Steven McQuillin & Associates, Rules for Tax Credits

RULES FOR TAX CREDITS

Section I. Tax Incentives for Historic Preservation
     A. Overview of the Federal Income Tax Rules
     B. Financial Aspects
     C. Use of the Rehabilitation Credit by Non-Profit Organizations
                 Types of Investors; Typical Eligible Non-Profit Projects; Restrictions on Properties;
                 Other Considerations

Section II. The Secretary of the Interior's Standards
     A. Standards, General Statement
     B. Standards for the Treatment of Historic Properties
                  Preservation; Rehabilitation

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Tax Incentives for Historic Preservation

An Overview of the Federal Income Tax Rules on Rehabilitation Investment Tax Credit

Federal historic preservation tax incentives are available for any qualified project that the Secretary of the Interior designates as a certified rehabilitation of a certified historic structure. These incentives were established and modified by the Tax Reform Act of 1976, the Revenue Act of 1978, the Tax Treatment Extension Act of 1980, the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986.

This tax credit consists of 20% of the costs of rehabilitation of a certified historic structure. A certified historic structure is any structure, subject to depreciation as defined by the Internal Revenue Code, that is listed individually in the National Register of Historic Places or which is located in a registered historic district and certified by the Secretary of the Interior as contributing to the historic significance of the district. For purposes of the charitable contributions provisions only, a certified historic structure need not be a building nor be depreciable to qualify. A registered historic district is any district listed on the National Register or any district which is designated under a state or local statute which has been certified by the Secretary of the Interior as meeting substantially all the requirements for the listing of districts on the National Register.

A certified rehabilitation is any rehabilitation of a certified historic structure which the Secretary has certified to the Secretary of the Treasury as being consistent with the historic character of such structure and, where applicable, with the district in which such structure is located.

Tax incentives for rehabilitation are limited by the Internal Revenue Code to depreciable structures such as buildings used in a trade or business or held for the production of income, including commercial or rental residential properties. Single-family owner-occupied houses are generally not eligible for the tax credit.

To qualify for the tax incentives, property owners must complete the Historic Preservation Certification Application. Competed applications are sent first to the State Historic Preservation Officer. The state will forward applications to the National Park Service, generally with a recommendation. All projects are reviewed and evaluated in accordance with the Secretary of the Interior's Standards for Rehabilitation. These ten standards are broadly worked to guide the rehabilitation of all historic structures. The underlying concern expressed in the Standards is the preservation of significant historic materials and features of a building in the process of rehabilitation. The Standards apply with equal force to both interior and exterior work and the National Park Service reviews the entire rehabilitation project (including any new construction on the site) rather than just a single segment of work. Certification is based on whether the overall project meets the Standards.

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Rehabilitation Standards, General | Treatment Standards

Financial Aspects of the Tax Credits

The Rehabilitation Investment Tax Credit is allowed for every dollar spent on a Secretary of the Interior certified rehabilitation. The rate for the credit is 20% for historic buildings. There is a 10% credit available for rehabilitations of non-historic non-residential income-producing properties that were erected prior to 1936. The tax credit is a dollar for dollar reduction in federal tax liability subject to certain limitations. The alternative minimum tax may only be partially offset. A tax expert should be consulted for specific information.

Graduated recapture of the credit will occur of the property is sold within five years of being placed in service. Recapture will also occur if non-certified alterations are made within five years or if the building is demolished.

The tax credit is recognized in the year the building is placed in service. Tax credits that are currently unused may be carried back three years and forwarded for fifteen years.

Substantial rehabilitation is required under the rules governing this provision. Generally, this means that the cost of rehabilitation must exceed the basis value of the building. The basis value is often calculated by taking the purchase price for the property and subtracting out the land value and any depreciation of the building. If a property was purchased for $100,000 and the land value alone is $25,000 and depreciation of $25,000 has been taken on the building, then a certified rehabilitation of the property must total at least $50,000 in order to meet the substantial rehabilitation test for use of the rehabilitation investment tax credit.

