History in the Making
Tax credits help developers fund certified property rehabilitations.
By taking advantage of rehabilitation tax credits sprovided under Internal Revenue Code Section 47, owners or developers of historic properties can inject significant equity into their real estate projects to cover funding gaps, increase project amenities, or avoid expensive bridge financing. RTCs are equal to 20 percent, or 10 percent in certain instances, of the qualified rehabilitation expenditures incurred in the certified rehabilitation of a certified historic structure. RTCs work with any type of real estate held for investment, such as office buildings, residential rental properties, and mixed-use complexes; however, for-sale condominium projects are not eligible. Developers can successfully combine RTCs with state historic credits, new-markets tax credits, and low-income housing tax credits to further maximize project equity.
Retailer Urban Outfitters used federal rehabilitation tax credits
to help finance the $100 million transformation of Philadelphia’s
historic naval yards into a national corporate headquarters.
RTC qualification requires compliance with National Park Service standards for historic rehabilitation. Both the property and the planned rehabilitation must be NPS-certified before any RTCs can be claimed. While NPS compliance always is more expensive than non-certified rehabilitation, the investor equity from a certified rehabilitation project can be worth the additional compliance cost.
Because of RTCs’ tax benefits, there is an active market of corporate investors who invest in historic projects. With prices over $1.00 per RTC, investor equity often equals or exceeds 15 percent of historic rehabilitations’ total hard costs. However, RTCs cannot be “stripped” or sold independent of an ownership interest in a project. Therefore, developers who want to use RTC equity must be willing to accept investors as partners.
Partnering With an Investor
To claim RTCs, investors must become partners before a project is placed in service. RTCs are allocated tax items that flow from the owner or developer to the partners in accordance with the partners’ respective interests in bottom-line profits. This means that RTC investors must receive 99 percent or more of profits from project operations to maximize the allocation of RTCs and the investors’ equity contribution. Investors also will seek a priority return of cash flow from their investments typically equal to 2.5 percent to 3 percent of invested equity after taxes, in addition to any residual cash flow that is left for distribution.
Thus, developers must share project economics with RTC investors. However, projects can be structured so that the developer receives reasonable development and project management fees prior to sharing net profits with the investor.
Investors also will protect their investment by requiring a voice in important development or operational decisions and will insist on developer guarantees of project performance.
During the five-year period after the credit is initially earned, RTCs can be recaptured if the property is sold or foreclosed on, the project fails to comply with the historic rehabilitation standards, or a partner disposes of more than one-third of its interest. However, during the recapture period, 20 percent of the RTCs vest cumulatively each year and no longer are subject to recapture. Accordingly, investors must remain partners for a minimum of five years after project completion to claim 100 percent of the RTCs.
In the simplest RTC investment structure, which often is combined with LIHTC investments, the investor acquires a 99 percent partnership interest in the property owner in exchange for its equity contribution. The IRC requires that the owner reduce the property’s depreciable basis by the RTC amount, and the owner’s partners must reduce their capital accounts in an amount equal to the RTC share each partner receives. In other words, the total amount of depreciation deductions available from the property is reduced by the RTC amount and the income recognized upon the property’s sale may be greater. Because the partners’ capital accounts also must be reduced, investors either will recognize less loss or more gain on the sale of their interests than otherwise would have been recognized, reducing the return to the investors.
In a more-complex investment structure, a master tenant entity is formed to lease and operate the entire property, the developer maintains a much higher ownership interest in the owner, and investors are admitted to the master tenant to receive income and cash from the property’s operations. If various technical rules are complied with, RTCs associated with the rehabilitation may be passed through to the master tenant. In this case, there is no reduction in the basis of the property from the RTC, but the master tenant must take into income a ratable amount of the RTC amortized over the depreciable life of the property. While this results in annual income to the partners of the master tenant, the owner is entitled to depreciation based upon the property’s unreduced depreciable basis, and the partners of the master tenant do not have an immediate downward adjustment in their capital accounts. This structure also may permit greater fine-tuning of the way the developer and the investor share project economics.
Equity investors will demand that their interests in the project be protected from the risks of recapture. Accordingly, developers must expect to identify guarantors of substantial net worth to provide completion guarantees, guarantees against operating deficits, and recapture guarantees.
Although investors may not be forced to leave the partnership for less than the fair-market value of their shares, both investors and developers typically want the option to unwind the transaction after all of the credits have vested and cannot be recaptured. This almost always is accomplished by granting the investor the option to “put” its interest to the developer or an affiliate for a percentage, often 15 percent to 20 percent, of its invested equity. If the investor does not exercise its option, the developer typically has a call option to buy the investor’s interest for its then fair-market value. This exit strategy allows the investor to evaluate the benefits of selling its interest after the value of the RTC has been realized or remaining in the deal to recognize potential future economic benefits. However, the developer may pay fair-market value for the investor’s interest to unwind the transaction, even if the investor chooses not to exercise its put option.
Enhancing RTC Projects
Many states have rehabilitation tax credits with rules similar to the federal program, although some state credits are as high as 30 percent of QREs. Like federal RTCs, many state RTCs must be allocated to a partner with an ownership interest in the project, but many also can be stripped and sold as certificates. Investors and developers should note that there are numerous federal income tax consequences in structuring state tax credits and many traps for the unwary. However, they often make the difference between a project that is feasible and one that is not by increasing investor equity and expanding the universe of potential investors.
If the property is located in a low-income area, it also may qualify for the new-markets tax credit, a credit commonly combined with RTCs. While these additional credits add complexity (and cost) to the transaction, the extra financing generated from these credits can be well worth it.