Introduction:
There are numerous commercial real estate investment techniques available. Learn about historic tax credits here!
Investing in Commercial Real Estate
Unlike residential real estate, commercial real estate (CRE) is utilized solely for business purposes or to provide a workspace rather than as a place to live. Most of the time, commercial real estate is rented out to businesses to generate revenue. One storefront to an entire shopping mall is all examples of commercial real estate.
There are numerous types of commercial real estate. If you’re looking for office space, you’ll find plenty of options here. Commercial real estate can be rented out or bought and resold by individuals, businesses, and corporate interests to generate income. Office space, hotels and resorts, strip malls, restaurants, and healthcare facilities are all examples of commercial real estate.
There are numerous commercial real estate investment techniques available. Historic tax credits are one of the more specialized – but incredibly useful – options. Federal and state governments generally provide tax breaks to real estate investors that renovate historic houses while preserving their original aesthetics. As a result, we’ll utilize this article to discuss historic tax credit real estate investing from both the developer and investor perspectives.
We’ll go through the following subjects in particular.
An Overview of Historic Tax Credit Real Estate Investing
The federal government has devised a scheme to incentivize historic property renovation. The Federal Historic Preservation Tax Incentives program, dispensed by the National Park Service (NPS), encourages real estate developers to renovate and re-use old properties. And many states (now more than 30) have followed suit, offering their versions of this tax break. Many of these state-level initiatives are modeled after federal programs. However, for simplicity, we shall limit this essay to the NPS-administered program.
This historic tax credit program provides two major benefits from the government’s standpoint. For starters, the program indirectly produces jobs by incentivizing private sector investment. Every project requires workers from architects to electricians to property managers and everyone.
Second, the historic tax credit scheme has developed a low-cost and very effective method of community revival. Since its inception in 1976, the NPS program has leveraged approximately $102.64 billion in private funding to protect 45,383 historic properties. Many of these historic structures are in underprivileged communities that have historically gotten little outside investment. With these tax credits, the federal government encourages private investment and regeneration in certain neighborhoods, resulting in economic growth while preserving the neighborhood’s historical “look and feel.”
Real estate developers can apply for a 20% income tax credit for renovating historic, income-producing properties under the federal program (owner-occupied residential properties do not apply). These properties must be “certified historic structures,” a distinction conferred by the National Park Service. In other words, just because a property is old does not automatically qualify it.
Following the qualifying of a property, future restoration work must adhere to tight requirements. These guidelines, outlined in the Secretary of the Interior’s Standards for Rehabilitation, serve as the foundation for computing the 20% tax credit. In general, only costs directly related to repairing or improving structural and architectural characteristics of a historic property are eligible for this credit. While not exhaustive, below are some of the more frequent qualified rehabilitation expenditures (QREs). Please note that acquisition costs do not qualify:
- Walls/Partitions
- Floors
- Ceilings
- Paneling or tiles are examples of permanent coverings.
- Doors and windows
- Central air conditioning or heating system components
- Plumbing systems and fixtures
- Lighting fixtures and electrical wiring
- Chimneys
- Stairs
- Elevators, escalators, sprinkler systems, and fire escapes
- Other components connected to the building’s operation or upkeep
Assume that the entire rehabilitation costs for a project are $1,200,000. Following a cost audit, $1,000,000 of these expenses was considered qualifying rehabilitation expenses. These qualified rehabilitation expenditures (QREs), if taxed at 20%, would generate a $200,000 tax credit for the historic rehabilitation project.
This initiative provides enormous financial prospects for two parties: real estate developers and investors in historic tax credits. We’ll look at the curriculum from their views in the following two sections.
The Developer’s View of Historic Tax Credits
Following the preceding example, many real estate developers may not possess a $200,000 tax bill. As an outcome, a $200,000 tax credit would be rendered ineffective. Rather, the historic tax credit program is enticing due to the potential for deal financing. Real estate developers can apply this program to fund development with no (or very little) contributed money in a carefully evaluated contract.
Assume a developer can buy an underused school building from a local government for $500,000. The developer plans to transform this old school into luxury apartments with the “recognized historic structure” designation. The developer expects an $8,000,000 renovation budget when underwriting the deal. Assume $6,000,000 represents qualified rehabilitation expenditures (QREs) in the tax credit calculation, resulting in a credit of $1.2 million ($6 million x 20%).
As previously noted, the developer is unlikely to be able to use the full tax benefit. Instead, the team recruits a historic tax credit investor, a company, or an individual who can use the credit. As a bonus, the developer offers the investor these credits for 80 cents on the dollar. With this approach, the investor would contribute $960,000 ($1,200,000 x 80%) of the project’s capital and receive all its past tax credits in exchange.
Assume the stabilized property is valued at $10,000,000. The developers secure a $8,000,000 permanent mortgage at 80% loan-to-value. The permanent mortgage exceeds all project expenditures, with costs of $8,500,000 (acquisition + rehab budget) minus $960,000 in contributed cash from the historic tax credit investor (usually used to limit the deal’s short-term financing). The historic tax credit developers can execute this transaction with no outside funding.
Note: To qualify for the initial acquisition/construction loan, developers will require funds, either their own or through bridge financing. As a result, while a solid historic tax credit agreement does not eventually necessitate contributed capital, developers will demand cash until they receive the investor contribution and permanent finance.
Yes, these are simple numbers used to explain things. The main takeaway is the historic tax credit scheme’s extraordinary funding opportunity. You can construct and control a commercial real estate property with no contributed capital in a properly assessed arrangement.
The Investor’s View of Historic Tax Credits
Whereas most real estate developers see the historic tax credit program as a cost-effective way to fund acquisitions, tax credit investors see things differently. These investors see a deal’s past tax benefits as an opportunity to dramatically lower tax obligations. For example, banks and other lending institutions regularly participate in deals as historic tax credit investors since they typically have large enough tax liabilities to put the credits to good use.
In the preceding example, the tax credit investor paid 80 percent of the deal’s federal tax credits, or $960,000 ($1,200,000 total tax credits x 80 percent). The federal tax credit scheme must use these tax credits over five years. As an outcome, for the next five years, this investor would receive a 20% discount on the first $240,000 in federal income tax ($1,200,000 in total tax credits / five years).
However, in this example, the 80% figure utilized is not a hard and fast rule. Each market is different. Nonetheless, historic tax credit investors can expect to earn between 60 cents and 95 cents on the dollar for each credit. The crucial takeaway for investors, regardless of the amount, is the enormous tax-saving potential of historic tax credit deals.
The preceding article touched the surface of the National Park Service’s Federal Historic Preservation Tax Incentives program. Our goal was not to turn readers into specialists in this system. Rather, this paper aims to educate readers on the possible benefits of historic tax credits in real estate, both as a developer and an investor.
We’d love to discuss other real estate investing opportunities for your specific scenario! Call us discuss available projects and investment opportunities.
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