Q&A of the Week - 11/11/2021
The topic of historic tax credits (HTCs) for the rehabilitation and adaptive reuse of older buildings is one that comes up often, particularly where we are in Milwaukee, Wisconsin. What we’ve found, however, is that while people are generally aware of the concept of HTCs, the details of what HTCs are available and what is required to obtain them are largely misunderstood. We’re dedicating today’s post to those questions and ultimately how an owner and/or developer can monetize HTCs to make rehab projects economically viable.
DEVELOPMENT QUESTION OF THE WEEK
Q: In times of limited land supply, challenging lending requirements and inflated material prices, how can historic tax credits help open up alternative development opportunities?
A: The Federal Historic Preservation Tax Incentives program – and the state programs that mimic it – was created to “encourage private sector investment in the rehabilitation and re-use of historic buildings”. The federal program is administered by the National Park Service and the Internal Revenue Service, in partnership with State Historic Preservation Offices (SHPOs). Through the program, the rehabilitation of buildings listed on the National Register of Historic Places or located in established historic districts may be eligible for historic tax credits (HTCs) at both the state and federal levels, provided that the rehab work meets specific standards. The tax credits can then be used by the owner(s) to offset their income tax liability on a dollar-for-dollar basis.
HTCs can be a true win-win-win proposition.
The HTC program is an example of public-private partnership that meets in a reasonable middle to bridge a critical financial gap and create broadly-shared benefits. As nicely summarized by Ogee Preservation and Neal Hefferren for Property Metrics:
“’Historic tax credits…are intended to make old buildings economically viable. Historic tax credits are not about restoring historic buildings to their original use and appearance…. Instead, tax credits encourage the preservation of original building materials, configurations, and appearance where possible while adapting the building for continued use in the modern world. The credits help offset the additional costs associated with the rehabilitation of historic buildings.
… Because historic projects are more labor-intensive, they provide more jobs than comparable new construction projects. Rehabilitation preserves not only historic buildings, but also precious natural resources. By rehabilitating a building rather than demolishing and building new, historic projects preserve the embodied energy in the building and avoid sending waste to the landfill. Preservationists everywhere know that the greenest building is the one already built.’
Additionally, rehabilitating these kinds of structures can spur surrounding development. Because many of these historic properties are in downtown areas, incenting their preservation and modernization can revitalize an entire downtown. Conversely, failing to do so can result in a neglected and dying downtown.”
Tax Incentives for Preserving Historic Properties
Federal credits: It’s important to first note that Public Law No. 115-97 (Dec. 22, 2017) significantly modified the federal 20% Historic Rehabilitation Tax Credit and repealed the federal 10% tax credit for the rehabilitation of non-historic buildings. See below for a discussion about the impacts of these changes. Legislation has been drafted on multiple occasions since 2017 to reinstate – and even increase – these HTCs, but as of this writing no further modifications have been passed.
20% Tax Credit: A 20% income tax credit is available for the rehabilitation of historic, income-producing buildings that are determined by the Secretary of the Interior, through the National Park Service, to be “certified historic structures.” The State Historic Preservation Offices and the National Park Service review the rehabilitation work to ensure that it complies with the Secretary’s Standards for Rehabilitation. The Internal Revenue Service defines qualified rehabilitation expenses on which the credit may be taken. Owner-occupied residential properties do not qualify for the federal rehabilitation tax credit.
10% Tax Credit [Repealed in 2017]: The 10% tax credit is available for the rehabilitation of non-historic buildings placed in service before 1936. The building must be rehabilitated for non-residential use. In order to qualify for the tax credit, the rehabilitation must meet three criteria: at least 50% of the existing external walls must remain in place as external walls, at least 75% of the existing external walls must remain in place as either external or internal walls, and at least 75% of the internal structural framework must remain in place. There is no formal review process for rehabilitations of non-historic buildings.
State Credits: Most state tax credit programs mirror the federal tax credit program, although often with different rules and percentages. The State of Wisconsin offers a 20% state tax credit for the rehab of certified income-producing properties. The tax credit must be approved by Wisconsin Economic Development Corporation, but the eligibility, timing and recapture rules are the same as for the federal historic tax credit.
What Types of Projects Are Eligible?
The NPS considers four primary factors for determining whether a project meets the requirements for the 20% tax credit:
1. The historic building must be listed in the National Register of Historic Places or be certified as contributing to the significance of a “registered historic district”. If your property is located in a National Register district or a certified state or local district, it still must be designated by the National Park Service as a structure that retains historic integrity and contributes to the historic character of the district.
2. The project must meet the "substantial rehabilitation test." In brief, this means that the cost of rehabilitation must exceed the pre-rehabilitation cost of the building. The cost of a project must exceed the greater of $5,000 or the building’s adjusted basis.