Qualified expenditures include the costs of rehabilitation, construction interest and taxes, architectural and engineering fees, legal and other professional fees, developers fees, general and administrative costs, and the costs of a preservation consultant. Non-qualified expenditures include acquisition costs, enlargement costs such as constructing an addition, acquisition interest and taxes, realty fees, paving and other landscaping costs, and sales and marketing costs. Furniture and furnishings are generally not included, unless attached to the building. They can be depreciated on a shorter timeframe.

For depreciation, generally straight line depreciation must be used. Industrial real property is recovered in 31.5 years. Residential income property is recovered in 29.5 years. A property's depreciable base is reduced by the amount of the rehabilitation tax credit and is therefore 80% of basis value.

The value of the rehabilitation investment tax credit may be realized in a number of ways. Credits normally increase profits by reducing taxes. The owners of structures being rehabilitated may obtain cash by selling equity in the property before it is placed in service which gives the investor a proportional share of the credit. The possibilities here are infinite.

A charitable contribution is available for a qualified conservation contribution or conservation easement. The corporate deduction of a facade contribution is restricted to 10% of the corporate taxable income. In general, a conservation easement restricts the right to alter a building facade or architectural characteristic. Herein facade means the entire building exterior. The contribution of a facade increases cash without acquiring partners. The subsequent restrictions on a property suggest a careful pre-commitment analysis.

Application fees are assessed by the National Park Service for reviews of requests for certification of rehabilitation except for projects under $20,000. The fee for projects costing $20,000 to $99,999 is $500. The fee for projects costing $100,000 to $499,999 is $800. The fee for projects costing from $500,000 to $999,999 is $1,500. The fee for projects costing more than one million dollars is $2,500.

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Rehabilitation Standards, General | Treatment Standards

Use of the Rehabilitation Credit by Non-Profit Organizations

The Federal Rehabilitation Investment Tax Credit provides a dollar-for-dollar reduction of federal tax liability for 20% of the costs of certified rehabilitation activities to certified historic structures. Non-profit organizations can utilize this credit by forming a Limited Liability Company (LLC) that would operate the property for a minimum five-year period. The non-profit organization could maintain full control and ownership rights through the LLC. An investor that has federal tax liability would participate in the LLC and, in effect, purchase the tax credits from the non-profit organization. The tax credits are discounted by approximately 10% to attract an investor to the project.

Types of Investors

Banks and other financial institutions are ideal candidates for these projects. Under the Federal Community Reinvestment Act, they need to participate in projects in places that are designated as lower income areas, often center cities and their surrounding neighborhoods. Banks are often utilized by non-profit organizations to help finance a rehabilitation project during the construction phase. The tax credit can become part of the equity in the project, providing greater loan security and therefore more favorable financing.
Locally based corporations can be ideal partners for non-profit organizations. They gain local recognition for participating in an important community enterprise and they can benefit the non-profit organization by providing a higher return on the tax credit, or by augmenting that purchase with an outright donation.
Nationally, there is a well-established secondary market. Financial brokers from around the country are looking for projects to invest in that can provide the rehabilitation credit. These buyers of the tax credit are concerned only with the value of the credit and "due diligence" issues such as ensuring the project will survive as an LLC for the five-year period, no physical changes to the project take place during the review period that are not approved by the National Park Service, and that adequate records of expenditures are maintained.

Typical Eligible Non-Profit Projects

Historic theater renovation projects are an increasing source of tax credit projects because they typically involve landmark buildings where restoration is a key ingredient of the program, and have income-producing activities such as theater rentals and concession sales that easily meet the requirement that the property have an income-producing use for a minimum five-year review period.
Non-profit residential rental housing also provides ideal candidates. This includes college and university dormitories, fraternities and sororities. YMCA facilities have been restructured into health clubs and apartment housing to utilize the tax credit. Neighborhood non-profit organizations have typically used the credit when buying and renovating older housing units as part of their goal to improve neighborhoods and communities.
Historical societies can utilize the tax credits, subject to the restriction outlined below, if they can achieve rental income from leasing an historic property for events or ongoing activities such as a teahouse, gift shop or offices.
Cultural museums are often housed in landmark facilities and can utilize the credit if they segregate income-producing activities such as restaurants, multi-purpose auditoriums and bookstores in historic portions of their complexes.
Colleges and universities can utilize the tax credit for academic buildings if they either do not already own the affected building or set aside a percentage of a prior-owned building for income-producing activities.

