In the past few years, the real estate industry has grappled with fluctuating demand, rising labor and material costs, and the impacts of a sluggish economy. While adaptation is key, real estate developers, investors and owners can proactively strengthen their equity within their capital stack, and lessen the blow of a fluctuating market, by taking advantage of tax credits and incentives.
What Is a Capital Stack in Real Estate?
Before we discuss how tax credits can benefit a project’s equity stack, let’s first define what a capital stack is: A capital stack is the different types of funding used for an investment project and the repayment obligations for each one (i.e., the order in which returns will be paid).
The separate types of financing within the stack can typically fall into one of two categories and will affect the project’s investors in different ways:
- Debt: This refers to any funds that have been provided by a lender, for example, a mortgage on the investment property or issued bonds that will be repaid with interest. An investor that holds a debt is granted higher priority when receiving returns on the investment.
- Equity: This is the amount of investment made into the project in the form of monetary funds or labor that equates to an ownership amount. Equity holders will have a lower priority when receiving their returns on the investment, however, they typically earn a higher return on investment (ROI) than debt holders.
How Tax Credit Equity Affects a Cap Stack
Tax equity — as the name suggests — is a form of equity investment. Tax equity investors are stakeholders that provide capital for the project in exchange for a portion of the tax credits received. In other words, these types of investors are not looking for returns based on the generated cash flow but are instead interested in the tax benefits of the project.
By applying for applicable tax credits, projects can attract another form of capital to their equity stack through tax equity investors. This can help provide additional funding and offset less than favorable market conditions.
Tax Credits To Grow Your Real Estate Stack
As mentioned above, there are numerous tax credits that can be leveraged towards a capital stack:
Historic Tax Credits
The historic tax credit (HTC), also known as the rehabilitation tax credit, is a federal general business credit available for developers who own certified historic buildings that undergo rehabilitation efforts for income-producing uses.
The National Park Service, in conjunction with the State Historic Preservation Office, certifies each structure and determines project eligibility. The HTC is calculated as 20% of Qualified Rehabilitation Expenditures (QRE’s), which represent capitalized rehabilitation expenses incurred by the taxpayer. The tax credit is taken ratably over a 5-year period.
In addition to the federal credit, many states offer rehabilitation tax credits that often mirror elements of the federal program with important varying distinctions. The state credits can generally be used in combination with the federal credit or used independently depending on the state program.
HTCs can be utilized by the taxpayer incurring the credits, or the credits may be monetized. When monetizing federal HTCs, the investor contributes equity directly to the project through a capital contribution. The investor subsequently receives the HTC through a tax credit allocation provided on a Schedule K-1.
The investor must maintain their ownership for five years after the final QRE’s are placed in service but will typically exit after the expiration of the five-year compliance period. The state credit can be monetized; however, each participating state has its own legislation and historic tax credit program. These state historic credits are either allocated through a partnership structure or directly sold to an investor depending on the state.
Using Historic Tax Credits
Cherry Bekaert is committed to assisting companies with navigating HTC resources and revitalizing abandoned buildings. These revitalization efforts create new economic opportunities and preserve a state's history and culture.
For instance, South Carolina has increased and extended its abandoned buildings tax credit. The South Carolina Abandoned Buildings Revitalization (ABR) credit is set to expire December 31, 2035. It was previously set to expire in 2025. This credit gives developers the ability to claim 25% of eligible rehab expenses.
New Market Tax Credits
New market tax credits (NMTCs) are another type of federal tax credit that can be a powerful way to attract investors and lenders to a real estate project in a low-income community, which often otherwise lacks access to traditional capital. Through NMTCs, investors, in exchange for investing in a Community Development Entity (CDE), are awarded a tax credit equivalent to 39% of equity invested.
Administered by the Community Development Financial Institutions Fund (CDFI Fund), a division of the Treasury, CDEs and Community Development Financial Institutions (CDFIs) apply to the CDFI Fund on an annual basis for allocation of NMTCs. The CDFI then invests these tax credits in projects located in low-income census tracts. The CDEs and CDFIs partner with investors who make an equity contribution in exchange for NMTCs that are generated by their investment over a seven-year period. The NMTCs can be used to offset the investor’s federal income taxes.
