DEVELOPMENT
"OPPORTUNITIES"
by David F. Belkowitz *
Any attorney working with developer clients, especially those who work in urban areas, needs to be familiar with the various development "opportunities" that may be available under the Internal Revenue Code of 1986, as amended (the "Code") or the Code of Virginia of 1950, as amended (the "Virginia Code"). Some of the opportunities that are available are a means to raise equity; others are measures that reduce operating expenses. This article will discuss in overview form only a number of these opportunities. Due to its complexity, each "opportunity" could be the subject of a separate article.
I. TAX CREDITS
Perhaps the most familiar "opportunity" is the rehabilitation tax credit. This credit is available under section 47 of the Code and is euphemistically known as the "historic" tax credit. Not many people realize that a building does not have to be "historic" to qualify for the rehabilitation tax credit. There are two types of rehabilitation tax credits: a 10% credit for a renovation to a building first placed in service prior to 1936 and a 20% credit to a renovated certified historic structure, which is any building listed in the National Register or any building in a registered historic district and certified by the Secretary of Interior as being of historic significance to the historic district. The credit percentage is applied to the "qualified rehabilitation expenditures" made to the building. Typically the rehabilitation tax credits are sold to an investor partner which acquires 99.9% of the entity that owns the building. For the syndication to work, the ownership entity must be a pass through entity for tax purposes, such as a limited partnership or a limited liability company. Rehabilitation tax credits are a one-time credit taken by the taxpayer the year the building is placed in service. Certain uses of the building are not permitted and use by a government agency or a nonprofit agency could void the credit. Lessees who undertake rehabilitation may also qualify for the credit provided the term of the lease on the date the work is completed exceeds the recovery period for the building.
Once renovated, the building must remain "investment credit property" for five years to avoid recapture of the credit. Recapture is phased out over a five year period so that if the loss of the credit occurs in the fourth year, there is only a 40% recapture.
There is no limit on the amount of the rehabilitation credit; nor is there a competitive process to obtain the rehabilitation credit, but the proposed rehabilitation must be approved by state and federal agencies.
II. VIRGINIA HISTORIC REHABILITATION TAX CREDIT
Section 58.1-339.2 of the Virginia Code is the state counterpart to the federal rehabilitation tax credit. It is similar, but not identical, to the federal credit. To qualify for the Virginia credit, the building must be (i) on the Virginia Landmarks Register, (ii) certified as contributing to the historic significance of a historic district that is listed on the Virginia Landmarks Register, or (iii) certified as meeting the criteria for listing on the Virginia Landmarks Register. The amount of the credit is 25%. A taxpayer may claim the Virginia credit without claiming the federal rehabilitation credit, or the taxpayer may claim both the Virginia and federal credits. Under the Virginia credit, an owner-occupied building is eligible for the credit.
A unique feature of the Virginia credit is that it is available to a Virginia individual, trust, estate or corporation that incurs eligible expenses in the rehabilitation of a certified historic structure in another state. If that state has in effect a reciprocal historic rehabilitation tax credit program and agreement for residents of that state who rehabilitate historic structures in Virginia, the Virginia taxpayer shall be entitled to the Virginia credit as if the property was in Virginia.
III. LOW INCOME HOUSING TAX CREDIT
A second tax credit that may be of interest to apartment developers is the federal low income housing tax credit available under section 42 of the Code. Unlike the rehabilitation tax credit which is a one-year credit, the federal low income housing tax credit is a ten-year credit.
In order to qualify for the credit, a developer must agree to rent 20% of the units to individuals/families with incomes not in excess of 50% of the area's median family income or 40% of the units to individuals/families with incomes not in excess of 60% of the area's median family income. The greater the percentage of units occupied at whichever level is selected, the greater the amount of the credit.
