Financing Hotel Rehabs With Federal Rehabilitation Tax Credits
By Robert Plotka Managing Director, CityScape Capital Group | October 28, 2008
Through the Internal Revenue Code Section 47, the federal government offers lucrative rehabilitation tax credits to encourage preservation and adaptive reuse of historic and pre-1936 buildings. Calculated as a percentage of the eligible rehabilitation expenses, federal tax law offers a 20% tax credit for substantial rehabilitations of historic buildings, and a 10% tax credit for substantial rehabilitations of non-historic, non-residential buildings built before 1936.
A substantial rehabilitation means that a taxpayer's rehabilitation expenditures during a 24-month or 60-month measuring period must exceed the aggregate "adjusted basis" of the building. The adjusted basis is generally defined as the purchase price, minus the value (or cost) of the land, plus the value of any capital improvements made since the building acquisition, minus any depreciation already claimed.
The federal tax credit program for historic buildings is administered by each state's historic preservation office and requires approval from the National Park Service, a division of the U.S. Department of the Interior. In contrast, the 10% rehabilitation tax credit for substantial rehabilitations of non-historic, non-residential buildings built before 1936 is a single IRS tax form submission and requires no federal or state involvement.
These tax credits can be either used to offset the building owner's federal income tax liability or transferred to an institutional investor in exchange for additional equity capital that can be utilized for long-term financing of the project. Because the Internal Revenue Code's Passive Activity Rules and Alternative Minimum Tax Regulations severely limit and, sometimes, prohibit the use of tax credits by individuals, many building owners syndicate the tax credits to a third-party institutional investor who can utilize the tax credits.
Syndicated tax credit transactions require the tax credit investor to be admitted into a legal entity, such as a limited partnership or limited liability company that will either own the building or hold a long-term operating lease on the building. In these circumstances, the tax credit investor acts as either the limited partner or investor member while the building owner serves as either the general partner or managing member.
When visiting any metropolitan area, odds are at least one hotel renovation can be found underway that is eligible for the federal rehabilitation tax credit. Such examples might be the restoration of a historic hotel to its original grandeur coupled with all the conveniences of contemporary culture, the adaptive reuse of a vacant office building into a luxurious four-star hotel, or the rehab conversion of a residential estate into a quaint bed and breakfast. However, one question always comes to mind... Does the hotel owner realize that the renovation work qualifies for federal rehabilitation tax credits?