Tax issues

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.

Investment Period

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.

Typical Structures

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.

Exit Strategies

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.

Kristin A. DeKuiper, JD, and Jeffrey D. Gaulin, JD

Kristin A. DeKuiper, JD, is a partner in Holland & Knight LLP’s syndication practice group in Boston. Contact her at (617) 523-2700 or kristin.dekuiper@hklaw.com. Jeffrey D. Gaulin, JD, practices in Holland & Knight LLP’s syndication practice group in Boston. Contact him at (617) 523-2700 or jeff.gaulin@hklaw.com.Qualifying for RTCsSince qualifying for federal rehabilitation tax credits requires compliance with the National Park Service standards for historic rehabilitation, a project’s owner or developer must file parts 1 and 2 of the historic certification application. Part 1 documents the property’s historic status, and once it is approved by the NPS, the property becomes a certified historic structure eligible for RTCs.The project’s owner then must seek approval for the rehabilitation plan by filing part 2 of the application. Approval requires a strong understanding of NPS guidelines and the RTC program. For example, under NPS guidelines, repair of original windows always is preferable to replacement. Or, in another instance, project timing may favor a phased rehabilitation, but the tax consequences of a phased project will be affected by the way this is presented in the part 2 filing. Part 2 approval usually is subject to a list of conditions that must be satisfied to win final approval. A heavily conditioned part 2 approval can slow the closing process, delay equity contributions, or increase guaranty requirements.In addition to complying with NPS standards for rehabilitation, the property and the rehabilitation also must qualify under the Internal Revenue Code. The IRC requires that the rehabilitation itself be “substantial.” This means that the qualified rehabilitation expenses incurred in connection with the rehabilitation must exceed the greater of $5,000 or the adjusted basis of the property as of the start of a 24?month measuring period (60 months for a phased rehabilitation) selected by the owner that ends in the year the project is placed in service. The measuring period is only a tool for testing the rehabilitation’s substantiality, and costs incurred before the commencement of the measuring period may be included in the project’s QREs, as can costs incurred through the end of the taxable year in which the measuring period ends. In the case of a “rolling rehabilitation,” the project even may involve multiple measuring periods. In all cases, QREs incurred during the selected measuring period or periods must meet the substantial rehabilitation test to qualify the project for RTCs.At its most basic, a QRE is any expense properly capitalizable into the depreciable basis of the property, but excluding certain specified costs such as site work, enlargement costs, and demolition costs. The RTC is earned in the year in which the QREs are placed in service. This most commonly is documented with a certificate of occupancy. Buildings, floors of buildings, or even portions of buildings may be placed in service separately.Particularly complex issues are encountered when tax-exempt entities are involved in the project’s development and when the project is to be leased to or operated by tax-exempt entities. Accordingly, structuring a successful RTC project requires the assistance of competent tax counsel and accounting professionals.

Recommended

Forming a Tax Plan

March.April.19

The real estate industry generally fares well under the 2017 Tax Cuts and Jobs Act, but many new provisions heighten the importance of advance tax planning for real estate investors.

Read More

Main Street Win

September.October.18

The recent court decision of South Dakota v. Wayfair is a win for commercial real estate, brick-and-mortar businesses, and state and local governments alike, bringing similar taxes to online and brick-and-mortar transactions.

Read More

Navigating Stormy Seas

Mar.Apr.17

For most real estate analysts, the beginning perspective for retail real estate market analysis is often a site in search of a user, according to “A Rational Approach to Feasibility Analysis” in The Appraisal Journal. This is consistent with the theory that a user can pay the most to occupy a site since the user can place it into productive use immediately. An astute investor or developer values the property based on what the user can afford to pay to occupy the space.

The Graaskamp Legacy reiterated the Graaskamp courses of action that exist in real estate feasibility, which include the site in search of user, site selection, and an investor looking for an investment property.For years, the Chicago Housing Authority was the poster child for development gone wrong. Cabrini Green, for example, became  a breeding ground for crime and was far more dangerous than the housing it replaced. On the bright side, Austin, Texas, shows how good development planning enhances a city's prosperity enticing more companies and employees.

Read More

Taxing Changes

Mar.Apr.13

In the wee hours of Jan. 1, 2013, Congress passed the American Taxpayer Relief Act of 2012 and the tax changes that resulted will drastically alter the way commercial real estate professionals plan for major transactions. Additionally, tax provisions written

Read More