Real estate investments may make sense for corporations with high tax burdens and an interest in socially conscious investing. There are real estate investment opportunities that provide the investor with bond-type returns and an added incentive: certain available tax credit programs that provide significant social benefits as well. By availing themselves of these tax credits, organizations are provided the opportunity to improve communities in need, publicly demonstrate their social consciousness, and, of course, improve the bottom line. The following article discusses three such tax credits: low-income housing, rehabilitation, and the new markets tax credit.
I. Low-Income Housing
The Low-Income Housing Tax Credit ("LIHTC") was created under the Tax Reform Act of 1986 (P.L. 99-514). The goal of the LIHTC is to facilitate the creation of affordable housing for eligible Americans by providing tax credits to private sector developers of qualified projects. The LIHTC generally permits a credit for certain types of low-income housing over a 10-year period. Albeit a federal program, the program is actually administered by state agencies adhering to federal guidelines. Funds for the program are allocated to states annually that in turn award the credits to winning developers who submit proposals via a competitive bidding process.
Generally, for new construction or rehabilitation projects, the annual tax credit is currently nine percent of a project's qualified basis. For example, if a new building construction project has a qualified basis of $1,000,000, the annual tax credit will be $90,000 per year for 10 years. In general, the applicable percentage rate is calibrated so the present value of 10 years of tax credits will offset 70 percent of the building's qualified basis. In the context of existing and federally subsidized buildings, the applicable percentage rate is calibrated much lower (e.g., three percent) so that the present value of all the credits is 30 percent of qualified basis.
The market for these tax credits has led to creative sales techniques and a complex secondary market. Corporations that purchase these credits not only benefit by reducing their annual tax obligation, but also promote their public perception via their involvement in low-income housing. Typically, the developer will possess a small fractional interest in the partnership (e.g., one percent) and the developer will maintain management and authority over the project. The investor, usually a corporation, will be provided with a large ownership interest in the project but will not actively participate in the management of the project, and its risk will be limited to its investment in its limited partnership interest. The investor will receive a share of the cash flow at an agreed upon return with the excess going to the developer through fees or other arrangements. The primary goal of the investor corporation is generally using the tax credits to offset its overall tax liabilities. Such offset will be an integral component of the calculation of the investment's return and viability. Further, the return on investment is enhanced for investors when taxation factors such as losses, depreciation and deductions for debt service enter the equation.
Additionally, at any time during a specified 15-year compliance period, the taxpayer risks recapture of the credit if the project's building's statutorily defined "qualified basis" is less than it was at the end of the preceding year. A building's qualified basis is generally a function of the number of low-income housing units present. Hence, any decrease in qualified basis will underscore a reduction in low-income housing units. Under such circumstances, the taxpayer will face a methodical recapture of credits.
II. Rehabilitation Tax Credit
The Rehabilitation Tax Credit provides incentives to the private sector to rehabilitate and reconstruct a building that is deemed a "certified historic structure." By using this tax credit, an organization demonstrates its involvement in a community's image, regardless of the community's economic climate (i.e., the rehabilitation does not have to occur in a low-income community). Under the Code, a certified historic structure is any building (and its structural components) that is either (a) listed in the National Register of Historic Places, or (b) located in a registered historic district and is certified by the Secretary of the Interior as being of historic significance to the district; or (c) any other building first placed in service prior to 1936. While rehabilitation includes renovation, restoration and reconstruction, it does not include enlargement or new construction. In general, the credit is 10 percent for buildings erected before 1936 and 20 percent for certified historic structures.
Corporations that are lessees of buildings should note a special element of this program. Lessees may be able to claim the rehabilitation tax credit if the lessee incurs the costs of rehabilitation and the length of the lease term is greater than the depreciation recovery period under the Internal Revenue Code. The recovery period is 39 years for non-residential real property and 27.5 years for residential rental property. If the lessee satisfies these requisites, the lessee must then meet the "substantial rehabilitation test" to receive the credit.
Under the substantial rehabilitation test, the aggregate costs of qualified rehabilitation expenditures incurred by the lessor and any lessees must exceed the aggregate adjusted basis of all parties who have an interest in the building. Hence, both the lessor and multiple lessees could obtain their proportionate share of the tax credit.
To illustrate, consider a landlord of a historic building with an adjusted basis of $60,000 prior to rehabilitation. The landlord leases the building to Alpha and Beta, two small corporations. The landlord and the tenants each spend $40,000 (total of $120,000) to rehabilitate the building. Because this is a historic building, these rehabilitation costs generate a tax credit of $24,000. This $24,000 tax credit will be divided equally among the landlord and the two tenants so each party will receive an $8,000 credit.
Furthermore, under certain conditions provided by Code, the lessor may pass through the rehabilitation tax credit to its lessees if the lessor is not a tax-exempt entity. If the tax credit is successfully passed to the lessee, the lessee must treat the tax credit as income, but must spread the income evenly over the course of 27.5 or 39 years.
Investors should note that the Rehabilitation Tax Credit is subject to recapture if the building is sold or ceases to be business use property within five years from the date it was first placed in service. The potential recapture amount decreases 20 percent per each full year since the property is placed in service until the potential for recapture is completely phased out. To illustrate, a property that is sold within one year of being placed in service is subject to 100 percent recapture, while a property sold after seven years is not subject to any recapture. Furthermore, taxpayers using the rehabilitation tax credit must reduce their basis in the building when calculating depreciation deductions and gain stemming from the sale of the property.
III. New Markets Tax Credit
A third form of tax credit, the New Markets Tax Credit ("NMTC"), provides another avenue of tax liability reduction for corporations while benefitting communities in need. The program was created in 2000 and through tax incentives. The NMTC program aims to foster private investments in low-income communities.
The principal players in the New Markets Tax Credit program are groups called Community Development Entities (CDEs). CDEs must be certified by the Treasury Department and serve as intermediaries between the Treasury Department, investors and businesses in the targeted communities. CDEs have been formed by non-profit and for-profit entities such as investment banks and real estate development companies.
Once certified by the Treasury Department's Community Development Financial Institutions Fund (CDFI), CDEs compete for tax credit allocations from the government. Much like the LIHTC program, the government is selective in determining which CDEs will receive credits. Upon being awarded a certain number of tax credits, the CDEs use the credits as a carrot to entice private sector investment in exchange for investment capital. Investors receive a credit that is worth 39 percent of their investment in the CDE and is claimed over a seven-year credit allowance period.
Upon receipt of the capital, the CDEs subsequently invest the proceeds in low-income communities. The CDE channels its investments into the community via below-market interest rate loans or investments in businesses located in low-income communities. The New Market Tax Credit program targets areas with poverty rates greater than 30 percent, tracts where the median income is below certain thresholds and areas that suffer from unemployment rates that exceed 1.5 times the national average.
IV. Conclusion
Tax credit programs can provide tangible tax benefits while providing an intangible, perhaps invaluable, positive effect on public image. This overview should not be used as a comprehensive report on these complex and intricate programs. Taxpayers wishing to use these programs, or who are interested in learning more about these programs, are strongly encouraged to contact their tax advisors.
Published April 5, 2010.
