The Personal Income Tax Law and the Corporation Tax Law allow various credits against the taxes imposed by those laws.

This bill would allow to a taxpayer that receives a tax credit reservation allocation a credit against those taxes for each taxable year beginning on or after January 1, 2016, and before January 1, 2024, 2021, in an amount, determined in modified conformity with a specified section of the Internal Revenue Code, for rehabilitation of certified historic structures and, under the Personal Income Tax Law, for a qualified residence. This bill would provide for a 20% credit, or 25% credit, of qualified rehabilitation expenditures if the structure meets specified criteria, for rehabilitation of a certified historic structure or a qualified residence, as provided, within the state to be reserved and allocated by the California Tax Credit Allocation Committee, which shall consult with the Office of Historic Preservation, as provided, and which may adopt a reasonable fee to cover specified expenses. The aggregate amount of credit would be $50,000,000 per calendar year, plus unused allocation tax credit for the preceding year, $10,000,000 of which would be set aside for rehabilitation projects with qualified rehabilitation expenditures of less than $1,000,000, as specified. This bill would require the Legislative Analyst to, on an annual basis, collaborate with the California Tax Credit Allocation Committee to review the tax credit, as provided.

This bill would take effect immediately as a tax levy.

The Personal Income Tax Law and the Corporation Tax Law allow various credits against the taxes imposed by those laws.

This bill would allow to a taxpayer that receives a tax credit reservation a credit against those taxes for each taxable year beginning on or after January 1, 2016, and before January 1, 2024, in an amount, determined in modified conformity with a specified section of the Internal Revenue Code, for rehabilitation of certified historic structures and, under the Personal Income Tax Law, for a qualified residence. This bill would provide for a 20% credit, or 25% credit, of qualified rehabilitation expenditures if the structure meets specified criteria, for rehabilitation of a certified historic structure or a qualified residence, as provided, within the state to be reserved and allocated by the California Tax Credit Allocation Committee, which shall consult with the Office of Historic Preservation, as provided and which may adopt a reasonable fee to cover specified expenses. The aggregate amount of credit would be $50,000,000 per calendar year, plus unused allocation tax credit for the preceding year, $10,000,000 of which would be set aside for rehabilitation projects with qualified rehabilitation expenditures of less than $1,000,000, as specified. This bill would require the Legislative Analyst to, on an annual basis, collaborate with the California Tax Credit Allocation Committee to review the tax credit, as provided.

This bill would take effect immediately as a tax levy.

Date of Hearing: May 27, 2015

ASSEMBLY COMMITTEE ON APPROPRIATIONS

Jimmy Gomez, Chair

ABPCA Bill Id:AB 771

Author:(Atkins) – As Amended Ver:May 12, 2015

Urgency: Yes State Mandated Local Program: No Reimbursable: No

SUMMARY:

This bill allows a tax credit under the personal income tax and corporation tax laws, for taxable years beginning on or after January 1, 2016 and before January 1, 2021, for qualified costs paid or incurred by a taxpayer in rehabilitation of a certified historic structure, in modified conformity with the federal income tax laws, subject to an aggregate annual cap of $50 million. Specifically, this bill:

1) Allows an income tax credit in an amount equal to 20% of the qualified rehabilitation expenditures with respect to a certified historic structure, defined as a structure located in California that appears on either the National Register of Historic Places or the California Register of Historic Places.

2) Increases the applicable percentage to 25% in the case of a certified historic structure that meets specified criteria:

3) Allows an income tax credit, not more than once per taxpayer every 10 taxable years, between $5,000 and $25,000 for qualified rehabilitation expenditures for a residence, owned and occupied as the taxpayer's principal residence, provided the taxpayer's modified adjusted gross income is $200,000 or less, but only if the residence is determined by the California Tax Credit Allocation Committee (CTCAC) and the Office of Historic Preservation (OHP) to have a public benefit in the year of completion.

4) Requires that rehabilitation commence within 18 months of the issuance of the tax credit allocation or else be forfeited, and allows CTCAC to reallocate any forfeited amounts.

5) Authorizes CTCAC to establish criteria and procedures for applications and the allocation and certification of credits, provide the Franchise Tax Board (FTB) with an annual list of taxpayers who were allocated credits, and determine and allocate an aggregate amount of the tax credits, and any carryover of unallocated credits from prior years, subject to specified allocation criteria:

6) Requires taxpayers to issue a cost certification for qualified rehabilitation expenditures with the tax credit application, including an independent certification from a licensed certified public accountant for expenditures in excess of $250,000.

7) Requires CTCAC to set aside $10 million of tax credits each calendar year for taxpayers with qualified rehabilitation expenditures of less than $1 million, but allows any unused portion to be made available for other taxpayers.

8) Authorizes CTCAC to adopt a reasonable fee in an amount sufficient to cover its expenses and the expenses of OHP to administer the program.

9) Authorizes the taxpayer to carry forward the tax credit up to seven years or until the credit is exhausted; allows the tax credit to reduce the taxpayer's liability below the tentative minimum tax; requires the basis of the property to be reduced by the amount of any historic preservation tax credit allowed; and includes a five-year tax credit recapture provision when the property, or interest in the property, is sold.

10) Provides the tax credit shall be allocated to the partners of a partnership owning the project in accordance with the partnership agreement, regardless of federal rules or economic effect.

11) Requires the Legislative Analyst Office, beginning January 1, 2017, to collaborate with the CTCAC to review the effectiveness of the historic building tax credit program; and contains legislative findings and declarations relating to the goals, purposes and objectives of the tax credit, as well as performance indicators, as required by Section 41 of the Revenue and Taxation Code (R&TC).

FISCAL EFFECT:

1) Likely significant costs to CTCAC and OHP to develop processes and regulations to administer the program, some or all of which may be recovered through application fees; potentially significant costs to FTB to update systems and procedures.

2) The bill creates an aggregate annual cap of $50 million of credits, the effects of which will phase in over the first few years of implementation. Estimated GF revenue decreases of $19 million, $41 million, and $48 million in FY 2015-16, FY 2016-17, and FY 2017-18, respectively.

COMMENTS:

1) Purpose. According to the author, California is one of the few states that do not provide an incentive for the preservation of historic buildings. The author believes this tax credit will help stimulate local economies, revitalize downtown areas and communities, promote and increase the supply of affordable housing, support smart growth and infill development, encourage historic property rehabilitation, and leverage federal tax credits. The author claims this activity will increase construction jobs, encourage heritage tourism, and increase tax revenues through higher employment, wages, and property values.

