Historic Rehabilitation Tax Credits: Using Tax Incentives to Develop and Invest in Historic Properties - GSMSummit 2014, Dan Kolodner

www.kleinhornig.com
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
www.kleinhornig.com 2

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.

The NPS Rules: Certified Historic Structure Requirement
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 (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.

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?
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).

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
Tax Credit Investor
LLC
Rental
Payments
Tenants
Managing Member
(Developer Affiliate)
Tax Credit, LLC
(Property Owner)
Construction/
Perm Lender
Historic
Tax Credit
Equity
99% Credits,
Profits & Losses
and Cash Flow
Loan
Proceeds
Debt
Service
Payments
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
Tax Credit Investor
LLC
Rental
Payments
Sub-Tenants/
End Users
90% Profits &
Losses, Fees and
Cash Flow
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)
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
dkolodner@kleinhornig.com

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