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Small Historic Renovation Projects Offer Opportunities for Developers, Investors

Published by Jason Korb on Thursday, August 1, 2013

Journal cover August 2013   Download PDF

The historic tax credit (HTC) industry has been hammered by summer doldrums because of the uncertainty court cases, such as Consolidated Edison Company Inc. of New York v. United States and Historic Boardwalk Hall LLC v. Commissioner, have created. In the face of the uncertain HTC investor market, where can HTC developers turn to fulfill the HTC’s mission to create jobs, infuse our economy with capital and rehabilitate dilapidated structures into community gems? Perhaps small HTC deals, those with less than $500K in total credits, are the answer.

Small HTC transactions can fulfill the intent of the HTC program while strictly complying with the Internal Revenue Service’s interpretation of the economic substance doctrine and Internal Revenue Code (IRC) Section 47. A small HTC transaction incorporates the HTCs as a component of the total after-tax return, but the HTCs are not the central component of the investor’s overall return. Although small projects sidestep some of the troubles that larger projects are facing, small HTC deals do include challenges not often encountered by their larger counterparts.

Meeting NPS Part 1 Criteria
As with large HTC transactions, the first step to identifying a potential small HTC project is to find a structure or structures listed either individually on the National Register of Historic Places or as a contributing structure in an existing National Register Historic District. It is common for larger buildings to be listed individually on the National Register or to be nominated during the development process, but registering a small building can be a challenge because it is often difficult to prove individual historical significance. Typically, small buildings fit into a larger context with neighboring properties. So, unless it’s possible to prove that Benjamin Franklin invented bifocal glasses in the parlor or the first governor of Massachusetts wrote his inauguration speech in an upstairs bedroom, finding a structure already listed on the National Register or a structure that is contributing to an already existing National Register Historic District is recommended. In addition to issues with trying to prove historical significance, the cost and time to add a small structure to the National Register is equal to the costs of listing a larger building. The National Register costs for the small project, however, represent a significantly higher proportion of the total development cost and would likely be cost-prohibitive.

A building being listed on the National Register does not guarantee that it is eligible for the HTC. Many National Register Historic District approvals are decades old and structures may have since been altered beyond recognition. It is recommended that the developer file Part 1 of the historic preservation certification application with the applicable state historic preservation office (SHPO) or contract with an experienced historic consultant to determine if the structure is still contributing to a historic district before undertaking the project.

Meeting NPS Part 2 Criteria
Large HTC transactions often entail the rehabilitation of buildings that include hundreds of thousands of square feet. They may be mills, factories or schools. The National Park Service (NPS) often requires beams, original flooring, brick, hallway widths and stairwells to be exposed and retained. Smaller HTC projects often entail the rehabilitation of homes where the developer has the opportunity to preserve and restore intricate features such as doors, clapboards, trim, moldings, columns, stained glass, marble mantles, ornate windows, ceiling medallions, and lavish stairwells. The restoration work requires careful attention to individual features, such as historic hinges or balusters, which may appear in only one location in the entire structure.

As with large HTC transactions, a coordinated team is needed to successfully identify which physical features to retain and preserve. Unless a developer has a staff member trained to identify significant historic features and describe historic rehabilitations, it is recommended that the developer retain a qualified historic consultant to assist with developing the scope of the rehabilitation and completing Part 2 of the application. Many times a small HTC transaction incorporates the retention of more discrete features than a large HTC deal. The contractor, architect, historic consultant and developer must work together to formulate the rehabilitation plan.

Deal Structure
Once SHPO and the NPS have approved the Part 2, there are a number of considerations in structuring the transaction to ensure compliance with IRC Section 47. First and foremost, the project should comfortably exceed the “substantial rehabilitation test.” In other words, your qualified rehabilitation expenditures (QRE’s) should exceed the adjusted basis of your building within a set 24-month period. In small deals, a few thousand dollars can be the difference between passing the test and not qualifying for any HTCs.

The good news is that structuring small HTC transactions can be simpler than structuring large transactions. Although large corporations with passive income tend to invest in large HTC transactions, there is still a market for smaller amounts of tax credits. Any individual who has passive income can offset their passive income with HTCs, as was common in the late 1980s when individuals often invested in tax credit transactions. Individuals can also offset a small portion of their ordinary income with HTCs, subject to certain limitations and income phase outs.

The more pragmatic approach is to find potential investors who are real estate professionals as defined by IRC Section 469(c)(7). These individuals are true investors in the transaction where the HTCs are only one component of the overall return. Also, note that pursuant to The Housing and Economic Recovery Act of 2008, HTCs can be used to offset the Alternative Minimum Tax (AMT). (Note: Developers should not advertise the investment, though, or they risk Securities and Exchange Commission issues).

The deal structure closely mirrors a non-tax credit transaction. In these single tier structures (goodbye convoluted sandwich leases!), the developer/sponsor typically does not provide any tax credit recapture guaranties and the investor is truly “at risk” where its return is derived from cash flow, losses and capital transactions in addition to receiving tax credit benefits. There are also no put or call options since investors are motivated to maximize their return through the deal’s economic success. These transactions strictly adhere to the economic substance doctrine.

Other considerations include the at risk rules. Since the investor is an individual, the investor’s capital account must stay positive for at least the five-year recapture period following completion of construction. Because of the single tier structure, the investor’s capital account must also be reduced by the HTCs, so a thorough pre-closing capital account projection is crucial. Also consider the effect of recourse and qualified non-recourse debt, as well as IRC Section 704(b) on distributions of cash flow and capital proceeds. Furthermore, since you must hold the investment as an income producing property for at least five years after the building is placed in service, consider the property management implications of operating a small property.

Finally, it is highly recommended that the developer retain an accountant and attorney experienced in HTC transactions to draft an operating agreement and financial projections that comply with IRC Section 47. Although developing an HTC operating agreement from scratch can be a time-consuming process, once you have a boilerplate operating agreement and a spreadsheet projections model, future small HTC transactions will be more streamlined.

The challenges inherent in rehabilitating a small historic building are greatly fulfilling and intellectually stimulating. Many of these dilapidated buildings have floundered in their current condition for decades. Without the federal HTC these structures would continue to be underutilized rather than contributing to communities’ growth. Rehabilitating these structures infuses capital into the local economy, supports local retailers, creates jobs and preserves the important historic fabric of our neighborhoods.

Jason Korb is the principal of Capstone Communities LLC. Prior to forming Capstone in October 2010, Jason was the vice president of acquisitions at Beacon Communities LLC, a developer, owner and manager of more than 9,000 apartment homes in the Northeast. Jason specializes in complex affordable housing and historic tax credit transactions that involve multiple government subsidies. The foregoing has been prepared for general information. It is not meant to provide legal or tax advice with respect to any specific matter and should not be acted upon without professional counsel.

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