There is a limited supply of federal low income housing tax credits. They are available through a competitive process administered by the Virginia Housing Development Authority ("VHDA"), and the competition is keen. If the developer utilizes tax exempt bonds to finance the project, then the developer can obtain federal low income housing tax credits without having to go through the competitive process, but (i) the development must be in compliance with VHDA's qualified allocation plan, (ii) the amount of credits that will be awarded will not exceed the amount necessary to make the project feasible and (iii) the credit will be a "4% credit" (instead of a "9% credit"). The terms "4% credit" and "9% credit" no longer are the applicable credit limits but are commonly used to distinguish the credit a developer gets for acquisition and the credit a developer gets for new construction.
The actual credit percentage determination is now more complicated and changes monthly, but the percentages are the percentages which will yield over a ten-year period a present value equal to 70% of the qualified basis for new construction and 30% of the qualified basis for existing buildings or new buildings which are federally subsidized.
Developers are limited in the amount of rent that they are permitted to charge tenants. The annual rent cannot exceed 30% of the applicable median family income limit (50%/60%), and there are no direct rental subsidies available. Students are not eligible tenants.
IV. REAL ESTATE TAX EXEMPTION
If one's client is a tax exempt organization, it may be possible for the client to qualify for the real estate tax exemption. Exemption from real estate taxation under the Virginia Code is available either by classification (§58.1-3606 and §§58.1-3609 to -3622) or by designation (§58.1-3607 and §58.1-3650). The difference between these categories is that exemption by classification is a statutory scheme where specific types of organizations enumerated in the Virginia Code, such as volunteer rescue squads, automatically qualify for real estate tax exemption, whereas exemption by designation requires approval by the General Assembly on an organization by organization basis. Exemption by designation is the path most organizations will need to follow.
Before the General Assembly will even consider a request for real estate exemption by designation, the governing body of the host jurisdiction must adopt a resolution after conducting a public hearing in accordance with section 30-19.04 of the Virginia Code. If approved by the General Assembly, the tax exemption will go into effect on July 1 in the year of the approval.
V. REAL ESTATE TAX ABATEMENT AND TAX CREDITS
In addition to the provisions for taking a real estate tax exemption, the Virginia Code also contains numerous opportunities for real estate tax abatement and one opportunity for a tax credit.
Virginia Code section 58.1-3220. This section authorizes the governing body of any county, city or town to provide partial exemption from real estate tax for any residential structure that is over fifteen years of age which has undergone substantial rehabilitation, renovation or replacement for residential use. Under this provision much discretion is left to the local governing body to establish the criteria for the partial abatement. The amount of the abatement is subject to determination by the local governing body, and may be equal to the increase in assessed value due to the renovations or a percentage of such increase or alternatively an amount up to 50% of the cost of the renovation. The abatement may run for a period not to exceed fifteen years. It is worth noting that if the rehabilitation is achieved through demolition of a structure that is on the Virginia Register or is determined to contribute to the significance of a registered historic district, the project is not eligible for partial tax abatement.
Virginia Code section 58.1-3220.1. This section authorizes the governing body of any county, city or town to provide partial exemption from real estate tax for real estate on which a hotel or motel no less than 35 years of age has undergone substantial rehabilitation, renovation or replacement for residential use. The partial exemption may not exceed either an amount equal to 90% of the total assessed value of the rehabilitated, renovated or replaced structure or an amount equal to the increase in assessed value attributable to the rehabilitation, renovation or replacement and may not run for longer than twenty-five years. As with Virginia Code section 58.1-3220, there is no exemption if the structure demolished is listed on the Virginia Register or is determined to contribute to the significance of a registered historic district.
Virginia Code section 58.1-3221. This section authorizes the governing body of any county, city or town to provide a partial exemption from real estate tax for real estate on which any structure no less than twenty years old, or fifteen years old if the structure is in an enterprise zone, has undergone substantial rehabilitation, renovation or replacement for commercial or industrial use. The amount of the abatement may not exceed an amount equal to the increase in assessed value resulting from the rehabilitation, renovation or replacement of the structure or an amount up to 50% of the cost of the rehabilitation, renovation or replacement. The abatement may run for a period not to exceed fifteen years. As with Virginia Code sections 58.1-3220 and 3220.1, there is no exemption if the structure demolished is listed on the Virginia Register or is determined to contribute to the significance of a registered historic district.