NMTCs are an essential gap-filling financial tool and traditionally offset 10% – 20% of total project costs, making additional traditional investments in the project more financially feasible. In addition, the NMTCs often spur additional private investments in the surrounding community, which can have a positive impact on property values and economic development.
Using New Market Tax Credits
Cherry Bekaert can help companies in navigating NMTC resources for various projects. Read these case studies to see how our professionals assisted with a 10,000-square-foot space in Athens, Georgia, as well as a repurposed mill in South Carolina, which is now used for non-profit, health and wellness, and retail businesses.
Low-Income Housing Tax Credits
The Low-Income Housing Tax Credit (LIHTC) is a good way for developers and investors to partner together to provide much-needed affordable housing in communities around the country. The LIHTC is a federal credit that is earned based on the amount of eligible costs spent on a project. New construction and substantial rehabilitation of residential developments can qualify as a LIHTC project.
Developers and tax credit investors form a partnership to facilitate the project and deliver the credit. While the credit does have a 15-year compliance period, investors can claim the credit over a 10-year period. Tax credit equity can account for 30% – 70% of the equity needed for a project.
Not only does this program provide affordable housing for low-income families, but it can also be coupled with other federal and state incentives to help revitalize communities and strengthen economically distressed areas.
Energy Tax Credits
Renewable energy tax credits and sustainability incentives created under the Inflation Reduction Act help cover the costs of renewable energy investments and the proliferation of energy-efficient buildings, with the credit worth up to 70% of investment. These credits and incentives can be used to offset a portion of the cost of installing renewable energy equipment, such as solar panels, wind turbines and geothermal systems. Other incentives also create accelerated deductions for investments in HVAC, interior lighting and overall building envelope.
The aforementioned credits (IRC Section 48) can be worth up to 30% of the system costs while the accelerated deductions (IRC Section 179D) can be in excess of $5.00 per square foot.
Using energy tax incentives can be a powerful way to attract investors and lenders to a real estate project that includes energy-efficient features. The credits can be used to offset a significant portion of the cost of energy efficiency improvements, making it more financially feasible for investors and lenders. In addition, energy-efficient buildings can be more attractive to tenants and buyers, resulting in a positive impact on property values and economic development.
Using Energy Tax Credits
Our Energy Tax Credits & Incentives team has saved companies thousands of dollars through utilizing energy tax credits and supporting clean energy production, advanced manufacturing and energy-efficient construction. Learn more with our case studies on optimizing tax credits for real estate and construction firms and how Section 45L helped a construction firm save over $350,000.
State Credits and Incentives
In addition to federal tax credits, many states offer their own credits and incentives to support real estate development. These may include property tax abatements, sales tax exemptions, income tax credits, infrastructure assistance, reduced land costs, utility and other incentives designed to encourage investment in specific areas or industries.
By taking advantage of these state credits and incentives, developers can reduce the overall cost of the project, making it more attractive to investors and lenders. In addition, state incentives can help to attract additional private investment in the community, which can have a positive impact on property values and economic development.
Using State Credits and Incentives
Read more guidance from Cherry Bekaert’s Tax Advisory team on state tax credits and incentives to help determine if your company is eligible.
How Cherry Bekaert Can Help
Historic tax credits, new market tax credits, low-income housing tax credits and state credits and incentives can all be powerful tools for boosting equity and improving the bottom line. Cherry Bekaert can help you understand how these programs can best support real estate development. We will guide your business forward so you can stay ahead of the curve and take advantage of new opportunities as they arise.
Related Insights
- Article: Tax Considerations When Disposing of Qualified Opportunity Zone Business Property
- Article: Top 3 Tax-Efficient Strategies for Deferring Real Estate Gains
- Alert: Amend Your Notice of Intent by October 15, 2024 for Your Current SC Abandoned Building Project
- Article: Monetizing Energy Tax Credits: A Guide to Transferability and Tax Equity Transactions
- Article: Top 10 States for Credits and Incentives Opportunities