Restrictions on Properties Currently Owned by Non-Profit Organizations

If a non-profit organization is considering purchasing an historic building and rehabilitating it, the non-profit can form an LLC and become the primary tenant for the minimum five-year period and then take actual ownership after that time. However, if a non-profit organization currently owns a building and plans to continue ownership after the minimum year-year period, then federal tax regulations require that the non-profit cannot be a tenant in more than 35% of the property in question during this five-year period. The following are some examples of how this requirement can be successfully managed to achieve the tax credit:

A local historical society currently owns an historic house museum and plans a major renovation that qualifies for the tax credit. During the five-year review period it must rent out 65% of the usable space to another organization, for example, an antique or crafts shop in some of the period rooms, or law offices in the historic house parlors. These activities meet the requirement for income-producing use, provide a side benefit of rental income and, after the five years have expired, the society can reclaim all of the space for museum purposes.
An art museum owns a complex that includes historic as well as modern buildings. If it places income-producing activities, such as cafes, meeting halls and bookstores such that these uses constitute 65% of the space in the historic part of their complex, the renovation costs of that portion would earn a 20% credit.
A university has an historic campus in a busy metropolitan area. If it can rent out its classrooms and lecture halls on evenings and weekends for conferences and other special events such that these periods constitute 65% of the total usage, these projects would become eligible for the tax credit.
A college is planning a major expansion and renovation program that takes place over a number of years. If it can arrange to temporarily house income-producing uses in historic buildings for a minimum five-year period, it can realize the tax credit. Alumni groups, medical research centers, think tank groups are all possible short-term tenants.

Other Considerations

A project should generally have a minimum cost of at least $1 million, and larger projects are easier to find tax credit buyers for than smaller projects.
Some states have a tax credit that can "piggyback" onto the federal credit.
Façade easements can provide a charitable contribution that can yield additional funds to selected eligible projects.

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Rehabilitation Standards, General | Treatment Standards

The Secretary of the Interior's Standards for Rehabilitation

General Statement of Standards

Every reasonable effort shall be made to provide a compatible use for a property which requires minimal alteration of the building structure or site and its environment, or to use the property for its originally intended purpose.
The distinguishing original qualities or character of a building, structure or site and its environment shall not be destroyed. The removal or alteration of any historic material or distinctive architectural features should be avoided where possible.
All buildings, structures and sites shall be recognized as products of their own time. Alterations that have no historical basis and which seek to create an earlier appearance shall be discouraged.
Changes which may have taken place in the course of time are evidence of the history and development of a building, structure or site and its environment. These changes may have acquired significance in their own right, and this significance shall be recognized and respected.
Distinctive stylistic features or examples of skilled craftsmanship which characterize a building, structure or site shall be treated with sensitivity.
Deteriorated architectural features shall be repaired, rather than replaced, wherever possible. In the event replacement is necessary, the new material should match the material being replaced in composition, design, color, texture, and other visual qualities. Repair or replacement of missing architectural features should be based on accurate duplication of features, substantiated by historic physical or pictorial evidence rather than on conjectural designs or the availability of different architectural elements from other buildings.
The surface cleaning of structures shall be undertaken with the gentlest means possible. Sandblasting or other cleaning methods that will damage the historic building materials shall not be undertaken.
Every reasonable effort shall be made to protect and preserve archaeological resources affected by or adjacent to any project.
Contemporary design for alterations and additions to existing properties shall not be discouraged when such alterations and additions do not destroy a significant historical, architectural or cultural material, and such design is compatible with the size, scale, color, material and character of the property, neighborhood or environment.
Wherever possible, new additions or alterations to structures shall be done in such a manner that if such additions or alterations were to be removed in the future, the essential form and integrity of the structure would be unimpaired.