2) Federal Historic Tax Credit. The Federal Historic Preservation Tax Incentives Program was created in 1976 to promote community revitalization and encourage private investment through historic building rehabilitation. Over 39,600 projects to rehabilitate historic buildings have been undertaken using the program's incentives. These projects come in all sizes. The National Park Service reported that in fiscal year 2013, almost 8% of the certified projects were under $100,000, 46% were under $500,000, and the majority of all projects – 59% – involved less than $1 million in costs. Housing has been the single most important use for rehabilitated historic buildings under the federal program. Over the past five years, between 36% and 69% of the projects have included housing, and more than 130,000 of low- and moderate-income housing units have been created under the program.

To qualify for the federal historic preservation credit, the structure must be individually listed on the national Register of Historic Places or be certified as contributing to a registered historic district, or for a lesser credit, be built before 1936 and used for income-producing, non-residential purposes. The developer must submit an application with details of the rehabilitation plan to the Department of the Interior for approval, and once completed must submit a certificate of completion. A historic preservation credit is then issued and usually must be claimed in the tax year in which the building was placed in service. The federal rules contain a "recapture provision" that requires a portion of the credit to be repaid if the rehabilitated building is sold or otherwise ceases to qualify within five years of being placed into service.

3) Typical Rehabilitation Financing Structure. In many cases, historic preservation and rehabilitation using the federal tax credit and other tax and financial incentives is accomplished through a partnership or joint venture structure. Developers will often partner with third party investors, selling or syndicating the tax credits to the investors in exchange for a cash contribution to the venture. Investors may also be allocated a share of profits over the minimum five year holding period required to avoid recapture, while developers charge fees and act as the managing partner, possibly taking a portion of rents or profits from the building. At the end of the five year holding period, the financing structure is usually unwound and investors exit the partnership by selling to the developer or another third party. This bill also ensures that any capital losses that may be claimed by a selling investor are deferred until the period following the expiration the federal credit.

4) Experience of Other States. 35 other states offer tax incentives of various kinds for historic preservation and rehabilitation projects, many of them similar to the federal program. These state programs often seek to leverage the federal tax credits, and studies have concluded those states with the strongest credits regularly lead the nation in the use of the federal credit. For example, an annual report of the Ohio Historic Preservation tax credit program states the $327 million in tax credits approved are projected to leverage more than $2 billion in private investment and federal tax credits, which translates to $6.25 of investment for every dollar of the state tax credit. According to a 2011 economic impact study conducted by Cleveland State University, the $246 million in approved tax credits is expected to result, during the construction period alone, in nearly $10 billion in economic activity in the state between 2007 and 2025. Similarly, studies in Minnesota and North Carolina found that every dollar of the state historic tax credit created $8.32 and $12.51, respectively, in economic activity.

5) Prior Legislation. This bill is nearly identical to AB 1999 (Atkins) of last year, which passed this committee but was vetoed by the Governor. In his veto message, the Governor noted that while he supported the policy goals of the bill, its high cost was something that should be considered against other spending priorities in the budget.

Analysis Prepared by: Joel Tashjian / APPR. / (916) 319-2081

Date of Hearing: May 18, 2015

ASSEMBLY COMMITTEE ON REVENUE AND TAXATION

Philip Ting, Chair

ABPCA Bill Id:AB 771 (

Author:Atkins) – As Amended Ver:May 12, 2015

SUSPENSE

Majority vote. Tax levy. Fiscal committee.

SUBJECT: Personal income and corporation taxes: credits: rehabilitation.

SUMMARY: Allows a temporary income tax credit for qualified costs paid or incurred by a taxpayer in rehabilitation of a certified historic structure, as defined ("the Historic Preservation Tax Credit"), in modified conformity with the federal income tax laws, subject to an aggregate annual cap of $50 million. Specifically, this bill:

1. Declares legislative intent to preserve and restore California's historic buildings, which are an important asset to communities throughout California, and to create tools to incentivize economic development and revitalize economically distressed areas.
   
   

2. Allows an income tax credit, under both the Personal Income Tax (PIT) and the Corporation Tax (CT) laws, in an amount equal to 20% of the qualified rehabilitation expenditures with respect to a certified historic structure, as defined.
   
   

3. Increases the applicable percentage to 25% in the case of a certified historic structure that meets one of the following criteria:
   
   

   1. The structure is located on federal surplus property, state, or local surplus property, as defined;
      
      

   2. The rehabilitated structure includes affordable housing for lower-income households, as defined by Health and Safety Code Section 50079.5;
      
      

   3. The structure is located in a designated census tract, as defined in Revenue and Taxation Code Section 17053.73(b)(7);
      
      

   4. The structure is a part of a military base reuse authority established pursuant to Title 7.86 commencing with Section 67800 of the Government Code; or,
      
      

   5. The structure is a transit-oriented development that is a higher density, mixed-use development within a walking distance of one-half mile of a transit station.
      
      

4. Allows the credit for taxable years beginning on or after January 1, 2016, and before January 1, 2021.
   
   

5. Provides that the term "certified historic structure" means a certified historic structure, as defined in Section 47(c)(3) of the Internal Revenue Code (IRC), that is a structure located in this state and is listed on the California Register of Historical Resources.
   
   

6. Defines a "qualified residence" by reference to IRC Section 163(h)(4), as a residence that will be owned and occupied, or will be occupied after the rehabilitation, by an individual taxpayer as a taxpayer's principal residence, provided that the taxpayer's modified adjusted gross income is $200,000 or less.

7. Defines the term "qualified rehabilitation expenditure" by reference to IRC Section 47(c)(2), but modifies the federal definition to provide that "qualified rehabilitation expenditures" may include both of following:

   1. Expenditures in connection with the rehabilitation of a building even if the building is, or is reasonably expected to be, tax-exempt use property.

   2. Expenditures incurred by the taxpayer with respect to a qualified principal residence for the rehabilitation of the exterior of the building or rehabilitation necessary for the functioning of the home, including, but not limited to, rehabilitation of the electrical, plumbing, or foundation of the principal residence.

8. Allows the Historic Preservation Tax Credit for qualified rehabilitation expenditures for a qualified residence only if the residence is determined jointly by the CTCAC and the OHP to have a public benefit in the year of completion. The amount of the Historic Preservation Tax Credit shall only be allowed in an amount equal to or more than $5,000, not to exceed $25,000; and the tax credit shall only be allowed to a taxpayer once every 10 taxable years.

9. Requires a taxpayer to request an allocation of the Historic Preservation Tax Credit from California Tax Credit Allocation Committee (CTCAC), in the form and manner prescribed by CTCAC.

