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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2012

Find Rewards in Preserving History

Take advantage of tax credits for the preservation and rehabilitation of older buildings

Find Rewards in Preserving History

Many cities across the country have treasures of historic, older buildings that occupy prime locations and can be used for commercial or residential purposes. These properties — that once were headed to demolition — can be turned into successful and rewarding assets for clients who value them and are willing to see the potential returns on investing in  their rehabilitation. 

Commercial mortgage brokers who want to take advantage of the opportunities these buildings represent must know the federal tax-credit programs that are in place to promote the rehabilitation and renovation of older buildings. With this knowledge and in-depth market experience, they — and their clients — can capitalize on a niche that often is overlooked.

"Many cities use these incentives to encourage developers to work in downtown locations." 

Commercial mortgage brokers may be familiar with the many types of federal and state tax-credit programs that promote investment in specific market segments — affordable housing or new markets, for example. The tax-credit program for the preservation and rehabilitation of older and historic buildings is one that can be a great addition to any commercial mortgage broker’s knowledge base.

The current tax incentives for these properties were established by the Tax Reform Act of 1986 (Internal Revenue Code Section 47 [formerly Section 48(g)]). The goal of these incentives is to promote the rehabilitation and substantial renovation of older buildings that are either listed in the National Register of Historic Places or are to be certified as contributing to the significance of a registered historic district.

To be eligible for these tax credits, the property must meet a few conditions:

  • The property must be rehabilitated according to standards set by the secretary of the interior. 
  • The property must be income-producing. 
  • After rehabilitation, the historic building must be used for an income-producing purpose for at least five years.
  • The project must meet the “substantial rehabilitation test.” This means that the cost of rehabilitation must exceed the pre-rehabilitation cost of the building. Generally, this test must be met within two years or within five years for a project completed in multiple phases. 


Before the enactment of Internal Revenue Code Section 47, older buildings were more likely to be demolished than to go through a rehabilitation process to preserve them and make them usable. The changes introduced by Section 47 made the federal tax code more in line with legislation that has been applicable in many European countries for years. The tax code has a hand in promoting a national historic-preservation policy to encourage voluntary, private-sector investment in preserving historic buildings. 

In addition, the incentives offered by these tax credits have provided for one of the most successful programs used by the federal government to generate jobs — in the construction phase and in the subsequent use of these renovated buildings. As a result of the success of the historic tax-credit program on the federal level, 27 states now have enacted similar state tax-credit programs.

These programs often create middle-income and low-income housing in historic buildings. In fact, many cities use these incentives to encourage developers to work in downtown locations. This type of private investment in the historic core of cities and towns is crucial to the long-term economic health of many communities. In fact, historic tax credits and rehabilitation tax credits often result in augmented revenues for local and state government through increased property, business and income taxes.

Through Section 47, the federal government’s historic tax credits promote the preservation and adaptive reuse of certified historic and older buildings. They work as a dollar-for-dollar reduction of federal income tax liability. If the building isn’t historic, the federal tax credit is 10 percent. Historic tax credits only apply to commercial buildings; they cannot be used for private-residence buildings. Most state programs are based on 25 percent expenditures and some have maximum limitations — New York and Wisconsin, for example.

The dollar value of the historic tax credit is calculated as a percentage of certain expenditures known as qualified rehabilitation expenditures (QREs). These expenses are incurred in the course of construction. For the rehabilitation of certified historic buildings, the percentage is equal to 20 percent of QREs; for the rehabilitation of non-historic, nonresidential buildings built before 1936, the percentage is 10 percent of QREs. These credits become available to the property owner after the completed project is placed in service, and taxes are filed with the Internal Revenue Service. 


The qualification requirements for the 20 percent historic tax credit and the 10 percent rehabilitation tax credit include the condition that the rehabilitation must be substantial. A substantial rehabilitation means that a taxpayer’s QREs must exceed the “adjusted basis” of the building or $5,000, whichever is greater in a 24-month or 60-month measuring period (for a phased project). According to the National Trust Community Investment Corp., the adjusted basis is generally defined as the acquisition price, minus the land cost, plus the value of any capital improvements made since the building acquisition, minus any depreciation already taken.

To qualify for the 20 percent credit, the rehabilitation also must be certified as conforming to the secretary of the interior’s standards for historic rehabilitation. This entails completing a three-part application, which is reviewed first by the state historic preservation officer and then by the interior secretary’s designee — that is, the National Park Service. The three parts are:

  • The first part affirms the situation of the property being listed on the National Register or verifies that a property is a contributing structure in a national registered district; or is a building that could qualify as historic but isn’t listed on the National Register;
  • The second part sums up the rehabilitation work and includes a set of plans that must be approved by the state historic preservation officer; and 
  • The third part documents that the work has been done as proposed in the approved second part. 

There are just a few exceptions between the rules that apply to the 20 percent rehab credit and those that apply to the 10 percent credit. For example, the 10 percent credit requires no design review at the state or federal level, but there is a “wall test” requiring that three of the original four walls remain intact. Federal and state historic tax-credit programs have a five-year compliance and recapture period from the date the property is placed in service.

Because many building owners may not be able to use rehabilitation tax credits personally, they monetize them by selling the credits to others — mostly banks, insurance companies and large corporations. Because Section 47 requires that credits can only be claimed by project owners, the property owner may choose to form a limited partnership or a limited liability corporation with an investor to take advantage of the tax credits. Through these partnerships, the investor becomes one of the building owners for a five-year period. Investors typically are required as owners to receive the cash flow and all losses. 

Because developers frequently have strong economics and are not willing to give up the losses or the cash flow, a lease pass-through structure has been created to enable the investor to claim the federal tax credits generated by the project and defray its federal income-tax liability but not share in most of the economics of the property.

Many investors require an annual cash payment between 1 percent and 4 percent per annum and a buyback of their interest for between 5 percent and 20 percent. Depending on payment terms, the federal tax credits sell from $1 to $1.20 per tax credit dollar. State tax credits generally sell around $0.80 per tax credit dollar. In return, the corporate investor makes an equity investment in the project. 

• • •

Although details of the different tax credits can be complicated and often confusing, commercial mortgage brokers who can understand and help their clients take advantage of these programs will position themselves to stand out from the pack. This knowledge can be invaluable to clients because it helps them take advantage of long-standing tax incentives and makes their investments more fruitful.


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