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The rise of the State Historic Rehabilitation Tax Credit.

The popularity and effectiveness of the Federal Historic Rehabilitation Tax Credit program has soared in the past few years, with unparalleled numbers of real estate developers taking advantage of this lucrative financing tool.

While this may come as no surprise to those of us in the industry, what has raised a few eyebrows is the cutting edge appearance of the State Historic Rehabilitation Tax Credit that can be combined with the federal tax credit on the same project.

For the uninitiated, the Federal Historic Rehabilitation Tax Credit is a dollar-for-dollar reduction of federal income tax liability, and is calculated as a percentage, 20 percent or 10 percent, of the eligible rehabilitation expenditures for either certified historic buildings, or non-historic, non-residential buildings constructed before 1936. These tax credits can be either used to offset the property owner's tax liability or sold to a tax credit investor in exchange for additional equity capital that can be used for the project's long-term financing. Faced with these options, most developers elect to syndicate or transfer the tax credits to a corporate investor because under current federal tax law, such as the Passive Activity Rules and the Alternative Minimum Tax Regulations, corporations constitute the most efficient tax credit consumers.

Recognizing the monumental role that historic tax credits have played in encouraging community redevelopment and preserving our nation's historic structures, and noting the success of the federal program, several states have adopted new legislation establishing State Historic Rehabilitation Tax Credits. Among the primary forerunners are Colorado, Indiana, Maryland, Michigan, Missouri, New Mexico, North Carolina, Utah, Vermont, Virginia, West Virginia, and Wisconsin, with rumors of pending legislation in other states such as New Jersey, Pennsylvania, New York and California. However, unlike the federal program, the individual states are achieving mixed results.

In theory, any additional equity that can be generated from State Historic Rehabilitation Tax Credits should be encouraged and applauded. After all, it's never easy to convince state officials' to withdraw money from the tax coffers, even if studies show that historic tax credits taken today will result in greater economic benefits tomorrow, including more employment, income, wealth and tax revenues from productive real estate. Yet, from the practical perspective of a firm that advises developers upon the nuances of understanding, structuring and syndicating both federal and state historic tax credits, further legislative refinements are necessary in many instances to achieve more efficient utilization of the state tax credits.

Generally, most of the basic provisions of the existing State Historic Rehabilitation Tax Credit programs are sufficient because they derive from the time-tested federal model. However, in working with various state tax credits, we have observed modifications that would make the state tax credits more user friendly - both to the developer, in need of equity and the "willing" investor. An old quote comes to mind, "There is no such thing as a free lunch." Placed into context, the lesson to be heeded is that there are transaction costs associated with the most seamless transfer of tax credits, such as expenditures for legal, accounting and syndication. As a result, larger state tax credits without maximum cap amounts are preferable in order to motivate developers and investors alike to proceed along the historic redevelopment path. Thus, developers in states such as Maryland, Missouri and Virginia, with a generous 25 percent state tax credit, will generally fare better in transforming those tax credits to real e quity dollars and therefore, finished restoration projects, as opposed to those states with a 5 percent state tax credit or a restrictive tax credit cap per project. Similarly, states that permit the full amount of tax credits to be recognized and applied in the year in which the developer places the building into service will generate a higher equity raise for developers, and thus, be more attractive than those allowing only a modest percentage of the full amount of the tax credits to be applied each year, over a multiyear period.

Another area of concern is the appetite of investors, for State Historic Rehabilitation Tax Credits. Simply put, because the majority of states only allow the state tax credits to offset state income tax, investors need to have state tax liability to effectively utilize the tax credits. Where the desired investor is a national corporate entity, this can prove problematic. Ways to mollify this factor include permitting the state tax credits to reach beyond traditional income tax to other state tax revenues, such as state franchise tax and state sales and/or use tax. A second approach is to adopt more generous carry back and carry forward rules. As a result, a national investor with an insufficient annual state tax liability would be afforded a longer period in which to apply the tax credits against their past and future tax liability before losing the tax credits altogether.

One might ask why a developer would choose a national corporate investor given the potential limitations on the national investor's use of the state tax credit. The answer lies in the investor's experience, ability to utilize the federal tax credit, and economies of scale. Overall, there are very few local state investment entities that have enough state and federal tax liability to absorb several million dollars in historic tax credits. In this regard, while our firm has syndicated projects with combined federal and state tax credits in the $2 million range, we usually consult on single projects capable of generating well in excess of $5 million. Of those local state investment entities who might satisfy this criteria, few are aware of the tax credit, and even less have experienced and survived the trials and tribulations of bidding, negotiating, closing and funding equity pursuant to a historic tax credit transaction. Thus, given the choice of selling the federal and state tax credits, especially where time is of the essence, the experienced national corporate investor with a proven record of funded deals is often the better option. While the pricing on the state tax credits may not be as high as that of a local state investor, the tangible benefits of lower transaction costs and top dollar pricing on the federal tax credits, combined with the intangible benefit of "deal certainty," will go a long way to fill that gap.

But wait, is it possible to bifurcate the deal structure so that a national investor purchases the federal tax credit and a local state investor purchases the state tax credit? Yes and no. While new legislation is pending, currently only a few of the State Historic Rehabilitation Tax Credit programs, such as Missouri and Virginia, have granted the express ability to separate the federal and state tax credit investors on the same transaction. Outside of these jurisdictions, bifurcation of the deal structure may be accomplished by utilizing the Internal Revenue Code's "passthrough" elections in a complex master lease model. However, while this approach provides an excellent solution for individual transactions, the typical strategies driving both developers and investors, as well as the inherent requirements of the lease structure, limit its widespread applicability. Rest assured, however, that this state of affairs in no way suggests that local investors should be treated as second-class citizens.

As investor awareness grows and more state legislators plunge headlong to enact state historic tax credits, it's a safe bet that increased numbers of experienced national and local state investors will enter the combined federal and state tax credit arena. Let's just hope that the state legislators do their homework before passing new tax credit legislation. Regardless of good intentions, the success or failure of the State Historic Rehabilitation Tax Credit is inexorably linked to its ease of use and practical value to the real world tax credit investor.
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Article Details
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Author:Hoffman, William L.
Publication:Real Estate Weekly
Geographic Code:1USA
Date:Dec 15, 1999
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