Virginia Code section 58.1-3220.01. This section authorizes the governing body of any county, city or town to provide a real estate tax credit equal to certain property tax liens owed on real estate on which any structure or other improvement no less than fifteen years of age has undergone substantial rehabilitation, renovation or replacement for residential use. The local tax credit is available only to those property owners who have purchased a structure which at the time of purchase contained property tax liens exceeding 50% of the assessed value of the property and the amount of the credit may not exceed the amount by which the property tax liens exceeded 50% of the assessed value of the property at the time of purchase. Once again, no credit is available if the structure demolished is on the Virginia Register or determined to contribute to the significance of a registered historic district.
VI. ENTERPRISE
ZONE REFUNDABLE REAL PROPERTY
INVESTMENT
TAX CREDIT
Virginia Code section 59.1-280.1 creates an investment tax credit against personal income tax and corporate income tax for "qualified zone improvements." The amount of the credit depends on whether the taxpayer is a "large qualified zone resident" or a "small qualified zone resident." For a "small qualified zone resident," the tax credit is equal to 30% of the "qualified zone improvements" and may not exceed $125,000 in any five-year period, but note that statewide the aggregate amount of (i) tax credits granted to small qualified zone residents and (ii) business tax credits granted to small qualified business firms under section 59.1-280 for each fiscal year may not exceed $16,000,000. For a "large qualified zone resident," the tax credit is allowed in an amount of up to 5% of qualified zone investments, which is the sum of qualified zone improvements and the cost of machinery, tools and equipment used in manufacturing tangible personal property.
In order to quality for the tax credit, the taxpayer must incur rehabilitation or expansion expenditures on depreciable real property equal to or in excess of (i) $50,000 and (ii) the assessed value of the original facility immediately prior to the rehabilitation or expansion. If new construction is involved, the taxpayer must spend at least $250,000 on depreciable nonresidential real property.
VII. TAX EXEMPT FINANCING
Tax exempt financing is a term used to describe debt instruments the interest on which is excludable from Virginia income taxation and potentially federal income taxation. Due to exclusion of interest from taxation, tax exempt bonds will bear interest at rates lower than conventional sources of financing. Several types of tax exempt bonds the interest on which is exempt from both federal and Virginia income taxation are described below.
Tax exempt bonds for the benefit of private parties are known as "conduit financings" and are typically issued by redevelopment and housing authorities and industrial/economic development authorities ("Bond Issuers") – though there are a number of other limited purpose political subdivisions that have been created by statute to fulfill similar purposes. The Bond Issuer issues the bonds and the proceeds are then loaned to the private borrower to undertake the project.
A. Qualified Small Issue Bond
Section 144 of the Code provides that interest on a "qualified small issue" bond is excludable from federal income taxation. Qualified small issue bonds may only be used to finance manufacturing facilities. Prior to the Tax Reform Act of 1986, it was not uncommon to use a qualified small issue bond to finance a shopping center, hotel or office building in addition to manufacturing facilities.
In order to issue qualified small issue bonds, the Bond Issuer must obtain an allocation of "volume cap" from the Virginia Small Business Financing Authority ("VSBFA"). While there is a limit on how many bonds may be issued in any single year, obtaining "volume cap" for a qualified small issue financing has seldom been a problem.
To qualify as a "qualified small issue bond," the amount of capital expenditures for the facility, together with capital expenditures incurred by the owner in the same jurisdiction for the three years preceding the issuance of the bonds, may not exceed $10,000,000, regardless of the source of the financing of the capital expenditures. There is also a prospective limitation. The sum of the capital expenditures incurred by the borrower in the jurisdiction, including the capital expenditures for the facility, for the period beginning three years prior to the date of the issuance of the bonds and ending on the date which is three years after the date of the issuance of the bonds, may not exceed $10,000,000. If a large issue is contemplated, the borrower needs to think about future growth/expansion in the succeeding three years because if the growth/expansion causes the $10,000,000 limit to be exceeded, the tax exclusion is lost.
B. Qualified Residential Rental Project
Section 142(d) of the Code provides that interest on a "qualified residential rental project" is excludable from federal income taxation.
