HMD Work Session Federal/State Historic Tax CreditsFederal Taxation of State Historic Tax Credits
Historic Rehabilitation projects throughout the country are being threatened due to a Federal Appeals
Court ruling that treats certain types of historic preservation investments as sales for federal tax
purposes.
Financing for both large -scale and small structure historic redevelopment is threatened because of the
Fourth Circuit Court ruling. The ruling, decided in March 2011, is the "Virginia Historic Tax Credit Fund
2001 LP; Virginia Tax Credit Fund 2001 LLC; Tax Matters Partner (Petitioners - Appellees) versus
Commissioner of Internal Revenue (Respondent - Appellant). Briefly, the ruling allows the IRS to treat
investments in a historic preservation investment group as a "sale" for federal tax purposes. The impact
of this ruling is two -fold: on a going forward basis historic preservation investment groups will be willing
to pay 35% less for state credits, meaning the value of their economic participation will be 35% less; and,
developers and investors are bracing for audits of past deals. Unless projects identify solo investors
rather than investment groups, the financing gap for these projects prevent the projects from being
economically viable. This will be very difficult at best for most projects in Iowa.
To fully explain how the court's ruling adversely affects the tax credit projects, two hypothetical but
representative examples, one for a proposed project, the other for a completed and certified project are
detailed below.
Example A: Proposed Project
A project with $2 million in eligible expenses would receive $900,000 in state and federal tax credits:
Federal tax credit = $400,000 (20 percent of $2 million);
State tax credit = $500,000 (25 percent of $2 million).
If, through a partnership, the investors are allocated tax credits at 80 cents per dollar, then here's how
the credits breakdown when allocated:
Federal = $320,000 ($400k x $0.80);
State = $400,000 ($500k x $0.80).
Prior to the court's decision, a lender underwriting this project had a reasonable assurance that upon
certification by DHR, the project would generate a total of $720,000 ($320k + $400k) in tax credit equity.
Following the court's ruling, the $400,000 in state tax credit equity must now be considered income.
Taxed as such, at 40.75 percent (35 percent federal + 5.75 percent state), that $400k would result in an
estimated $163,000 in income tax liability. This tax liability of $163,000 translates into lost tax credit
equity, meaning a project that originally had $400,000 in tax credit equity now has only $237,000 in
equity ($400k - $167k).
Consequently, a lender underwriting this project must reduce significantly the financing provided, which
is based in part on tax credit equity that will be generated by the project.
Example B: A Completed /Certified Project
A project completed in 2007 with $2 million in qualified rehabilitation expenditures would have received
$500,000 in state tax credits (at 25 percent). According to the court ruling those credits allocated would
be taxed at 40.75 percent (35 percent federal, 5.75 percent state).
In this case, as before, the $500,000 in state tax credits that would be allocated through an investor
partnership at 80 cents on the dollar would generate $400,000 in tax credit equity.
If this $400,000 in allocated state tax credits is taxed at 40.75 percent, it would result in $163,000 in
back taxes owed plus an estimated $27,000 in interest, equaling $190,000. Accordingly, one must ask,
would the project entity have the cash available to pay a $190,000 tax liability in addition to repaying
the project financing?
A legislative correction to this issue has been introduced in both the U.S. House and Senate as part of
the broader: Creating American Prosperity through Preservation Act. A letter has been sent by the two
main co- sponsors of the CAPP Act asking for the scoring of the Federal taxation language. If the language
comes back as revenue natural there is hope that it could be separated from the larger bill and
presented as its own piece of legislation.