Tax Credits for Real Estate Developers

7 minute read

For the past few years, the name of the game for real estate developers has been adaptation. They have had to manage the rising costs of raw materials while simultaneously working with a dwindling pool of skilled labor and adjusting to rapid changes in demand. Even though there is no one right path forward, there is a tried and true technique that can help lessen the blow of a struggling economy: taking advantage of federal tax incentives.

New Markets Tax Credit

The new markets tax credit (NMTC) has been around since 2000, but it’s still going strong today. Its goal is to create jobs and spur investment in low-income communities across the nation.

What is the New Markets Tax Credit?

The federal government offers a non-refundable tax credit against federal income taxes that totals 39% of the cost for developers who invest in qualifying communities. This credit will be awarded over a seven-year period: 5% of the investment is awarded in each of the first three years, and 6% of the investment in the remaining four years.

To be eligible for the program, developers must apply to the Treasury’s Community Development Financial Institutions (CDFI) Fund. Once approved, they can claim the NMTC for qualifying equity investments. Because applying to the CDFI Fund can be onerous for smaller developers and investors, some choose to use an intermediary known as a Community Development Entity (CDE).

What are Community Development Entities? CDEs are intermediaries that help developers and individual investors claim the NMTC. CDEs apply to the CDFI Fund and initiate investments into qualifying communities. When they are awarded credits for their investments, they sell those tax credits to developers and other investors.

Although CDEs are not cost-free, some developers like to use CDEs to simplify the credit approval process. In fact, CDEs may even be more cost effective to developers than going it alone; CDEs often apply to other public subsidy programs and/or state or local tax incentives programs that can compound the tax savings for investors.

Even though the credit has been popular, it is slated to sunset at the end of 2025. Last year, two separate bills were introduced in Congress that would make the NMTC permanent: House Bill H.R. 1321 and Senate Bill S. 456. Neither has gotten any traction, but their presence may indicate that Congress is amenable to making the NMTC permanent in a future tax bill.

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Historic Rehabilitation Tax Credit Program

The rehabilitation tax credit awards developers with a federal income tax credit worth 20% of the cost of restoring historic buildings. This tax credit can be claimed over a five-year period beginning with the year the building was placed in service.

To qualify for the credit, the taxpayer must go through a three-part application process.

Part 1: Evaluation of Significance

Part 1 of the application ensures the building is certified as a historic structure. There are three ways to do this:

  1. Buildings that are listed in the National Register of Historic Places are already classified as certified historic structures.
  2. Buildings located in a registered historic district will be considered certified historic structures if the taxpayer gets approval from the National Parks Service (NPS) that their building contributes to the historic character of the district.
  3. Even if their building is located outside of a registered historic district, the taxpayer can get a preliminary determination from the NPS that their building is of historical significance. Their building will then be certified as a historic structure if their rehabilitation project plans in Part 2 get approved.

Part 2: Description of Rehabilitation

Once the historic structure is certified, developers will need to substantiate tothe NPS that their building rehabilitation plans will be consistent with the property’s historical character. When considering the project, the NPS will see whether the plans will meet the Secretary of the Interior’s Standards for Rehabilitation.

Part 3: Request for Certification of Completed Work

Once the work is completed, the developers can fill out Part 3 of their application to certify that the work was completed as it was proposed.

Other Requirements

There are a few other basic requirements for the program:

  • The building must be depreciable.
  • The building cannot serve as the owner’s primary residence.
  • The rehabilitation must be substantial, which means that rehabilitation costs must exceed the greater of $5K or the adjusted basis of the building.
  • Once the property is placed in service, it must be used for an income-producing purpose for at least five years.
  • The developer must be able to show the NPS “before” and “after” photos to confirm their work has been completed.

Developers can claim the credit by filing Form 3468.

Low-Income Housing Tax Credit (LIHTC)

The low-income housing tax credit (LIHTC) encourages developers to invest in the new construction, acquisition or rehabilitation of low-income housing. Investors who make long-term investments in rental housing for low-income tenants can take a credit between 4% and 9% of their capital investment.

To qualify for the LIHTC, developers must either:

  • Rent at least 40% of the units to tenants with incomes equal to or less than 60% of the region’s median income, or
  • Rent at least 20% of the units to tenants with incomes equal to or less than 50% of the region’s median income

Additionally, rents must be kept below 30% of the tenant’s maximum eligible income as determined by the US Department of Housing and Urban Development (HUD).

Here are a few more important things to know about this tax credit:

  • The credit is calculated as a percentage of the project’s costs that are used to house tenants meeting the income tests. To get the largest credits, most LIHTC applicants seek for most or all their tenants to qualify as low-income.
  • Taxpayers can claim this credit each year for up to 10 years beginning with the year in which they place their low-income housing project into service.
  • Because the LIHTC is a nonrefundable income tax credit, it will only benefit taxpayers who have taxable income, which is why some developers sell their credits to corporations that can utilizelarge credits.
  • LIHTC is a great credit to consider because it is a permanent fixture in the tax code, which makes it a reliable strategy for real estate developers when tax planning.

Tax Planning for Developers

Developers and other real estate investors can benefit from strategic tax planning using tax credits like these, but only if they know how to comply with the programs. Taxpayers should reach out to their CPAs to fully understand how these programs work and to ensure they are complying with all program requirements.

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