I see that several people have already posted answers, which are correct. There are federal and state programs. You should also consider faster depreciation under the new tax laws as well.
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How do historic tax credits work?
We are looking at a couple of investment opportunities as an LP investor. One of the opportunities is a hotel conversion project in a downtown district that is undergoing a lot of change. We have been told by the GP that the project is eligible for historic tax credits. We are not familiar with historic tax credits. How do they work? How do they impact the profitability of a project from an investor’s standpoint?
Answers
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There are federal historic tax credits and state credits. I believe the federal citation is Public Law No. 115-97 (Dec. 22, 2017). This is an area that has seen some changes, as recently as 2017. You need to retain experts to research whether you can apply for the tax credits. As to whether you get a state credit, it depends on which state. As a general matter, note that rehabilitating a historic site has a substantial amount of restrictions as to what you can and cannot do and, before you invest, this has to be deeply researched, as this can add time and money to any budget.
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Federal income tax credits for historic properties have benefitted several projects we have handled. The requirements for qualifying for historic tax credits are highly technical, but, assuming as you have stated that the project would qualify, credits against federal income taxes are available to the entity or the investors, depending on how the entities are organized. That is, every dollar of tax credit allowed per year can be applied against federal income tax liability for that year. Note that federal tax credits do not serve to diminish state income taxes, but depending on the jurisdiction in which the project is situated, there may be state income tax credits, real estate tax reductions or other state and local tax advantages associated with an historic property. The value of the tax credits to an investor will be a function of the investor's projected federal income tax liability for the periods in question, both in terms of the marginal tax rate and the overall size of the liability. Thus, if the investor or project entity is projected to have a relatively low federal income tax liability, the tax credits can, in effect, be sold to a third-party investor who pays significantly larger federal income taxes at a relatively high marginal tax rate.
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Based on our facts, there is incentive goal. The program encourages private sector investment in the rehabilitation and re-use of historic buildings. There are credits for rehabilitating non-historic buildings constructed before 1936 and another federal tax credit allowing participants to claim 20 percent of eligible improvement expenses against their federal tax liability on the qualified rehabilitation expenditures (QREs), use as rental residential and non-residential purposes. Those who qualify for 10 percent are not eligible for 20 percent. There is also a historic tax credit. QREs are construction and soft costs (i.e. repair, replacement of walls, floors, ceiling, etc., as well as architectural fees, rehab loan interest). The dollar value of tax credits is calculated by multiplying the value of the QREs by the 20 percent HTC rate. Banks can earn a return on these investments by offering discounted pricing for the credits. When the owner of a rehabilitated property is unable to use the tax credits, it creates limited partnerships (LP) that allow third-party funders, such as banks that can use the credits, to provide financing for the project. When third parties provide funding in exchange for the credits, it helps reduce the project’s need for additional financing. In order to qualify for HTCs, a building must be depreciable, so it must be income-producing or used in a trade or business. In addition, a “substantial” amount must be spent rehabilitating the historic building, meaning that the cost of rehabilitation must exceed the pre-rehabilitation cost of the building. There is some risk. Banks or investors, as limited partners/members of LP/LLC subsidiaries, must retain ownership of the property for a five-year compliance period following the year the property is placed in service to avoid tax credit recapture. Once the five-year compliance period is over, the IRS cannot recapture the tax credit and a bank is free to exercise its right to sell its interest in the partnership. To receive HTCs, property owners must complete the historic preservation certification application process. Typically, this process involves developer interaction with a SHPO. There are three parts to this process: part one, certification of the building as an historic structure; part two, certification of the proposed rehabilitation plan for the building; and part three, certification that the rehabilitation has been completed according to the certification rehabilitation plan. A developer’s completion of at least part one and part three of the certification application process is an important consideration for banks contemplating funding an HTC project. Without having completed part two certification, a project may not receive the final rehabilitation certification (part three), thereby putting the tax credit funds at substantial recapture risk.
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This is a complicated question depending on what the GP has in mind and your ability use actually use the tax credits, which is not clear. First of all, to be available for an HTC, the building must have been designated on the National Register of Historic Places as a landmark. If it has, then the property owner is entitled to receive federal tax credits based upon the amount of eligible capital expenditures spent on improving the historic building. Assuming the highest bracket U.S. tax rate for individual taxpayers of 38 percent (now 21 percent for C corporations), each dollar of an HTC is worth 38 percent (or 21 percent for corporations) to the taxpayer. HTC can be used by and passed through to partners of the owner, or it can be sold to third-party investors who would pay cash for the HTCs that would be invested into the project as owner equity through a complex lease structure, which does make bank financing more difficult to obtain due to the added complexity. Market rates for selling these tax credits to a tax credit investor (usually a large corporation whose tax benefits have been reduced recently due to the reduction in corporate rates from 35 percent to 21 percent) constantly changes, depending on the number available and tax rates in effect at that time. The financial analysis of the benefit to each project requires a good amount of work and due diligence.
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