In addition to these above standards, the U. S. Department of the Interior's National Park Service has more detailed Guidelines for Rehabilitating Historic Buildings. The Park Service also has a series of detailed Preservation Briefs on various preservation-related issues. The National Trust for Historic Preservation provides preservation assistance through its fine publications and outreach programs. To contact the National Trust, please call (202) 673-4000 or write to them at 1785 Massachusetts Avenue, N.W., Washington, D.C. 20036. The Ohio Historic Preservation Office; 567 E. Hudson St., Columbus, Ohio 43211, (614) 297-2470); manages state and federal preservation programs for Ohio and has much information available. The Cleveland Landmarks Commission may be reached by calling 664-2531.

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Rehabilitation Standards, General | Treatment Standards

Standards for the Treatment of Historic Properties

Standards for Preservation

A property shall be used as it was historically, or be given a new use that maximizes the retention of distinctive materials, features, spaces and spatial relationships. Where a treatment and use have not been identified, a property shall be protected and, if necessary, stabilized until additional work may be undertaken.
The historic character of a property shall be retained and preserved. The replacement of intact or repairable historic materials or alteration of features, spaces and spatial relationships that characterize a property shall be avoided.
Each property shall be recognized as a physical record of its time, place and use. Work needed to stabilize, consolidate and conserve existing historic materials and features shall be physically and visually compatible, identifiable upon close inspection, and properly documented for future research.
Changes to a property that have acquired historic significance in their own right shall be retained and preserved.
Distinctive materials, features, finishes, and construction techniques or examples of craftsmanship that characterize a property shall be preserved.
The existing condition of historic features shall be evaluated to determine the appropriate level of intervention needed. Where the severity of deterioration requires repair or limited replacement of a distinctive feature, the new material shall match the old in composition, design, color and texture.
Chemical or physical treatments, if appropriate, shall be undertaken using the gentlest means possible. Treatments that cause damage to historic materials shall not be used.
Archaeological resources shall be protected and preserved in place. If such resource must be disturbed, mitigation measures shall be undertaken.

Standards for Rehabilitation

A property shall be used as it was historically or be given a new use that requires minimal change to its distinctive materials, features, spaces, and spatial relationships.
The historic character of a property shall be retained and preserved. The removal of distinctive materials or alteration of features, spaces, and spatial relationships that characterize a property shall be avoided.
Each property shall be recognized as a physical record of its time, place, and use. Changes that create a false sense of historical development, such as adding conjectural features or elements from other historic properties, shall not be undertaken.
Changes to a property that have acquired historic significance in their own right shall be retained and preserved.
Distinctive materials, features, finishes, and construction techniques or examples of craftsmanship that characterize a property shall be preserved.
Deteriorated historic features shall be repaired rather than replaced. Where the severity of deterioration requires replacement of a distinctive feature, the new feature shall match the old in design, color, texture, and, where possible, materials. Replacement of missing features shall be substantiated by documentary and physical evidence.
Chemical or physical treatments, if appropriate, shall be undertaken using the gentlest means possible. Treatments that cause damage to historic materials shall not be used.
Archaeological resources shall be protected and preserved in place. If such resources must be disturbed, mitigation measures shall be undertaken.
New additions, exterior alterations, or related new construction shall not destroy historic materials, features, and spatial relationships that characterize the property. The new work shall be differentiated from the old and shall be compatible with the historic materials, features, size, scale and proportion, and massing to protect the integrity of the property and its environment.
New additions and adjacent or related new construction shall be undertaken in such a manner that, if removed in the future, the essential form and integrity of the historic property and its environment would be unimpaired.

Tax Incentives I Financial Aspects I Use of Rehabilitation Credit
Rehabilitation Standards, General | Treatment Standards

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