Greg K. Bryant, CCSP – Managing Partner of Bedford Cost Segregation, LLC
Alex Bagne, JD, CPA, MBA, CCSP – President of ICS Tax, LLC
John Hoffman, CPA, CCSP – President of Bracket Partners, LLC
The Federal Rehabilitation Tax Credit
The Federal Rehabilitation Tax Credit (“Historic Tax Credit”) for older buildings was established in 1976 to incentivize property stakeholders to invest in the preservation and rehabilitation of historic buildings. Since its enactment, the credit has been responsible for billions of dollars being invested into historic buildings across the county. These projects have not only served to preserve historic buildings but have led to the revitalization of countless communities across America by driving economic development, creating jobs, and improving property values.
Up until recent tax reform via the Tax Cuts and Jobs Act (“TCJA”), there was a 10% and 20% tax credit available. The 10% rehabilitation tax credit was for the rehabilitation of certain buildings that were (1) not on the National Register of Historic Places, (2) non-residential income producing, and (3) built before 1936. However, the TCJA removed this 10% credit for projects that are not grandfathered.
Conversely, the more commonly used 20% Historic Tax Credit is for the rehabilitation of historic buildings that (1) must be listed, or eligible for listing, on the National Register of Historic Places, (2) must be income producing (can include residential rental), and (3) the renovations must meet the Secretary of the Interior’s Standards for Rehabilitation. These standards, which often affect the exterior and interior of the building, spell out guidelines for rehabilitation projects and generally require that alterations remain consistent with the building’s historic character. Unlike the 10% credit, there is no minimum building age requirement for the 20% credit. The 20% credit requires the building owner to go through a three-part approval process through the state and ultimately the National Park Service.
Prior to the TCJA, the tax credit could be used in its entirety in the same year that the property was placed into service. However, the current law requires that the tax credit be spread out over 5 years (4% utilization per year). For example, if a HTC project was completed and placed in service in 2016, all 20% of the credit was available in the 2016 tax year. Conversely, if a non-grandfathered HTC project is complete and placed in service in 2020, the 20% credit is spread equally over 2020, 2021, 2022, 2023, and 2024.
An attractive feature of the Historic Tax Credit is that property owners or developers have the option use the tax credits themselves or to bring an investor into the project and allocate the credit to that investor. Although it is common to hear developers selling tax credits, the credits are not technically sold. Technically the investor is allocated the credit though various types of tax structures.
The current Historic Tax Credit is calculated as 20% of all qualified rehabilitation expenditures (“QREs”) incurred during the renovation. Examples of qualified expenditures generally include building rehabilitation costs, architectural and engineering fees, site survey fees, legal expenses, development fees, and any other construction-related costs that can be added to the basis of the building. Note that land improvements and personal property are not QREs.
There is a substantial rehabilitation requirement such that the amount spent on the rehabilitation must equal or exceed the original basis of the building (excluding land, land improvements, and personal property) at the start of the renovation. If the overall property was acquired for $3,000,000, of which $500,000 was land leaving $2,500,000 as the basis of the building, then the rehab expenses must equal or exceed $2,500,000.
Depending on current state legislatively activity, there are approximately 35 +/- states with some type of rehabilitation tax credit that range from 20% to 25% of the QREs. In total, the combined federal and state tax credits could equal 45% of the QREs.
A cost segregation study allows for real estate owners to accelerate depreciation deductions by reclassifying certain items from Sec. 1250 property to Sec. 1245 property. Generally, Sec. 1245 property is tangible personal property and Sec. 1250 property is real property that is not Sec. 1245 property. Sec. 1245 property has shorter recovery periods for depreciation purposes than that of Sec. 1250 property. More specifically, Sec. 1245 property may be depreciated over five and seven years and is often eligible for accelerated methods and bonus depreciation. Land improvements, which have a 15-year recovery period, are Sec. 1250 property. Sec. 1250 building property is generally depreciated over a lengthy 27.5 years for residential property and an even longer 39 years for nonresidential property. Additional Sec 1250 property includes qualified improvement property (39 yr), qualified leasehold improvement property (39 or 15 yr), qualified retail improvement property (15 yr), and qualified restaurant property (15 yr).
A cost segregation study is done for acquisitions as well as new construction or renovations. The study can be done in the tax year when the property is placed in service or can be done retroactively.
In general, a taxpayer benefits from a reduced tax liability by maximizing depreciation deductions. Therefore, by using a cost segregation study to reclassify certain property items eligible for accelerated depreciation, a taxpayer lowers tax liability in the early years of ownership. The benefit of utilizing this technique is to take advantage of the immediate cash flow generated from the tax savings, particularly the tax savings attributable to the catch-up adjustment that is often available in the year the cost segregation study is completed for existing buildings that have utilized a straight line 27.5 or 39-year approach for all property assets. This tax strategy is advantageous for the taxpayer because they receive an influx of cash in the same year.
Can Both Strategies Be Implemented?
In general, a taxpayer would want to tread carefully when considering utilizing both the HTC and a cost segregation study. This is especially true if a tax credit investor is part of the transaction and/or if a state HTC is in play. Lastly, if the project includes new markets tax credits or low-income housing tax credits, additional considerations are warranted particularly because of basis issues and tax losses. It is critical that the stakeholders in the transaction understand the implications of the credits and the additional deductions generated which can create significant tax losses.
Recall that the Historic Tax Credit is only available for the renovation costs made to the existing historic building which is real property. The HTC is not applicable for the acquisition of the property or for any addition costs to the building or the property. Doing a cost segregation study on the renovation costs will change certain property items from real to personal and therefor reduce the HTC. For example, performing a cost segregation study to reclassify a portion of the rehabilitation work, such as ornamental lighting, decorative millwork or removable flooring, to Sec. 1245 personal property would reduce the value of both the federal and state Historic Tax Credit since the credit can only be applied against rehabilitation to Sec. 1250 real property.
However, cost segregation could still be beneficial. First, a cost segregation study could be done on the original acquisition cost to ensure that the basis of the building is accurate and that the personal property and land improvements have been appropriately depreciated. This could help to keep the starting basis lower and therefore the substantial renovation threshold lower. Second, since the Historic Tax Credit would not apply to any expansions or additions to the original building, a cost segregation study could be performed on that portion of work which could be significant. Third, a cost segregation study can identify qualified improvement property (“QIP”). QIP includes most improvements made to a nonresidential building’s interior but currently has a 39-year life due to a drafting error in the TCJA. However, it is anticipated that QIP may be changed to have a 15-year life via current draft legislation if approved. It is important to note that QIP, and the other qualified property categories, often are eligible for bonus depreciation depending on when they are placed in service and other factors. If the desire is to maximize the HTC (especially in situations where there is a state HTC), bonus depreciation must be opted out because QREs are reduced dollar for dollar by the amount of bonus depreciation claimed.