10. Specifies that a tax credit allocation provided to a taxpayer shall not constitute a determination by CTCAC regarding a taxpayer's eligibility for the Historic Preservation Tax Credit.

11. Provides that rehabilitation must commence within 18 months of the issuance of the tax credit allocation; otherwise, the allocation shall be forfeited and the credit amount associated with the tax credit reservation shall be treated as an unused allocation tax credit amount.

12. Authorizes the California Tax Credit Allocation Committee (CTCAC) to allocate the Historic Preservation Tax Credit and requires CTCAC to do all of the following:

    1. On and after January 1, 2016, and before January 1, 2021, to allocate tax credits to applicants, as provided.
       
       

    2. Establish a procedure for applicants to file with the CTCAC a written application, on a form jointly prescribed by CTCAC and the Office of Historic Preservation (OHP) for the allocation of the tax credit.
       
       

    3. Establish criteria for allocating tax credits, consistent with the requirements of the tax credit program. Criteria shall include, but not be limited to, all of the following:
       
       

       1. The number of jobs created by the rehabilitation project, both during and after the rehabilitation of the structure;
          
          

       2. The expected increase in state and local tax revenues derived from the rehabilitation project, including those from increased wages and property taxes; and,
          
          

       3. Any additional incentives or contributions included in the rehabilitation project from federal, state, or local governments.
          
          

       4. Finding of a public benefit, as determined jointly with the OHP, in the case of qualified rehabilitation expenditures with respect to a qualified residence.
          
          

    4. Determine and designate, in consultation with the OHP, applicants that meet the specified requirements to ensure that the rehabilitation project meets the Secretary of the Interior's Standards for Rehabilitation, as specified.
       
       

    5. Process and approve, or reject, all tax credit allocation applications.
       
       

    6. Allocate an aggregate amount of the tax credits, under both the PIT and the CT laws, and any carryover of unallocated credits from prior years, subject to the annual cap of $50 million.
       
       

    7. Certify tax credits allocated to taxpayers.
       
       

    8. Allocate a tax credit pursuant to the taxpayer's tax credit allocation upon receipt of a cost certification for the qualified rehabilitation expenditures. For projects with qualified rehabilitation expenditures in excess of $250,000, the cost certification must be issued by a licensed certified public accountant.
       
       

    9. Provide the Franchise Tax Board (FTB) an annual list of the taxpayers that were allocated a credit, as specified, including each taxpayer's taxpayer identification number and the amount allocated.
       
       

    10. Establish procedures for the recapture of amounts allocated for a tax credit for the rehabilitation of a qualified residence if the taxpayer does not use the qualified residence as his/her principal residence within two years after the rehabilitation.
        
        

13. Requires CTCAC to set aside $10 million of tax credits each calendar year for taxpayers with qualified rehabilitation expenditures of less than $1 million. To the extent that this amount is not fully reserved in any calendar year, the unused portion shall become available for reservation to other taxpayers.

14. Allows the CTCAC to adopt a reasonable fee in an amount sufficient to cover its expenses and the expenses by the OHP incurred in administering the Historic Preservation Tax Credit program.
    
    

15. Authorizes the taxpayer to carry forward the tax credit to the following tax year, and succeeding seven years, if necessary, until the credit is exhausted.
    
    

16. Disallows any deduction for the amount of paid or incurred by the taxpayer for which a credit is allowed to the taxpayer.
    
    

17. Requires the basis of the property to be reduced by the amount of the Historic Preservation Tax Credit allowed.

18. Adds a five-year tax credit recapture provision, in conformity with IRC Section 50(a), when the property, or interest in the property, is sold.

19. Provides that the credit shall be allocated to the partners of a partnership owning the historic rehabilitation project in accordance with the partnership agreement, regardless of how the federal historic rehabilitation tax credit, with respect to the project, is allocated to the partners, or whether the allocation of the credit under the terms of the agreement has substantial economic effect, within the meaning of Section 704(b) of the Internal Revenue Code (IRC).
    
    

20. Allow the Historic Preservation Tax Credit to be used to reduce the taxpayer's tax liability below the tentative minimum tax.

21. Requires the Legislative Analyst Office, beginning January 1, 2017, to collaborate with the CTCAC to review the effectiveness of the historic building tax credit program. Provides that the review shall include an analysis of the demand for the tax credit, the types and uses of projects receiving the tax credit, the jobs created by the use of the tax credit, and the economic impact of the tax credit.
    
    

22. Contains legislative findings and declarations relating to the goals, purposes and objectives of the tax credit, as well as performance indicators, as required by Section 41 of the Revenue and Taxation Code (R&TC).
    
    

23. Takes effect immediately as a tax levy.
    
    

EXISTING FEDERAL LAW:

1. Allows a two-tiered tax credit for the rehabilitation expenses of older or historic buildings. Specifically, it provides:
   
   

   1. A 10% credit for the rehabilitation expenses of non-historic buildings with an additional requirement that the building must have been originally constructed before 1936; and,
      
      

   2. A 20% credit for the rehabilitation expenses of a certified historic structure, i.e. a structure that is listed on the national Register of Historic Places or located in a Registered Historic District and determined to be of significance to the Historical District.
      
      

2. Allows a taxpayer engaged in a trade or business to deduct all expenses that are considered ordinary and necessary in conducting that trade or business.

EXISTING STATE LAW does not conform to the federal tax credit for rehabilitation expenses of older or historic buildings, but does allow taxpayers, in conformity with the federal law, to deduct ordinary and necessary business expenses.

FISCAL EFFECT: The FTB staff estimates that this bill will result in an annual revenue loss of $19 million in the fiscal year (FY) 2015-16, $41 million in FY 2016-17, and $48 million in FY 2017-18.

COMMENTS:

1. The Author's Statement: The author has provided the following statement in support of this bill:

"California is one of the few states to not provide an incentive for the preservation of our historic buildings. A state tax credit for this purpose would help stimulate local economies, revitalize downtown areas and communities, promote and increase the supply of affordable housing, support smart growth through infill development, encourage property maintenance and rehabilitation, and leverage use of the federal rehabilitation tax credit.

"Additionally, it would increase construction and building industry job creation, increase state tax revenues through increased employment and wages, increase local property tax revenues through increased property values, and increase local tax revenues through sales tax and heritage tourism.

"AB 771 helps communities adjust to the phase-out of redevelopment dollars and stimulates public and private investment, all while building civic pride as we celebrate our heritage and preserve California's past."

