Recently, developers and investors in historic rehabilitation projects—and the communities in which they work—let out a big sigh of relief. After months of uncertainty, the Internal Revenue Service issued guidance on January 9, 2014 that cleared up the terms by which developers can allocate to their investors the federal income tax credit that has been a linchpin of the financing—and ultimate viability—of historic rehabilitation projects. Before we explain the main takeaways from the IRS guidance, some context is necessary for the uninitiated…
The commercial reuse of historic properties is more expensive to execute than new construction. So, the federal government created an income tax credit in 1978 for qualifying historic rehab projects that offsets much of the developer’s additional expense. However, the tax credit is claimed over 5 years following the completion of the project. So, developers form partnerships with investors to transfer rights to the stream of income tax credits in exchange for up-front capital to fill the financing gap between the cost of the project and the loan the bank is willing to make.
Since 1978, the federal tax credit has spurred more than $106 billion of investment in historic rehabilitation projects across the U.S., creating more than 2.3 million jobs (measured as person-years), according to a report by the National Park Service, which qualifies projects for the tax credit. North Carolina also offers a complementary state income tax credit to provide deeper subsidy for projects that are more difficult or less attractive to investors.
Leveraging the federal and state tax credits, many North Carolina towns are rejuvenating distressed areas of their community through the adaptive reuse of historic properties. Examples range from a 30,000-sq. ft. river mill conversion into retail in Northwest North Carolina to a former bank tower repurposed as a 125-room boutique hotel and art museum in the Triangle. Recently, the fate of such catalytic projects hung in the balance.
The uncertainty began with the U.S. 3rd Circuit Court of Appeals ruling in September 2012 to disallow the allocation of historic tax credits to the investor in the Historic Boardwalk Hall partnership in New Jersey. The court found that the investor did not have a meaningful stake in either the financial upside or downside of the project, having created a set of partnership agreements with the developer that effectively guaranteed the investor the tax credits and no other economic return. Thus, the investor was deemed to not be a true partner in the historic rehab project.
While the Historic Boardwalk Hall partnership was atypical in many respects, after the ruling the IRS began to audit historic rehabilitation partnerships more severely, applying the court’s logic to disallow other tax credit allocations using more run-of-the-mill transaction structures. These actions sent the marketplace for historic tax credit equity into a deep freeze.
For months the pipeline of historic rehabilitation projects was slowed, if not halted, due to a lack of clarity around legitimate tax credit partnerships. This reaction led the IRS to formulate a set of guidelines to give investors comfort. Released in Revenue Procedure 2014-12, these guidelines (not regulations or laws) provide for a “safe harbor” in which the IRS will not challenge the allocation of historic tax credits to investors.
The Historic Tax Credit Coalition provides an excellent overview of the implications of Revenue Procedure 2014-12 for developers and investors. The main takeaways are highlighted below:
- The guidance only applies to the historic rehab tax credit, not to other federal tax credits such as the Low-Income Housing Tax Credit or New Markets Tax Credit.
- The Developer (or general partner) needs to have a minimum 1% interest in the partnership. The Investor (or limited partner) must have a minimum interest of at least 5% of its largest share of the partnership (i.e. if the investor owns 99% of the partnership at the beginning, they can flip their share down to a minimum of 4.95%).
- The Investor’s partnership share needs to be based on a bona fide equity investment with anticipated value contingent on the Partnership’s net income, gain, and loss and not “substantially fixed.” The Investor must also “not be substantially protected from losses.” The Investor’s partnership share cannot be artificially reduced through unreasonable fees or lease terms, which should be justified with market comparables.
- The Investor must contribute at least 20% of its equity before the building is placed in service. That 20% cannot be protected from loss in any way. At least 75% of the total expected equity contribution must be fixed before the building is placed in service.
- Examples of permitted guarantees are completion guarantees, operating deficit guarantees, environmental indemnities, and financial covenants. The guarantees must be unfunded, meaning there cannot be money or property set aside for specific payment of the guarantee. Reserves of 12 months of operating expenses or less are acceptable.
- The Developer cannot have a call option to buy the Investor’s interest in the partnership. The Investor can have a put option to sell its interests to the Developer at fair market value.
In the short time that the IRS guidance has been out, anecdotal evidence suggests that the marketplace for historic tax credits is functioning again. With developers and investors confident in the legality of their tax credit partnership, communities in North Carolina will continue to tap this financing tool to repurpose some of their most historic commercial properties for new economic activity.
For additional information about filling financing gaps in historic rehab projects even after the tax credit has been utilized, check out this CED blog post about mezzanine debt.
Peter Cvelich is a candidate for the MBA and MCRP graduate degrees and is a Community Revitalization Fellow with the School of Government’s Development Finance Initiative (DFI).