When it comes to commercial real estate, a variety of investing strategies exist. One of the more niche – but extremely valuable – strategies involves historic tax credits. Broadly speaking, federal and state governments offer real estate investors tax incentives to rehabilitate historic properties while retaining their original aesthetics. As such, we’ll use this article to outline historic tax credit real estate investing – from both the developer’s and investor’s perspectives.
Specifically, we’ll cover the following topics:
- An Overview of Historic Tax Credit Investing in Real Estate
- Historic Tax Credits – the Developer’s Perspective
- Historic Tax Credits – the Investor’s Perspective
- Final Thoughts
An Overview of Historic Tax Credit Investing in Real Estate
The Concept
At the federal level, the government has established a program to incentivize the rehabilitation of historic properties. Administered by the National Park Service (NPS), the Federal Historic Preservation Tax Incentives program encourages real estate developers to rehabilitate and re-use these buildings. And, numerous states (currently over 30) have followed suit, offering their own versions of this tax incentive. Many of these state-level programs have been modeled after the federal one. However, for the sake of simplicity, we will focus solely on the NPS-administered program in this article.
From the government’s perspective, this historic tax credit program offers two broad advantages. First, by incentivizing private sector investment, the program indirectly creates jobs. Every project requires labor across the entire spectrum of real estate development, from architects to electricians to property managers and everyone in between.
Second, the historic tax credit program has created a cost-effective and extremely successful means of community revitalization. According to the most recent numbers, the NPS program has leveraged over $102.64 billion in private investment to preserve 45,383 historic properties since beginning in 1976. Many of these historic structures are located in underserved communities, places that have not traditionally received significant outside investment. With these tax credits, the federal government incentivizes private investment and revitalization in these communities, driving economic growth in the process – while still retaining the historic “look and feel” of the neighborhood.
Tax Credit Details
Through the federal program, real estate developers can qualify for a 20% income tax credit for rehabilitating historic, income-producing properties (owner-occupied residential properties do not apply). These properties must qualify as “certified historic structures,” a designation provided by the NPS. In other words, an old property doesn’t automatically qualify simply because it’s old.
Once a property meets this qualification, subsequent rehabilitation work must comply with strict standards. Outlined in the Secretary of the Interior’s Standards for Rehabilitation, these standards serve as the foundation for calculating the 20% tax credit. That is, the IRS calculates the credit based on qualified rehabilitation expenses (QREs) – not all rehabilitation expenses apply. In general, only the costs directly related to the repair or improvement of structural and architectural features of a historic property count towards this credit. While not an all-inclusive list, here are some of the more common QREs (of note, acquisition costs do not qualify):
- Walls
- Partitions
- Floors
- Ceilings
- Permanent coverings, such as paneling or tiles
- Windows and doors
- Components of central air conditioning or heating systems
- Plumbing and plumbing fixtures
- Electrical wiring and lighting fixtures
- Chimneys
- Stairs
- Escalators, elevators, sprinkler systems, fire escapes
- Other components related to the operation or maintenance of the building
Say, for example, that a project has $1,200,000 in total rehabilitation expenses. Following a cost audit, it is determined that $1,000,000 of these expenses are qualified rehabilitation expenses. At 20%, these QREs would create a $200,000 tax credit for the historic rehabilitation project.
This program creates tremendous financial opportunities for two parties: real estate developers and historic tax credit investors. In the next two sections, we’ll review the program from both of their perspectives.
Historic Tax Credits – the Developer’s Perspective
Continuing the above example, many real estate developers may not have a $200,000 tax bill. As a result, a $200,000 tax credit wouldn’t be effectively used. Rather, the historic tax credit program proves so appealing due to its deal financing potential. In a properly analyzed deal, real estate developers can use this program to finance a development with no (or very little) contributed capital.
For instance, say a developer can purchase an unused school building from a local government for $500,000. With “certified historic structure” designation, the developer envisions converting this old school into luxury apartments. In underwriting the deal, the developer estimates a rehab budget of $8,000,000. Of that total, assume $6,000,000 represents QREs towards the tax credit calculation, generating a credit of $1,200,000 ($6,000,000 x 20%).
As stated, the developer likely cannot use this entire tax credit. Instead, the team brings on a historic tax credit investor, an entity or individual that can use the credit. And, as an incentive, the developer offers these credits to the investor at 80 cents on the dollar. With this design, the investor would contribute $960,000 ($1,200,000 x 80%) in capital to the project and receive all of its historic tax credits in return.
Now, assume that the stabilized property appraises at $10,000,000. At 80% loan-to-value, the developers secure an $8,000,000 permanent mortgage. With $8,500,000 in total costs (acquisition plus rehab budget) minus the $960,000 in contributed capital from the historic tax credit investor (typically used to curtail the deal’s short-term financing), the permanent mortgage exceeds all project costs. That is, the historic tax credit developers can complete this deal with no contributed capital.
NOTE: Developers will need cash – either their own or through bridge financing – to qualify for the initial acquisition/construction loan. Therefore, while a solid historic tax credit deal doesn’t ultimately require contributed capital, developers will need cash temporarily until receiving the investor contribution and permanent financing.
Yes, these are basic numbers used for explanatory purposes. But, the major takeaway is the incredible financing potential that the historic tax credit program offers. In a properly analyzed deal, you can develop and control a commercial real estate project with no contributed capital.
Historic Tax Credits – the Investor’s Perspective
Whereas most real estate developers view the historic tax credit program as an efficient means to finance deals, tax credit investors have a different focus. To these investors, the historic tax credits from a deal provide an opportunity to significantly reduce tax bills. For instance, banks and other lending institutions frequently join deals as historic tax credit investors, as they generally have large enough tax liabilities to put the credits to good use.
In the above example, the tax credit investor paid 80%, or $960,000, for all of the deal’s federal tax credits ($1,200,000 in total tax credits x 80%). With the federal tax credit program, these tax credits must be used across five years. Accordingly, this investor would receive a 20% discount on its first $240,000 in federal income tax for the next five years ($1,200,000 in total tax credits / 5 years).
However, the 80% used in this example is not a hard and fast rule. Depending on the market, historic tax credit investors may command anywhere from 60 cents to 95 cents on the dollar of each credit. Regardless of number, the important takeaway for investors is the tremendous tax-saving potential of historic tax credit deals.
Final Thoughts
The above article only scratched the surface of the NPS Federal Historic Preservation Tax Incentives program. Our intent was not to make readers experts in this system. Rather, this article should introduce people to the potential benefits to historic tax credits in real estate – both as a developer and an investor.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available historic tax credit investment opportunities.