2. Federal Historic Tax Credit (HTC). The Federal Historic Preservation Tax Incentives Program, created in 1976, is administered by the National Park Service in partnership with the State Historic Preservation Office. The goal of the program is to promote community revitalization and encourage private investment through historic building rehabilitation. Over 39,600 projects to rehabilitate historic buildings have been undertaken since the first project using the historic tax incentives was completed in 1977.¹ The HTC is claimed not only by large projects. As reported by the National Park Service, in fiscal year 2013, almost 8% of the certified projects were under $100,000, 46% were under $500,000, and the majority of all projects – 59% - involved less than $1 million in costs. (Id., p. 11.)
   
   Housing has been the single most important use for rehabilitated historic buildings under the program. Over the past five years, between 36% and 69% of the projects have included housing. Almost one-half of the projects certified in 2013, or 46%, reported housing as a final primary use, including multiple-family housing. As a result of this program, more than 130,000 of low- and moderate-income housing units have been created. According to the report issued by the National Park Service, one of the objectives of the program is to create and retain affordable housing. (Id., p. 12.) Other incentives utilized by developers, in addition to the HTC, include the New Market Tax Credit Program, Tax Increment Financing, and local property tax abatements.
   
   To qualify for the historic tax credit, a project must satisfy the requirements of IRC Section 47 and related regulations, as well as architectural standards regulated by the National Parks Service. Certification of Historic Significance is the first step in establishing eligibility for the HTC. A building must be individually listed in the national Register of Historic Places or be certified as contributing to a registered historic district in order to qualify for the 20% credit. A building that has been certified as non-significant (i.e., not contributing to a National Register historic district), but was built before 1936, can qualify for a 10% tax credit if it is rehabilitated for income-producing, non-residential purposes. A developer must submit an application detailing the plans and specifications for the rehabilitation. The plans must satisfy the Secretary of Interior Standards for Rehabilitation.
   
   Once the project is completed, a request for certification of completion is submitted. If the request is granted, the rehabilitation is considered a "certified rehabilitation." A certification of a completed project is issued only when all work has been finished on the certified historic building. Generally, the HTC must be claimed in the tax year in which the rehabilitated building is placed in service. However, the credit may be claimed before the date the property is placed in service under the rules for qualified progress expenditures (IRC Section 47(d).) Existing federal law contains a so-called "recapture provision," which provides that a portion of the tax credit must be recaptured (returned to the Federal Government) if the rehabilitated building is sold or otherwise ceases to qualify within five years from the date the building is placed in service.

3. The Financing Structure. In order to raise funds for rehabilitation of historic buildings, the owners, in most cases, enter into various financing transactions with private entities using the HTC, among other tax and financial incentives. A property owner, because of his/her tax position, may elect to syndicate the HTC to a third party through the issuance of partnership or limited liability company (LLC) interests. The financing of a historic building rehabilitation using the HTC requires the participation of a private investor (mostly a taxable corporation) that could take advantage of the credits to reduce its income tax liability. A typical arrangement is to match a corporate tax credit investor entity with a project developer, creating a partnership (such as a LLC) where the investor is allocated the tax credits in exchange for cash and the developer acts as a managing partner (or member). Usually, the percentage of allocated tax credits matches the percentage of allocated profits. Thus, if an investor entity is allocated all of the tax credits, then that entity will also receive all or nearly all of the profits for at least five years. In exchange, the developer will receive a developer fee or other distributions. An investor must retain ownership of the property (i.e. remain in the partnership) for at least five years after the project is placed in service in order to receive the full benefit of the tax credits, or the tax credits will be subject to recapture. At the end of this period, either the developer will buy out the investor or the investor will sell its interest in the partnership.
   
   In the case of a HTC, a certified historic structure, i.e. a building, must be owned by either the entity that utilizes the credit or a master tenant that leases the entire building from the owner. In a case of a master tenant partnership structure, the corporate entity will be allocated most, if not all, of the credit and profits. The corporate entity will also likely to receive an annual priority return, the amount of which is equal to a very small percentage of the investor's equity in the project. In exchange, the investor will contribute cash to the partnership to provide financing for the rehabilitation project. It is expected that after the expiration of the five-year recapture period the financing structure will be unwound and the property owner will directly own the historic building.

4. Tax Incentives: Do They Work? Generally, advocates for tax incentives, such as Arthur Laffer and N. Gregory Mankiw, argue that reduced taxes allow taxpayers to invest money that would otherwise be paid in taxes to better use, thereby creating additional economic activity. “Supply-siders” posit that higher taxes do not result in more government revenue; instead, they suppress additional innovation and investment that would have led to more economic activity and, therefore, healthier public treasuries, under lower marginal tax rates. Industry-specific credits complement this theory by lowering tax costs for industries that provide positive multiplier effects, such as stimulating economic activity among suppliers and increasing economy-wide purchasing power resulting from hiring additional employees.

Critics, however, assert that tax incentives rarely result in additional economic activity. Companies locate in California because of its competitive advantages, namely its environment, weather, transportation infrastructure, access to ports, highways, and railroads, as well as its highly skilled workforce and world class higher education system. These advantages trump perceived disadvantages resulting from California's tax structure and other policies. Additionally, critics argue that industry-specific tax incentives do not actually effect business decisions; instead, enhanced credits and deductions reward firms for investments they would have made anyway. [See, e.g., D. Neumark, J. Zhang, and J. Kolko, Are Businesses Fleeing the State? Interstate Business Location and Employment Change in California, (a PPIC report showing that, while California loses jobs due to firms leaving the state, these losses have a minimal effect on the economy); D. Neumark and J. Kolko, Are California Companies Shifting Their Employment to Other States? (finding that, while California companies have shifted jobs to other states, out-of-state firms have offset these losses by hiring more in California).]

As noted by the Legislative Analyst Office (LAO) in the presentation at this Committee's hearing "Assessing Tax Expenditure Programs in Light of California's Fiscal Challenges" on February 22, 2012, "Policymakers should regard many TEPs [tax expenditure programs] evaluations with skepticism." It was further explained that, "Analysis of alternative uses of public funds is difficult and often omitted entirely from . . . studies [of TEPs]. These studies also usually rely on extensive and sometimes subjective assumptions which, if changed, can produce very different results . . . . It is rare that the value of TEPs can be demonstrated conclusively compared to these alternate uses of tax dollars. If the Legislature wishes to use TEPs, despite these challenges, it is important that TEPs be used cautiously, structured carefully, and reviewed regularly to consider if they operate in an effective and cost-efficient manner."