3. The rehabilitation work must be done according to the Secretary of the Interior's Standards for Rehabilitation. These are ten principles that, when followed, ensure the historic character of the building has been preserved in the rehabilitation. The Standards are applied to projects in a reasonable manner, taking into consideration economic and technical feasibility.
4. After rehabilitation, the historic building must be used for an income-producing purpose for at least five years. Owner-occupied residential properties do not qualify for the federal rehabilitation tax credit. The 20% credit is available only to properties rehabilitated for income-producing purposes, including commercial, industrial, agricultural, rental residential or apartment use.
Note that there are also several secondary factors that determine if a property is eligible for the program, as well as a stipulation that, with limited exceptions, no more than 35% of the rentable area can be leased to tax exempt entities for a building to be eligible for HTCs.
Not all project costs are allowed to be included in the HTC calculation.
In general, only costs directly associated to the repair or improvement of structural and architectural features of a historic building will qualify for the 20% federal tax credit...
Rehab of “structural components” per IRS Reg. 1.48-1(e)(2) generally qualify:
Walls, partitions, floors, ceilings
Windows, doors, permanent coverings
HVAC systems, plumbing and fixtures
Electrical wiring and lighting fixtures
Stairs, elevators, sprinkler systems
Some development “soft costs” will also typically qualify:
Construction period interest and taxes
Architect and engineering fees
Construction management costs
Reasonable developer fees
Other fees typ. charged to capital accts
However, the following do not generally qualify for rehab tax credits:
Acquisition costs, demo, new construction
Appliances, cabinets, furniture, carpeting
Decks, fencing, landscaping, signage
Parking, sidewalks, retaining walls, lighting
Financing fees, leasing costs, feasibility
Application and Approval Process
Unlike Low Income Housing Tax Credit or New Markets Tax Credit programs, which can only award a specific amount of credits, HTCs are not limited – if the requirements are met, the credits are awarded. A three-part application is required to determine eligibility for the 20% tax credit:
Part 1 presents information about the significance and appearance of the building.
Part 2 describes the condition of the building and the planned rehabilitation work. The proposed work will be evaluated based upon the Secretary of the Interior’s Standards for Rehabilitation—a set of 10 rules of practice.
Part 3 of the application is submitted after the project is complete and documents that the work was completed as proposed. National Park Service approval of the Part 3 certifies that the project meets the Standards and is a "certified rehabilitation."
The National Park Service and SHPOs can — and should — be engaged to provide preliminary feedback and advice in the early stages of project planning. According to the NPS, “Parts 1 and 2 of the application will each generally be reviewed within 60 days of receipt of a completed, adequately documented application (30 days at the State level and 30 days at the Federal level).”
Monetizing the tax credits to finance the project
While developers could certainly use the HTCs to offset their own federal and state tax liabilities, they will more typically “sell” the tax credits and use the capital raised to offset the project costs or to obtain financing. Note the quotation marks around “sell”… federal historic tax credits are issued to the property owner and are non-transferable. To work around this limitation, it is common practice for a tax credit investor to be admitted into the property ownership group – most commonly as a partner in an LLC – in exchange for a capital contribution.
In such a partnership the developer will typically assume the role of general partner, managing the rehab project and operating the property, while the investor is given a limited partner role with no operational control or authority. However, it is important to touch on three important points:
Federal and state historic tax credits are allocated based on their proportionate share of partnership profits (i.e., a partner that owns a 75% interest in the LLC will be allocated 75% of the tax credits).
The IRS requires that the transaction by which the tax credit investor joins the ownership group must have “economic substance”, meaning that the investor must have a clear stake in the economic success of the project (i.e., they must be able to prove that they have legitimate upside and downside risk). The Property Metrics article referenced earlier offers several ways in which this can be undertaken.
The building must remain in service for a “holding period” of five years, after which the developer will typically buy out the tax credit investors’ interest for a nominal amount and then decide to sell or hold the property as they choose.
The “cost” to the developer is that the tax credit investor will typically purchase their partnership interest and corresponding rights to credits at a discount — generally 5 to 10%, but sometimes as much as 25%, depending on the nature, risk and timing of the tax credits (see below for further discussion). However, the point of the HTC program is to offer sufficient financial value to offset the unique costs of these projects — including these financial hurdles and the additional expense required to meet the program’s design standards — to incentivize developers and make historical rehabilitation projects economically viable.
Warren Kirshenbaum, founder and president of The Cherrytree Group, offered the following example in an article he wrote for the CCIM Institute:
“A historic building costs $200,000 to buy and another $800,000 in qualified rehabilitation expenses. The historic tax credit amounts to 20 percent of the QREs on both the state and federal levels, which would be $320,000 in this example. A developer may monetize the federal tax credits and receive a term sheet for the purchase of the state tax credit, thereby raising actual capital (in tranches as construction progresses) for the federal tax credit. This could add $137,600 in construction capital and $275,200 in net monetization proceeds.
