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State Tax Credits Help Finance Difficult Rehabs 

12-09-2015 17:35

One of the most important new preservation financing tools to emerge in the 1990s was the state historic rehabilitation tax credit. Effective advocacy by state and local preservation groups over the last decade has produced a steady stream of new laws and successful efforts to improve existing statutes. Today, 15 states offer some form of tax credit for investments in historic rehabilitations, and legislative efforts are under way in many others.

Statewide preservation organizations active in the national effort to enact a federal home-owners` credit for investing in historic properties have applied what they learned to their state legislative processes and achieved the enactment of historic homeowner credits in 11 states, while 13 states have credits for both income-producing property and historic homes.

Five states-Missouri, West Virginia, Maryland, Virginia, and North Carolina-have received the most attention because their tax credit statutes do not place a dollar cap on the credit and work well on large-scale projects that also qualify for federal rehabilitation and affordable housing credits. Missouri, Maryland, and Virginia provide a 25 percent credit for income and owner-occupied properties, while North Carolina has a 20 percent credit for income-producing buildings and a 25 percent credit for homeowners. West Virginia has a 10 percent credit for income-producing property.

Case Study: Durham, N. C.

Without combined federal and state tax credits, the historic Liggett & Myers warehouses in Durham, N.C., would have been candidates for the wrecking ball. Instead, the West Village Apartments offer an excellent example of a reuse of industrial properties that was made feasible by the 20 percent North Carolina state historic rehabilitation tax credit.

West Village in downtown Durham consists of five tobacco warehouse buildings on eight and one-half acres of land purchased from Liggett & Myers. The developer is Blue Devil Ventures (BDV), a group of young Duke graduates that includes Brian Davis and Christian Laettner, co-captains of the 1991-92 Duke Blue Devils basketball teams that won back-to-back NCAA national championships. These two local heroes, along with Tom Niemann, a 1991 MBA graduate of Duke University`s Fuqua School of Business, form the core of a development team dedicated to restoring historic properties that will help create a "24-hour city." Undaunted by such a big challenge, this trio of preservationists tackled the highly complex $36 million rehabilitation as their first real estate venture.

BDV is now in the construction phase of a plan to convert the warehouses into 243 market-rate, loft-style apartments and 31,500 square feet of offices and retail space. The total project cost of approximately $36.6 million has been financed from four sources: developer equity of $5.9 mil-lion, a HUD 221(d)(4) insured first mortgage of $22.8 million, a federal tax credit investment of $5.3 million, and a state historic tax credit investment of $2.6 million.

The federal tax credit investor, recruited by the National Trust`s Heritage Property Services group (HPS), is Fannie Mae`s American Communities Fund (ACF). The North Carolina state tax credit investor, also identified by HPS, is First Union Corporation. ACF worked diligently with legal counsel Gallagher, Evelius and Jones, LLP, in Baltimore, to create a sophisticated master lease limited liability corporation to accommodate the two rehabilitation tax credit investments. First Union`s staff showed great flexibility in structuring their state tax credit investment to comply with recent technical amendments to the North Carolina statute.

The figures for the West Village project are consistent with the general rule that a combination federal/state historic tax credit investment should raise about 1.5 times the amount of a federal-only investment. In the case of West Village, the federal credit investment is approximately twice the size of the state credit investment. Together, the two tax credits provide almost $8 million in equity on a $36.6 million property, or nearly 22 percent of the financing.

Making the State Tax Credits Work

The Missouri, West Virginia, Maryland, Virginia, and North Carolina credits closely follow the rules, standards, and application procedures for the federal rehabilitation tax credit. This approach keeps use of the state incentives simple and non-duplicative, especially for developers already familiar with the federal credit. Investment by individuals in large-scale projects is impractical given Internal Revenue Service limitations on "passive" real estate investments by individual taxpayers and low state personal income tax rates. Consequently, the emerging marketplace for state rehabilitation tax credits is corporations with taxable income in the state where the project is located.

While early efforts to sign up companies to invest in the state tax credits have proved successful, preservationists and historic tax credit syndicators have encountered some surprises. Many interstate corporations, particularly commercial banks, do not pay taxes on a proportional basis according to how much business they do in each state. What`s more, many corporations have found ways to shelter their state taxable income so they may not have enough state tax liability to use all of the credits of a large-scale project. (Corporate tax rates at the state level are typically 5 to.7 percent, compared to the top federal corporate tax bracket of 39 percent.)

These factors have made state historic rehabilitation tax credits more difficult to place than federal credits, at least until new marketing techniques are developed to help syndicators and developers quickly target companies whose state income tax positions match up well with the equity needs of the rehabilitation project at hand. Preservationists in Virginia have solved the problem by creating the Virginia Historic Tax Credit Fund, which essentially identifies state-based corporate investors in advance and then markets the availability of this equity to developers. The Missouri State Tax Credit Clearinghouse per-forms a similar service.

Legal Structures

Fortunately, the two basic alter-native legal structures that are used by developers for the federal rehabilitation tax credit also work for the state credits. Limited partnerships (LPs) and limited liability corporations (LLCs) can be used on historic income property developments that combine the state and federal credits with a set of adjustments that are becoming increasingly familiar to tax attorneys who write the required legal opinions. Corporations that want to invest in federal and state credits become limited partners or members of either an LP or an LLC. They literally "purchase" the project`s tax benefits by writing a check to the LP or the LLC without actually playing any material role in the rehabilitation or operation of the property. As passive owners, these companies can then transfer the tax benefits to their corporate tax returns.

Pricing State Tax Credits

Many experienced preservationists can do the simple math of figuring out the value of the federal rehabilitation tax credit. Hard construction costs plus most related professional fees and construction interest expenses qualify as "basis" for the federal credit. The basis- let`s say $1 million-can be multiplied by 20 percent to determine a credit value of $200,000. The corporate tax-credit investor earns a return on the cash they contribute to the project by "discounting" their cash payment for the credits by some percentage-usually 8 to 12 percent in today`s market. So a "pricing" of $.88 to $.92 for $1 of tax credit is typical for the federal credit, reducing the investor`s cash payment, in the above example, to a range of $176-184,000.

State credits are more heavily discounted because of the impact of state tax payments on corporations` federal tax liability. The best way to understand this is to think of your own federal and state tax returns. Individuals, like companies, can deduct state taxes from taxable income on their federal return (Schedule A for individuals). If a company uses a state historic rehabilitation tax credit to reduce its state tax liability, it unfortunately loses a federal deduction. Companies must take into account this "federal offset" when determining what they should pay in cash for the state credit; in essence, a reduction in state corporate tax liability means an increase in federal taxable income. Thus you can see why state tax credits are "selling" in the corporate tax credit market for amounts ranging from $.55 to $.58 for a dollar of state credits.

As the Durham, N.C., case study illustrates, a project that combines state and federal credits can expect to bring in about 1.5 times the equity of a project utilizing the federal credit alone, even though the eligible basis may be the same for both credits. It also shows how state rehabilitation tax credits can mean the difference between demolition and new life for a valuable historic property and the surrounding community.

Publication Date: March/April 2000

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Author(s):John Leith-Tetrault