2. The Proposed Historic Preservation Tax Credit: a Different Kind of Credit? This bill creates a historic preservation tax credit program modeled after the federal HTC. Unlike the federal HTC, however, the proposed credit is not permanent; the credit is allowed for seven taxable years, beginning with the 2016 tax year. This bill also provides for an increased tax credit rate of 20% and allows an additional 5% for certain projects, such as low-income housing; a transit-oriented development; and a structure located on federal, state, or local surplus property, in a designated census tract, on a specified military base. A building that is not included in the National Register of Historic Places may still qualify for the state credit if it appears on the California Register of Historical Resources.
   
   The proposed credit is different from other state tax credits, where a certain class of individuals or businesses may claim a credit based on membership in a certain industry or business location. In contrast to many tax incentives in California, the proposed tax credit is targeted, is capped at $50 million per calendar year, and is required to be allocated to taxpayers by the CTCAC on a competitive basis. In many respects, it is similar to a grant program. This bill prescribes certain criteria for CTCAC to utilize in determining whether a project should be awarded the state HTC, including the estimated number of jobs and potential state and local tax revenues to be generated by the project. Thus, the proposed credit is intended to result in a quantifiable public benefit. Finally, the LAO is required to review the effectiveness of this tax credit program, on an annual basis. The credit program sunsets on December 1, 2021, and is not refundable.

3. How Effective Are Historic Tax Credit Programs in Other States? Thirty-five states offer state tax incentives of various kinds for historic preservation rehabilitation projects. In many states, the income tax credit programs are similar to the federal HTC program. Several studies conducted by Rutgers University have shown that "in many parts of the country, $1 million in historic rehabilitation yields markedly better effects on employment, income, GSP, and state and local taxes than an equal investment in new construction or many other economic activities (e.g., manufacturing or services)." ² It was concluded that states with the strongest historical preservation tax credit statutes regularly lead the nation in the use of the federal HTC, which, due to its leverage and multiplier effects, benefits both state economies and the national economy. For example, an annual report of the Ohio Historic Preservation tax credit program states that the $327 million in tax credits approved are projected to leverage more than $2 billion in private investment and federal tax credits, which translates to $6.25 of investment for every dollar of the state tax credit.³ The Ohio Historic Preservation tax credit is capped at $60 million per year and allocated to applicants. According to a 2011 economic impact study conducted by Cleveland State University, the $246 million in approved tax credits is expected to result, during the construction period alone, in nearly $10 billion in economic activities in the state between 2007 and 2025. Recognizing the economic impact and job creation of the program, the Ohio General Assembly renewed the Program in the state's fiscal year 2012-13 budget. Similarly, it was found that in Minnesota and North Carolina, respectively, every dollar of the state historic tax credit creates $8.32 in economic activity and $12.51 in economic benefit.

4. Bifurcation of the Credit. A taxpayer who uses a state tax credit to reduce his/her state tax liability generally loses the ability to take a federal deduction for the state tax paid with the use of the state historic tax credit. As such, the value of a state tax credit is less that its face value. In practice, when federal credits are allocated through a partnership to an investor, ownership interests are valued at $0.95 or more on the dollar, while the after-tax value of the state tax credits tends to be in the range of $0.50 to $0.55 on the dollar.⁴ Furthermore, a state tax credit has value only to the extent that the taxpayer holding the credit has sufficient tax liability in the state. To remedy this problem, some states have permitted an outright sale of the credit or made it refundable, while others have allowed a partnership owning the property to make a disproportionate distribution (or bifurcation) of the federal and state credits to its partners. The bifurcation approach allows investors to enter into partnership agreements where they can purchase state tax credits without the corresponding federal credits. Thus, bifurcation allows investors to join the developing partnership and be awarded the federal HTC, a state historic tax credit, or both. Consequently, investors with no federal tax liability, but sufficient state tax liability, would have an incentive to invest in a rehabilitation project that would allow them to offset unrelated state income tax liability with the state HTC.
   
   This bill requires that the credit be allocated to the partners of a partnership in accordance with the partnership agreement, regardless of how the federal HTC is allocated to the partners or whether the allocation of the state credit under the partnership agreement has "substantial economic effect." Because this bill specifically excludes any consideration of the "substantial economic effect" of the partners' distributions, it creates a divergence from long-established tax policy and potentially leads to tax shelter opportunities.
   
   A bifurcation of the proposed tax credit from the federal HTC highlights a natural tension between the need to draw more investors and investment dollars to projects that rehabilitate historic buildings and create more low-income housing units and tax policy that strives to ensure that investments have substance other than tax incentives. The bifurcation approach, with very little economic impact on investors other than tax credits, balances at the precipice of tax sheltering activities. However, this approach was already approved by the Legislature in the case of the state's low-income housing tax credit (LIHTC) program. The bifurcation has been allowed in large part due to the type of projects created from the investment and the difficulty of raising sufficient capital to create low-income housing absent the credit incentives. In that case, the Legislature determined that the benefits of increased project capital exceeded the tax policy concerns of sanctioning a state tax shelter. Traditionally, the low-income housing tax credit (LIHTC) has been administered just as though it were an allocated grant program. The Tax Credit Allocation Committee evaluates the applications and allocates the available funds (the amount of which is capped) to those investors/developers who promise to produce the most housing for the state's dollar. Although the program is in the form of a tax credit, all the participants behave virtually as though they were dealing with an allocation of grant funds. For this reason, the Legislature decided that it is unlikely that a separation of a state and federal LIHTC would result in a significant increase of tax sheltering activities. The proposed credit is intended as a tool of economic development, especially in economically distressed areas that are difficult to revitalize and in light of the recent dissolution of the redevelopment program. The Committee may wish to consider whether the proposed historic preservation tax credit program is sufficiently comparable to the LIHTC program and whether it warrants a similar treatment.

5. Sale or Abandonment of Partnership Interests. As discussed, many rehabilitation projects are developed by a partnership or a LLC, in which the developer is the general partner or manager with a de minimus ownership interest and investors are limited partners/members with a 99.9% ownership interest in the partnership for the tax credit compliance period. A partner who sells or exchanges his/her partnership interest recognizes a capital loss or capital gain on that sale or exchange depending on the partner's basis in the partnership and the purchase price. If a partner abandons or forfeits his/her partnership interest, he/she will recognize an ordinary loss, provided that there are no partnership liabilities from which the partner is relieved. The amount of that loss is equal to the partner's basis in the partnership.
   