As with "qualified small issue bonds," it is necessary to obtain an allocation of "volume cap" from the VSBFA unless the issuer of the bonds is the Virginia Housing Development Authority, which has its own volume cap allocation. Obtaining volume cap for an apartment development through the VSBFA is difficult because there is only approximately $45,000,000-$50,000,000 annually allocated by the VSBFA for "qualified residential rental projects," and the most VSBFA will allocate to a single project is $7,500,000.
To qualify as a "qualified residential rental project," the owner must agree to rent either 20% of the units to individual/families whose incomes do not exceed 50% of the area's median family income (as determined by HUD) or 40% of the units to individuals/families whose income do not exceed 60% of the area's median family income. Most developers elect the 40/60 test but to maximize low income housing tax credits lease 100% of the units to tenants at the selected income level. There are no rent subsidies provided for the tenants as part of the bonds; nor is there a limit on the rents that can be charged. Recent college graduates and municipal employees are potential income eligible residents. Students are not eligible tenants.
C. Exempt Facility Bond
Section 1394 of the Code provides that an "exempt facility bond" (section 142 of the Code) includes any bond issued as part of an issue of which 95% or more of the net proceeds are used to provide an "enterprise zone" facility. The "enterprise zone" referred to in the Code is not the same enterprise zone created under the Virginia Code.
The rules for "enterprise zone facility" bonds are very complex. First, the principal beneficiary of the bonds must be an enterprise zone business. Second, the property financed must be "qualified zone property." To give the reader some sense of the complexity of the rules the following are only a few of the criteria that must be satisfied for a company to be an enterprise zone business.
VIII. FINANCING INFRASTRUCTURE
There are at least two "opportunities" available to developers to utilize tax revenues or special assessments to finance infrastructure. One of these methods is through the "tax increment financing," provisions of section 58.1-3245 et seq. of the Virginia Code. Under tax increment financing, a locality defines a development project area and then creates a "tax increment financing fund" into which are deposited real estate tax revenues attributable to the increased value between the current assessed value and the base assessed value of the real estate in the development project area. Moneys in the tax increment financing fund may be used to satisfy "obligations" or to pay "development project cost commitments." "Obligations" are bonds and other forms of indebtedness by the locality. A "development project cost commitment" is a determination by the locality to pay a sum specific of development project costs from the tax increment financing fund.
Tax increment financing benefits the developer because it is the tax increment, or public money, that pays the infrastructure costs. From the locality's perspective, tax increment financing requires the locality to dedicate tax revenues for a specific project which it may not want to do. It also requires the locality to make political decisions regarding the development impact of particular projects because once it has created a development project area for a particular development it can expect to receive requests for the establishment of other development project areas.
A second, and emerging, method for financing infrastructure is through a community development authority (section 15.2-5152 et seq of the Virginia Code). A community development authority may be created by petition of landowners who in their petition define the boundaries of the authority. The boundaries may overlap two jurisdictions. A community development authority has the power to issue revenue bonds to finance infrastructure. To repay the bonds the community development authority requests annually that the locality levy and collect a special tax. Note that the special tax is in addition to the regular tax, which distinguishes community development authority financing from tax increment financing.
The bonds issued by a community development authority would be issued as tax exempt bonds. If structured properly, the bonds would be considered, under federal tax law, as "governmental obligations" as opposed to "private activity bonds." Different rules apply depending on how the bonds are categorized, including having to get an allocation of volume cap if the bonds are deemed private activity bonds.
As this article is being written, the issuance of community development authority bonds by a proposed community development authority for a commercial development in western Henrico County has been determined to be improper. The owner of a competing mall and three taxpayers alleged in validation proceedings brought by the community development authority that the proceeds of the bonds were being used for private not public purposes. The trial court sustained that argument.
* David F. Belkowitz is a shareholder with Hirschler, Fleischer, Weinberg, Cox & Allen in Richmond, Virginia. He is a member of the Firm's Real Estate Section and focuses on governmental financings, public finance and tax credits.