In a situation where the bank is only offering a loan of 60 percent of the cost of the purchase price and QREs, or $600,000, there would be a $400,000 equity requirement to fund the transaction. As mentioned above, the historic tax credit would cover $275,200 (after factoring in transaction costs) of the equity required, leaving slightly less than a $125,000 equity requirement, which is 12.5 percent of the purchase price and QREs.
Banks financing commercial real estate transactions traditionally require a 20% equity contribution by the borrower. By requiring less than the average equity requirement of 20 percent, historic tax credits make such transactions possible.”
We’ll return to Neal Hefferren for an additional useful rule of thumb:
“Aside from the $5,000 minimum investment to meet the “substantial” rehabilitation requirement, there is no minimum project size requirement. However, because the application and approval process requires significant design, legal and accounting costs, professionals in the HTC arena have suggested that projects seeking credits should have at least $1,000,000 in QREs. This number may need to be even higher if the owner wants to syndicate the credits.”
There are firms out there who specialize in monetizing HTCs
These laws and regulations are complex and obviously subject to change, making it critical that anyone interested in applying for and securing HTCs assemble a knowledgeable support team – attorneys, accountants, tax advisors, consultants, syndicators. Early confirmation that credits are achievable, usable and viable will allow the development team to more accurately integrate tax credit equity into the development pro forma. There are many firms out there who can help with this process, one of which (Moss Adams LLP) outlines their value-add proposition as follows:
“Choosing to pursue restoration and making tax decisions based on those plans can be a complex process that consumes significant time and resources without guidance from proper tax professionals—who can help oversee that the credit is properly and timely applied for, calculated, certified, and if applicable, monetized.
“Comprised of CPAs and tax attorneys, our tax team consistently works with developers, state and federal historic tax credit syndicators, financial institutions and insurance companies buying and selling historic credits—with access to all states and markets that offer transferable historic tax credit programs. This allows us to provide up-to-date market pricing and compliance with evolving legislative measures… Our expertise can help bring large returns through your tax credit transactions while avoiding substantial risk.”
Impact of 2017 HTC law changes
As briefly introduced earlier, the federal tax bill that was passed in December 2017 repealed the 10% HTC for non-historical buildings and, while it retained the 20% HTC for certified rehabilitations of historic structures, modified that credit in one very important respect. Whereas the 20% credit was previously available to the owner(s) immediately upon post-rehabilitation occupancy of the building, the credit is now required to be distributed over a five year holding period — at an equal rate of 4% per year over those five years.
How significant is this change? Anyone who understands the time value of money will recognize that spreading the credits over a five year period will reduce their value to investors. Tax credit investors who would have paid 90 to 95 cents on the dollar for HTCs in 2017 are now paying 75 to 85 cents on the dollar. The examples to the right show how these values change based on the revised distribution requirements and investors’ return expectations.
HTCs obviously remain a substantial financial incentive, but it is important that all parties clearly understand the economic implications of the 2017 law changes.
Gordon H. Bock wrote an interesting article for Traditional Building that discusses these and other potential impacts of the law change. Some points and quotes of particular note:
Some believe that the deferral of tax credit receipt – from 20% up front to now 4% per year for five years – could diminish the sale value of the tax credit by up to 30%. “As Donovan Rypkema, Principal at PlaceEconomics, put it, ‘The longer I have to wait to get paid, the less valuable that payment becomes.’”
Bock points out that other elements of the federal tax overhaul – corporate tax rate cuts and changes to depreciation rules, for two examples – will also have an impact on the value of HTCs going forward. “Says Charles A. Rhuda III, CPA, partner at Novogradac & Company LLP, ‘…for each dollar invested, the investor is not saving 35 cents anymore, they’re only saving 21 cents. So, on a yield-adjusted basis, there’s an automatic reduction in the value of the credit just for the fact that a dollar of credit buys less tax savings than it did last year.’”
States are making adjustments to their own programs in response to the federal changes. “Renee Kuhlman, Director of Policy Outreach at the National Trust for Historic Preservation, notes, for example, that in Wisconsin, the department of revenue was surprised to find that their statutes tie the timing of the state tax credit to the timing of the federal credit and will now have to be taken over a five-year period. There’s also evidence of states looking to take up the slack left by the modified federal credit. ‘In Wisconsin, for example, the recent legislative session just increased the amount of its per-project cap from $500 thousand to $3.5 million,’ says Kuhlman.”