   One of the concerns raised in connection with the separation of the state and federal LIHTC was that an investor would be able to offset his/her income (albeit in different tax years) with both the LIHTC and a loss realized from the abandonment or sale of his/her partnership interest. Consequently, the Legislature decided to defer a recognition of that loss until the first taxable year following the expiration of the federal credit, i.e. a 10-year period, which mitigated the negative effect of an allocation of the state credit lacking substantial economic effect. This bill would add a similar deferral provision for the recognition of loses in the context of the state historic preservation tax credit program.

6. Tax Credit Percentages. This bill proposes tax credit percentages that are similar or higher than the federal HTC rates. The Committee may wish to consider whether the proposed percentages should be reduced in light of the fact that the California income tax rates are substantially lower than federal income tax rates.

7. Related Legislation.

   1. AB 1999(Atkins), of the 2013-14 Legislative Session, would have allowed a tax credit substantially similar to the credit proposed by this bill. AB 1999 was vetoed.

   2. AB 166 (Cedillo), of the 2001-02 Legislative Session, would have allowed a tax credit in an amount determined in accordance with provisions of the federal historic rehabilitation tax credit. AB 166 was held on the Assembly Appropriations Committee's Suspense File.

REGISTERED SUPPORT / OPPOSITION:

Support

American Institute of Architects California Council

American Planning Association, California Chapter

California Association of Realtors

California Preservation Foundation

League of California Cities

City of Burbank

Opposition

California Tax Reform Association

Analysis Prepared by: Oksana Jaffe / REV. & TAX. / (916) 319-2098

Date of Hearing: April 20, 2015

ASSEMBLY COMMITTEE ON REVENUE AND TAXATION

Philip Ting, Chair

ABPCA Bill Id:AB 771

Author:(Atkins) – As Introduced Ver:February 25, 2015

REVISED

Majority vote. Tax levy. Fiscal committee.

SUBJECT: Personal income and corporation taxes: credits: rehabilitation

SUMMARY: Allows a temporary income tax credit for qualified costs paid or incurred by a taxpayer in rehabilitation of a certified historic structure, as defined ("the Historic Preservation Tax Credit"), in modified conformity with the federal income tax laws, subject to an aggregate annual cap of $50 million. Specifically, this bill:

1. Declares legislative intent to preserve and restore California's historic buildings, which are an important asset to communities throughout California, and to create tools to incentivize economic development and revitalize economically distressed areas.
   
   

2. Allows an income tax credit, under both the Personal Income Tax (PIT) and the Corporation Tax (CT) laws, in an amount equal to 20% of the qualified rehabilitation expenditures with respect to a certified historic structure, as defined.
   
   

3. Increases the applicable percentage to 25% in the case of a certified historic structure that meets one of the following criteria:
   
   

   1. The structure is located on federal surplus property, state, or local surplus property, as defined;
      
      

   2. The rehabilitated structure includes affordable housing for lower-income households, as defined by Health and Safety Code Section 50079.5;
      
      

   3. The structure is located in a designated census tract, as defined in Revenue and Taxation Code Section 17053.73(b)(7);
      
      

   4. The structure is a part of a military base reuse authority established pursuant to Title 7.86 commencing with Section 67800 of the Government Code; or,
      
      

   5. The structure is a transit-oriented development that is a higher density, mixed-use development within a walking distance of one-half mile of a transit station.
      
      

4. Allows the credit for taxable years beginning on or after January 1, 2016, and before January 1, 2024.
   
   

5. Provides that the term "certified historic structure" has the same meaning as defined in Section 47(c)(3) of the Internal Revenue Code and additionally as a structure in this state that is listed on the California Register of Historical Resources.
   
   

6. Defines a "qualified residence" by reference to Internal Revenue Code (IRC) Section 163(h)(4), as a residence that will be owned and occupied, or will be occupied after the rehabilitation, by an individual taxpayer as a taxpayer's principal residence, provided that the taxpayer's modified adjusted gross income is $200,000 or less.

7. Defines the term "qualified rehabilitation expenditure" by reference to IRC Section 47(c), but modifies the federal definition to provide that "qualified rehabilitation expenditures" may include both of following:

   1. Expenditures in connection with the rehabilitation of a building even if the building is, or is reasonably expected to be, tax-exempt use property.

   2. Expenditures incurred by the taxpayer with respect to a qualified principal residence for the rehabilitation of the exterior of the building or rehabilitation necessary for the functioning of the home, including, but not limited to, rehabilitation of the electrical, plumbing, or foundation of the principal residence.

8. Allows the Historic Preservation Tax Credit for qualified rehabilitation expenditures for a qualified residence only if the residence is determined jointly by the CTCAC and the OHP to have a public benefit in the year of completion. The amount of the Historic Preservation Tax Credit shall only be allowed in an amount equal to or more than $5,000, not to exceed $25,000; and the tax credit shall only be allowed to a taxpayer once every 10 taxable years.

9. Requires a taxpayer to request a reservation of the Historic Preservation Tax Credit from California Tax Credit Allocation Committee (CTCAC), in the form and manner prescribed by CTCAC.

10. Specifies that a tax credit reservation provided to a taxpayer shall not constitute a determination by CTCAC regarding a taxpayer's eligibility for the Historic Preservation Tax Credit.

11. Provides that rehabilitation must commence within 18 months of the issuance of the tax credit reservation; otherwise, the reservation shall be forfeited and the credit amount associated with the tax credit reservation shall be treated as an unused allocation tax credit amount.

12. Authorizes the California Tax Credit Allocation Committee (CTCAC) to reserve and allocate the Historic Preservation Tax Credit and requires CTCAC to do all of the following:

    1. On and after January 1, 2016, and before January 1, 2024, to reserve and allocate tax credits to applicants, as provided.
       
       

    2. Establish a procedure for applicants to file with the CTCAC a written application, on a form jointly prescribed by CTCAC and the Office of Historic Preservation (OHP) for the reservation of the tax credit.
       
       

    3. Establish criteria for reserving tax credits, consistent with the requirements of the tax credit program. Criteria shall include, but not be limited to, all of the following:
       
       

       1. The number of jobs created by the rehabilitation project, both during and after the rehabilitation of the structure;
          
          

       2. The expected increase in state and local tax revenues derived from the rehabilitation project, including those from increased wages and property taxes; and,
          
          

       3. Any additional incentives or contributions included in the rehabilitation project from federal, state, or local governments.
          
          

       4. Finding of a public benefit, as determined jointly with the OHP, in the case of qualified rehabilitation expenditures with respect to a qualified residence.
          
          

    4. Determine and designate, in consultation with the OHP, applicants that meet the specified requirements to ensure that the rehabilitation project meets the Secretary of the Interior's Standards for Rehabilitation, as specified.
       
