Developers can recoup rehabilitation costs with tax credit - real estate developers taxation details - Brief Article

If you're undertaking substantial renovations to a building constructed before 1936, you may be eligible for the Rehabilitation Tax Credit. This credit enables developers to recoup up to 20% of their construction expenditures as tax credits at the front end, when the building is placed in service, rather than as depreciation deductions over the life of the building. Should a developer's situation prevent them from using the tax credits, the developer can still obtain a benefit by selling the tax credits to taxpayers who can use them. Taking advantage of these up-front tax benefits can significantly increase an investor's return on investment.

Generally speaking, the rehabilitation tax credit is calculated as follows. A percentage (either 10% or 20%, depending on your project) is applied to the "qualified rehabilitation expenditures" of a building that is "substantially rehabilitated." An expenditure that is directly associated with the rehabilitation of the project is considered a "qualified rehabilitation expenditure." These include hard construction costs, as well as interest on construction-related debt and construction-period real estate taxes. Only projects where the qualified rehabilitation expenditures exceed the purchase price of the building (excluding land) are considered "substantially rehabilitated." Projects that do not meet the "substantially rehabilitated" requirement are not eligible for the credit. Typically, the credit is claimed in the year in which the property is placed in service. However, a taxpayer can decide to claim the credit in each of the tax years during the rehabilitation period if it's more than 24 months. Qualified rehabilitation expenditures do not include amounts spent on equipment, furniture or other items not considered to be structural components of the building. In addition, amounts spent on expanding an historic structure are not eligible for the credit.

There are two types of rehabilitation tax credit -- a 10% credit on qualified expenditures for the rehabilitation of any pre-1936 building, and a 20% credit on qualified expenditures for the rehabilitation of "certified" historic buildings. The 10% credit is only available to commercial property, but requires no explicit approval from any governmental agency. The 20% credit is available for both commercial properties and residential rental properties provided that the property is either listed in the National Register of Historic Places or is located in a registered historic district. Certification of the rehabilitation project must be obtained from the Department of Interior by submitting a Historic Preservation Certification Application to the National Parks Service.

A perfect example of a historic rehabilitation occurred with the W Hotel at Union Square, which involved the conversion of a great old office building into a high-end luxury hotel. The property, located at 201 Park Avenue South, consists of a 20-story, 197,500-SF, masonry building built in 1911. Because the Landmark Preservation Commission designated the building as a historic landmark in 1988, the developers of the project received 20% tax credits. This amount represents 9% of the overall financing of the project and greatly enhanced the return to the developer.

In most instances, tax credits are much more beneficial to a taxpayer than depreciation deductions. Tax credits reduce a taxpayer's tax liability dollar-for-dollar, while depreciation deductions merely reduce the income on which the liability is based. Additionally, the portion of rehabilitation expenditures for which a tax credit is obtained is recovered in its entirety at the beginning of the property's depreciable life, whereas expenditures recovered through depreciation deductions are recovered incrementally over a period of up to 39 years. Another benefit of tax credits is the ability to carry credit back to previous tax periods. If, during the year that tax credits are generated, a taxpayer has more tax credits than it can utilize, the taxpayer has the ability to apply excess credits to the prior two years' tax liabilities, generating cash refunds. Any excess credits thereafter can be carried forward to subsequent tax years.

Some developers, depending upon their particular circumstances, may obtain little or no benefit from the tax credits generated from a rehabilitation project due to the effect of net operating losses, the Alternative Minimum Tax, or other sources of tax credits. These developers can still obtain an up-front economic benefit by selling the tax credits to investors who can utilize them. One should consult with a tax professional to assess which options make the most sense for a particular developer.

COPYRIGHT 2002 Hagedorn Publication
COPYRIGHT 2002 Gale Group