Converting Tax Incentives Into Profitable Historic Rehabilitation Projects
By Gordon Goldie, Linda Yudasz, & Jim Manning
Contstruction/Real Estate Tax Flash Advisor , January 2004


For years, resourceful developers have taken advantage of significant tax incentives to rehabilitate historic buildings into profitable development projects. Such incentives have sparked renewed interest in rehabilitating forgotten local landmarks and have enabled developers to successfully tap into an emerging market of commercial and residential tenants that are looking for unique space.

What tax incentives are available for historic rehabilitation projects? Depending upon the location of the property, the project may qualify for both federal and state historic tax credits.

Federal Rehabilitation Tax Credit

The Internal Revenue Code (IRC) provides a federal tax credit of either 10% or 20% of qualified rehabilitation expenditures (QREs). Tax credits are extremely valuable, since they represent a dollar-for- dollar reduction in your federal income tax liability. You may claim the credit in the year that the QREs incurred on a project are placed in service. However, many taxpayers are limited in their ability to utilize tax credits. Fortunately, an efficient market exists that allows developers to “sell” federal historic tax credits for approximately $.90 per $1 of credit.

In short, QREs represent all rehabilitation costs that are capitalized as part of the depreciable cost of the building. QREs exclude acquisition costs, land improvements, and personal property. However, they may include capitalized interest and property taxes, as well as reasonable construction management fees and developer fees paid to related parties.

State Historic Tax Credits

• Michigan — The State of Michigan also offers a tax credit for historic rehabilitation projects. The Michigan tax credit equals 25% of QREs. However, the Michigan credit must be reduced by the amount of any available federal historic tax credit (which may result in a 5% net state credit). The Michigan credit can be used to offset either your Michigan Single Business Tax (SBT) or your Michigan Income Tax liability. The credit may be claimed in the year that the completed rehabilitation certificate is issued for the project. The credit may be assigned (but not reassigned) to owners of a pass-through entity or to tenants. The State will allow you to assign 100% of the credit to a single owner or tenant. An efficient market also exists for the “sale” of these credits. These state tax credits typically “sell” for approximately $.60 per $1 of credit.
• Ohio — The State of Ohio does not currently offer a tax credit for historic rehabilitation projects.

Example — The value of historic tax credits in financing a certified historic rehabilitation project is illustrated in the following example, which assumes that the federal credits are “sold” for $.90 per $1 of credit and that the Michigan credits are sold for $.60 per $1 of credit:

As this example demonstrates, historic tax credits can finance a substantial portion of a project’s costs. When combined with other potentially available incentives, such as the Michigan Brownfield tax credit, tax incentives can finance up to 25% or 30% of the cost of a historic rehabilitation.

What Are the Eligibility Requirements for Historic Tax Credits?

• Federal Credit: Building Eligibility — Buildings that are listed on the National Register of Historic Places (either individually or as part of a historic district) are eligible for a 20% federal credit. Buildings that were originally placed in service prior to 1936 are eligible for a 10% federal credit. A building must be used in a trade or business to qualify for either credit. While the 20% credit is available for both nonresidential and residential rental properties, the 10% credit is only available for nonresidential rental properties. In addition, the availability of the credit may be restricted if the property is owned or used by a tax-exempt entity.
• Federal Credit: Rehabilitation Eligibility — The rehabilitation must also meet certain requirements to qualify for the credit. In short, the taxpayer must select either a 24- or 60-month period and the taxpayer’s rehabilitation expenditures during the period must exceed the building’s adjusted basis at beginning of period.
• Michigan Credit Eligibility — The Michigan credit is available for rehabilitations of buildings, structures, sites, objects, features and open spaces that are either individually listed on the National or State Register of Historic Places, or contributing to the historical significance of a National, State or local historic district. The property is not required to be used in a trade or business. In addition, the State places fewer restrictions on property that is owned or used by tax-exempt entities. To qualify for the state credit, the QREs must exceed 10% of the property’s State Equalized Value.

What Do You Have To Do To Obtain Historic Tax Credits?

• Federal 20% credit — The procedure for obtaining a federal historic tax credit differs between the 10% credit and the 20% credit. Rehabilitations of buildings eligible for the 20% credit must meet the Secretary of Interior’s Standards for Rehabilitation. In addition, the rehabilitation must be certified by the National Park Service. To obtain certification, taxpayers must submit a three-part application to the State Historic Preservation Office (SHPO). Part 1 of the application provides information regarding the historical significance of the building, and Part 2 includes a description of the proposed rehabilitation. Part 3 is submitted upon completion of the rehabilitation to request certification. Applicants must pay a fee ranging from $500 to $2,500 with their application.
• Federal 10% credit — There is no certification process required for rehabilitations of buildings eligible for the 10% credit and the rehabilitation is not required to meet the Secretary of Interior’s Standards for Rehabilitation.
• Michigan credit — The process required to obtain the Michigan historic tax credit is essentially identical to that required to obtain the federal 20% credit.

What Other Factors Are Important in Evaluating the Potential Benefit of Historic Tax Credits?

While historic tax credits can provide significant financial incentives for a rehabilitation project, they do not come without some costs. When evaluating the potential benefits associated with historic tax credits, it is important to consider the following:

• Construction Costs — Since the 20% federal credit and the Michigan credit require that the rehabilitation meet the Secretary of Interior’s Standards for Rehabilitation, the hard and soft construction costs associated with such projects will be higher.
• Reduced depreciation deductions — Taxpayers claiming a federal historic tax credit are required to reduce the depreciable basis of the rehabilitated property by the amount of the credit claimed.
• Potential credit recapture — Taxpayers claiming a federal or Michigan historic tax credit are required to recapture a pro rata portion of the credit if they dispose of their interest in the property within five years of the rehabilitated project being placed in service.
• Limitations on use of credits — A taxpayer’s ability to use a federal historic tax credit is often limited (due to at risk, passive activity and alternative minimum tax limitations). Consequently, taxpayers who generate such credits often “sell” the credits to investors who are able to utilize them quicker. Fortunately, as discussed above, an efficient market exists that allows developers to “sell” historic tax credits for approximately $.90 per $1 of federal credit and approximately $.60 per $1 of Michigan credit.
• Transaction structuring costs — Unfortunately, “selling” tax credits is not as easy as it sounds. The IRS and the State of Michigan do not permit the direct sale of such credits. To accomplish such a “sale,” developers typically enter into a partnership or LLC with the credit “purchaser.” Extensive financial projections are typically required to properly structure the transaction. In addition, the tax credit “purchaser” often requires an attorney to issue a tax opinion to give them comfort that the transaction is properly structured. Such complexities obviously increase the cost of the project.

What Are the Keys to a Successful Historic Rehabilitation Project?

The most important ingredient to a successful historic rehabilitation project is assembling a team of experienced professionals. One of the most important members of the team will be a historic consultant, whose primary job is to safeguard the tax credit (i.e., review plans and decisions as they are made, always with the credit in mind). It is also critical to the success of the project that the architect, CPA, and attorney all have experience with historic rehabilitation projects and the related tax credits.