       

    5. Process and approve, or reject, all tax credit reservation applications.
       
       

    6. Allocate an aggregate amount of the tax credits, under both the PIT and the CT laws, and any carryover of unallocated credits from prior years, subject to the annual cap of $50 million.
       
       

    7. Certify tax credits allocated to taxpayers.
       
       

    8. Allocate a tax credit pursuant to the taxpayer's tax credit reservation upon receipt of a cost certification for the qualified rehabilitation expenditures. For projects with qualified rehabilitation expenditures in excess of $250,000, the cost certification must be issued by a licensed certified public accountant.
       
       

    9. Provide the Franchise Tax Board (FTB) an annual list of the taxpayers that were allocated a credit, as specified, including each taxpayer's taxpayer identification number and the amount allocated.
       
       

13. Requires CTCAC to set aside $10 million of tax credits each calendar year for taxpayers with qualified rehabilitation expenditures of less than $1 million. To the extent that this amount is not fully reserved in any calendar year, the unused portion shall become available for reservation to other taxpayers.

14. Allows the CTCAC to adopt a reasonable fee in an amount sufficient to cover its expenses and the expenses by the OHP incurred in administering the Historic Preservation Tax Credit program.
    
    

15. Authorizes the taxpayer to carry forward the tax credit to the following tax year, and succeeding seven years, if necessary, until the credit is exhausted.
    
    

16. Disallows any deduction for the amount of paid or incurred by the taxpayer for which a credit is allowed to the taxpayer.
    
    

17. Requires the basis of the property to be reduced by the amount of the Historic Preservation Tax Credit allowed.

18. Adds a five-year tax credit recapture provision, in conformity with IRC Section 50(a), when the property, or interest in the property, is sold.

19. Specify that tax credits awarded to an "S" corporation shall be allocated among the shareholders of that corporation pro-rata in accordance with their respective pro rata shares determined in accordance with specified provisions of the IRC.

20. Provides that the credit shall be allocated to the partners of a partnership owning the historic rehabilitation project in accordance with the partnership agreement, regardless of how the federal historic rehabilitation tax credit, with respect to the project, is allocated to the partners, or whether the allocation of the credit under the terms of the agreement has substantial economic effect, within the meaning of Section 704(b) of the Internal Revenue Code (IRC).
    
    

21. Allow the Historic Preservation Tax Credit to be used to reduce the taxpayer's tax liability below the tentative minimum tax.

22. Contrary to the federal law, allows the Historic Preservation Tax Credit in the case of an activity engaged in by an individual or an S corporation not for profit.

23. Requires the Legislative Analyst Office, beginning January 1, 2017, to collaborate with the CTCAC to review the effectiveness of the historic building tax credit program.
    
    

24. Provides that the review shall include an analysis of the demand for the tax credit, the types and uses of projects receiving the tax credit, the jobs created by the use of the tax credit, and the economic impact of the tax credit.
    
    

25. States the intent of the Legislature, in enacting this bill, to comply with the requirements of Section 41 of the Revenue and Taxation Code (R&TC).
    
    

26. Takes effect immediately as a tax levy.
    
    

EXISTING FEDERAL LAW:

1. Allows a two-tiered tax credit for the rehabilitation expenses of older or historic buildings. Specifically, it provides:
   
   

   1. A 10% credit for the rehabilitation expenses of non-historic buildings with an additional requirement that the building must have been originally constructed before 1936; and,
      
      

   2. A 20% credit for the rehabilitation expenses of a certified historic structure, i.e. a structure that is listed on the national Register of Historic Places or located in a Registered Historic District and determined to be of significance to the Historical District.
      
      

2. Allows a taxpayer engaged in a trade or business to deduct all expenses that are considered ordinary and necessary in conducting that trade or business.

EXISTING STATE LAW does not conform to the federal tax credit for rehabilitation expenses of older or historic buildings, but does allow taxpayers, in conformity with the federal law, to deduct ordinary and necessary business expenses.

FISCAL EFFECT: The FTB staff estimates that this bill will result in an annual revenue loss of $19 million in the fiscal year (FY) 2015-16, $41 million in FY 2016-17, and $48 million in FY 2017-18.

COMMENTS:

1. The Author's Statement: The author has provided the following statement in support of this bill:

"California is one of the few states to not provide an incentive for the preservation of our historic buildings. A state tax credit for this purpose would help stimulate local economies, revitalize downtown areas and communities, promote and increase the supply of affordable housing, support smart growth through infill development, encourage property maintenance and rehabilitation, and leverage use of the federal rehabilitation tax credit.

"Additionally, it would increase construction and building industry job creation, increase state tax revenues through increased employment and wages, increase local property tax revenues through increased property values, and increase local tax revenues through sales tax and heritage tourism.

"AB 771 helps communities adjust to the phase-out of redevelopment dollars and stimulates public and private investment, all while building civic pride as we celebrate our heritage and preserve California's past."

2. Arguments in Support. The proponents state that this bill "will incentivize private investment to rehabilitate historic properties," many of which are located in "urban core areas." Upgrading these properties will support "city efforts to spur and retain economic activity in downtown areas." The proponents argue that the rehabilitation of historic properties will "increase property values, generating revenue for cities, counties, schools and special districts." In addition, this bill would provide incentives for projects that "include affordable housing and transit-oriented development."

3. Federal Historic Tax Credit (HTC). The Federal Historic Preservation Tax Incentives Program, created in 1976, is administered by the National Park Service in partnership with the State Historic Preservation Office. The goal of the program is to promote community revitalization and encourage private investment through historic building rehabilitation. Over 39,600 projects to rehabilitate historic buildings have been undertaken since the first project using the historic tax incentives was completed in 1977.¹ The HTC is claimed not only by large projects. As reported by the National Park Service, in fiscal year 2013, almost 8% of the certified projects were under $100,000, 46% were under $500,000, and the majority of all projects – 59% - involved less than $1 million in costs. (Id., p. 11.)
   
   Housing has been the single most important use for rehabilitated historic buildings under the program. Over the past five years, between 36% and 69% of the projects have included housing. Almost one-half of the projects certified in 2013, or 46%, reported housing as a final primary use, including multiple-family housing. As a result of this program, more than 130,000 of low- and moderate-income housing units have been created. According to the report issued by the National Park Service, one of the objectives of the program is to create and retain affordable housing. (Id., p. 12.) Other incentives utilized by developers, in addition to the HTC, include the New Market Tax Credit Program, Tax Increment Financing, and local property tax abatements.
   
