Tax Credits Boost Housing Rehabilitation

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While rehabilitation is often a cost-effective alternative to new construction, practical guidance on overcoming the many barriers to rehabbing older structures has been in short supply. Despite their value as both an affordable and a renewable resource in housing markets nationwide, the existing housing stock varies so much in terms of condition, age, and construction methods that the rehabilitation process is far from predictable, and often more challenging than new construction. Obtaining a sound grasp of these issues is difficult because the barriers vary across projects and communities.

To assist decisionmakers and housing professionals, The National Trust for Historic Preservation, The Center for Urban Policy Research at Rutgers University, Enterprise Community Partners, Inc., The National Center for Healthy Housing, and HUD collaboratively undertook an investigation into the status and potential of housing rehabilitation for positively influencing the nation’s supply of affordable housing. The results are available in a two-volume report, Best Practices for Effecting the Rehabilitation of Affordable Housing, which addresses the challenges to rehabilitation at the development, construction, and occupancy stages.

Tax credits are one of the most significant resources available for housing rehabilitation.

Tax Credit Resources

This study finds that tax credits are traditionally among the most significant resources available to rehabbers, especially low-income housing tax credits (LIHTCs), historic rehabilitation tax credits (HRTCs), and new markets tax credits (NMTCs). Federal funds in the amount of $3.6 billion a year leverage another $8.5 billion in private funding for a total of $12 billion being used to rehabilitate 115,000 housing units annually. Tax credits account for $2 billion of that $3.6 billion.

Low-Income Housing Tax Credits

Many states participate in both the federal LIHTC program, as well as sponsoring their own tax credit programs. Applications are competitive, and are scored according to criteria that vary from state to state. This study found that although some scoring systems favor rehabilitation, they more frequently are neutral or favor new construction. An analysis of the criteria in use identified four scoring features that give rehabilitation projects a better chance to compete: state set-asides for rehabilitation projects, points for historic rehabilitation, points for small projects, and points for rehabilitation projects in challenging locations, such as Difficult Development Areas.

Historic Rehabilitation Tax Credits

Since the late 1970s, more than 325,400 housing units were completed with the help of federal historic preservation tax incentives, with 23 percent of them being affordable to low- or moderate-income families. A 20-percent HRTC is available for rehabilitating certified historic structures to serve as residential rentals. Developers often use HRTCs in combination with other subsidies, such as LIHTCs, property tax exemptions, and preservation easements.

The researchers found that HRTCs seem underutilized as a tool for rehabilitation, due to a number of congressionally controlled constraints. For example, a 10-percent rehabilitation tax credit is available for substantial rehabilitation of nonhistoric buildings built before 1936, but it can’t be used for residential projects. Removing the nonresidential restriction could be very useful in financing the transition of older, nonhistoric buildings to affordable housing.

Another problem with the 10-percent credit is that a rehabilitated building has to have been built before 1936. This requirement, which was passed in 1986, is seemingly based on the assumption that an “old” building is at least 50 years old. The reference year of 1936 still stands, however, meaning that buildings now have to be over 70 years old to qualify. A simple solution, investigators point out, is to index the age requirement. Other recommended improvements would change the way in which the tax basis is calculated, allow a larger subsidy in distressed areas, and make HRTCs more viable for small projects.

New Markets Tax Credits

New Market Tax Credits were created in 2000 to stimulate long-term investment in the economic development of low-income communities by attracting investor capital. NMTCs give taxpayers credit against their federal income taxes in exchange for making equity investments in Community Development Entities (CDEs). CDEs use this equity to invest in or make loans to businesses in low-income communities. Investments that qualify include those which finance start-up businesses, inventory expansion, business expansion or acquisition costs, rehabilitation of commercial space, location of small-scale industries in upper stories, and stimulation of mixed-use commercial and residential space.

An investor earns a dollar-for-dollar reduction in taxes spread out over 7 years, equal to 5 percent of the equity investment for each of the first 3 years and 6 percent for the remaining 4 years, for a total of 39 percent. Investors may not redeem their investments in CDEs before the end of this 7-year period. In this way, NMTCs attract new capital to underserved communities that are cash poor, but rich in deteriorated properties. NMTCs can bring 20 to 25 percent more dollars to a qualifying rehabilitation project and can be combined with the 20- or the 10-percent HRTC.

Although NMTCs were meant to stimulate business development and expansion, the law permits their application in mixed-use projects that include condominium housing. One example of what is possible is the McKessow Building in Rock Island, Illinois, a mixed-use project using NMTCs that includes retail space at ground level and two floors of condominiums above. Another example is the Heritage Building in Auburn, Washington, which was once a bank, but is now being adapted to offer both retail and living spaces thanks to NMTCs. In St. Louis, Missouri, the adaptive reuse of the Old Post Office was subsidized with $13.5 million in NMTCs. In turn, the project stimulated the rehabilitation of five adjacent buildings that resulted in 400 market-rate and affordable housing units, plus parking, retail space, and office space.

Tax credits represent a powerful resource for housing rehabilitation efforts. The study team suggests that this resource can be enhanced if states revise LIHTC scoring criteria to eliminate any bias against rehabilitation, if states supplement federal LIHTC and HRTC programs with similar programs of their own, and if federal HRTCs are made more accessible to rehabilitation initiatives.

Best Practices for Effecting the Rehabilitation of Affordable Housing can be downloaded at www.huduser.org/publications/affhsg/bestpractices.html. Print copies are available for a nominal fee by calling HUD USER at 800.245.2691, option 1.