We’re combining the Design and Construction questions this time because they’re so integrally linked when it comes to planning, budgeting, designing and ultimately performing the construction work in a manner that meets the requirements for obtaining historic tax credits (HTCs).
DESIGN AND CONSTRUCTION QUESTION OF THE WEEK
Q: My client is weighing the choice of a new ground-up development against an HTC-supported adaptive reuse of an existing historical building. I know how to budget the “new” option, but what design and construction standards must be met — and what are the true costs required — for the rehab option to obtain the credits?
A: Because of the highly variable cost – and how that cost ultimately translates into historical tax rebates and the economic viability of a historical rehabilitation project – the design and construction team members provide critical insight for a developer or third-party client considering a such a project. Given that the “Standards for Rehabilitation” outlined below are the criteria used to determine if a rehabilitation project will qualify for HTCs, it is imperative that the design and construction team members provide their clients with a comprehensive and accurate assessment of the costs and operational impacts that adherence to the Standards will require.
According to the NPS, “The intent of the Standards is to assist the long-term preservation of a property’s significance through the preservation of historic materials and features. The following Standards are to be applied to specific rehabilitation projects in a reasonable manner, taking into consideration economic and technical feasibility.”
NPS Illustrated Guidelines for Rehabilitating Historic Buildings (click on image to download PDF)
The Secretary of the Interior’s Standards for Rehabilitation
A property shall be used for its historic purpose or be placed in a new use that requires minimal change to the defining characteristics of the building and its site and environment.
The historic character of a property shall be retained and preserved. The removal of historic materials or alteration of features and spaces that characterize a property shall be avoided.
Each property shall be recognized as a physical record of its time, place, and use. Changes that create a false sense of historical development, such as adding conjectural features or arch elements from other buildings, shall not be undertaken.
Most properties change over time; those changes that have acquired historic significance in their own right shall be retained and preserved.
Distinctive features, finishes, and construction techniques or examples of craftsmanship that characterize a historic property shall be preserved.
Deteriorated historic features shall be repaired rather than replaced. Where the severity of deterioration req’s replacement of a distinctive feature, the new feature shall match the old in design, color, texture, and other visual qualities and, where possible, materials. Replacement of missing features shall be substantiated by documentary, physical, or pictorial evidence.
Chemical or physical treatments, such as sandblasting, that cause damage to historic materials shall not be used. The surface cleaning of structures, if appropriate, shall be undertaken using the gentlest means possible.
Significant archeological resources affected by a project shall be protected and preserved. If such resources must be disturbed, mitigation measures shall be undertaken.
New additions, exterior alterations, or related new construction shall not destroy historic materials that characterize the property. The new work shall be differentiated from the old and shall be compatible with the massing, size, scale, and architectural features to protect the historic integrity of the property and its environment.
New additions and adjacent or related new construction shall be undertaken in such a manner that if removed in the future, the essential form and integrity of the historic property and its environment would be unimpaired.
NPS Standards for Treatment of Historic Properties (click on image to download PDF)
The NPS web site offers a substantial amount of guidance to designers and construction professionals tasked with applying the Secretary’s Standards for Rehabilitation, including collections of case studies related to commonly-encountered design questions, construction challenges and rule interpretations…
NPS Guidelines for Sustainability for Rehabilitating Historic Properties (click on image to download PDF)
Cumulative Effect and Historic Character explains that projects meet the Standards when the overall effect of all work on the property is consistent with the property’s historic character.
Interpreting the Standards Bulletins are case studies of specific rehabiliation treatments that do and do not meet the Standards.
Planning Successful Rehabilitation Projects provides guidance and other informatin on applying the Standards to some common rehabilitation concerns, including windows, interior treatments, additions and new construction, and modern requirement, technologies and materials.
Incentives is a guide to the Historic Preservation Tax Incentives program and includes examples of additional treatments that do and do not meet the Standards.
There are also several consulting firms, MacRostie Historic Advisors LLC being one, with specialized experience and expertise to support design and construction teams in properly executing HTC projects. As they put it…
“We are a valuable resource in the design process by advising our clients and project teams in ways to avoid any pitfalls or snags that may disqualify them from the tax credit programs or prolong the review of their certification application at the state or national level. From preliminary design review to ongoing project monitoring and management, our experts are an essential team member for successfully attaining historic tax credit equity.”
Interested in learning more? JJH3group is a commercial real estate development and design-build advisory firm based in Milwaukee, WI. The firm was founded on a core set of guiding values and principles, providing clients with quality development, design and construction services across a broad spectrum of project types. We are experienced in assembling multidisciplinary teams and partnering with public and private stakeholders to deliver well-designed, functional and efficient facilities. Let JJH3group help you plan and manage your next project. For a free consultation, please contact us at JJH3group@gmail.com or (414) 333-3430.
