, Esq.

Klein Hornig LLP

101 Arch Street

Boston, MA 02110

617-224-0617

[email protected]


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