   To qualify for the historic tax credit, a project must satisfy the requirements of IRC Section 47 and related regulations, as well as architectural standards regulated by the National Parks Service. Certification of Historic Significance is the first step in establishing eligibility for the HTC. A building must be individually listed in the national Register of Historic Places or be certified as contributing to a registered historic district in order to qualify for the 20% credit. A building that has been certified as non-significant (i.e., not contributing to a National Register historic district), but was built before 1936, can qualify for a 10% tax credit if it is rehabilitated for income-producing, non-residential purposes. A developer must submit an application detailing the plans and specifications for the rehabilitation. The plans must satisfy the Secretary of Interior Standards for Rehabilitation.
   
   Once the project is completed, a request for certification of completion is submitted. If the request is granted, the rehabilitation is considered a "certified rehabilitation." A certification of a completed project is issued only when all work has been finished on the certified historic building. Generally, the HTC must be claimed in the tax year in which the rehabilitated building is placed in service. However, the credit may be claimed before the date the property is placed in service under the rules for qualified progress expenditures (IRC Section 47(d).) Existing federal law contains a so-called "recapture provision," which provides that a portion of the tax credit must be recaptured (returned to the Federal Government) if the rehabilitated building is sold or otherwise ceases to qualify within five years from the date the building is placed in service.

4. The Financing Structure. In order to raise funds for rehabilitation of historic buildings, the owners, in most cases, enter into various financing transactions with private entities using the HTC, among other tax and financial incentives. A property owner, because of his/her tax position, may elect to syndicate the HTC to a third party through the issuance of partnership or limited liability company (LLC) interests. The financing of a historic building rehabilitation using the HTC requires the participation of a private investor (mostly a taxable corporation) that could take advantage of the credits to reduce its income tax liability. A typical arrangement is to match a corporate tax credit investor entity with a project developer, creating a partnership (such as a LLC) where the investor is allocated the tax credits in exchange for cash and the developer acts as a managing partner (or member). Usually, the percentage of allocated tax credits matches the percentage of allocated profits. Thus, if an investor entity is allocated all of the tax credits, then that entity will also receive all or nearly all of the profits for at least five years. In exchange, the developer will receive a developer fee or other distributions. An investor must retain ownership of the property (i.e. remain in the partnership) for at least five years after the project is placed in service in order to receive the full benefit of the tax credits, or the tax credits will be subject to recapture. At the end of this period, either the developer will buy out the investor or the investor will sell its interest in the partnership.
   
   In the case of a HTC, a certified historic structure, i.e. a building, must be owned by either the entity that utilizes the credit or a master tenant that leases the entire building from the owner. In a case of a master tenant partnership structure, the corporate entity will be allocated most, if not all, of the credit and profits. The corporate entity will also likely to receive an annual priority return, the amount of which is equal to a very small percentage of the investor's equity in the project. In exchange, the investor will contribute cash to the partnership to provide financing for the rehabilitation project. It is expected that after the expiration of the five-year recapture period the financing structure will be unwound and the property owner will directly own the historic building.

5. Tax Incentives: Do They Work? Generally, advocates for tax incentives, such as Arthur Laffer and N. Gregory Mankiw, argue that reduced taxes allow taxpayers to invest money that would otherwise be paid in taxes to better use, thereby creating additional economic activity. “Supply-siders” posit that higher taxes do not result in more government revenue; instead, they suppress additional innovation and investment that would have led to more economic activity and, therefore, healthier public treasuries, under lower marginal tax rates. Industry-specific credits complement this theory by lowering tax costs for industries that provide positive multiplier effects, such as stimulating economic activity among suppliers and increasing economy-wide purchasing power resulting from hiring additional employees.

Critics, however, assert that tax incentives rarely result in additional economic activity. Companies locate in California because of its competitive advantages, namely its environment, weather, transportation infrastructure, access to ports, highways, and railroads, as well as its highly skilled workforce and world class higher education system. These advantages trump perceived disadvantages resulting from California's tax structure and other policies. Additionally, critics argue that industry-specific tax incentives do not actually effect business decisions; instead, enhanced credits and deductions reward firms for investments they would have made anyway. [See, e.g., D. Neumark, J. Zhang, and J. Kolko, Are Businesses Fleeing the State? Interstate Business Location and Employment Change in California, (a PPIC report showing that, while California loses jobs due to firms leaving the state, these losses have a minimal effect on the economy); D. Neumark and J. Kolko, Are California Companies Shifting Their Employment to Other States? (finding that, while California companies have shifted jobs to other states, out-of-state firms have offset these losses by hiring more in California).]

As noted by the Legislative Analyst Office (LAO) in the presentation at this Committee's hearing "Assessing Tax Expenditure Programs in Light of California's Fiscal Challenges" on February 22, 2012, "Policymakers should regard many TEPs [tax expenditure programs] evaluations with skepticism." It was further explained that, "Analysis of alternative uses of public funds is difficult and often omitted entirely from . . . studies [of TEPs]. These studies also usually rely on extensive and sometimes subjective assumptions which, if changed, can produce very different results . . . . It is rare that the value of TEPs can be demonstrated conclusively compared to these alternate uses of tax dollars. If the Legislature wishes to use TEPs, despite these challenges, it is important that TEPs be used cautiously, structured carefully, and reviewed regularly to consider if they operate in an effective and cost-efficient manner."

2. The Proposed Historic Preservation Tax Credit: a Different Kind of Credit? This bill creates a historic preservation tax credit program modeled after the federal HTC. Unlike the federal HTC, however, the proposed credit is not permanent; the credit is allowed for seven taxable years, beginning with the 2016 tax year. This bill also provides for an increased tax credit rate of 20% and allows an additional 5% for certain projects, such as low-income housing; a transit-oriented development; and a structure located on federal, state, or local surplus property, in a designated census tract, on a specified military base. A building that is not included in the National Register of Historic Places may still qualify for the state credit if it appears on the California Register of Historical Resources.
   
   The proposed credit is different from other state tax credits, where a certain class of individuals or businesses may claim a credit based on membership in a certain industry or business location. In contrast to many tax incentives in California, the proposed tax credit is targeted, is capped at $50 million per calendar year, and is required to be allocated to taxpayers by the CTCAC on a competitive basis. In many respects, it is similar to a grant program. This bill prescribes certain criteria for CTCAC to utilize in determining whether a project should be awarded the state HTC, including the estimated number of jobs and potential state and local tax revenues to be generated by the project. Thus, the proposed credit is intended to result in a quantifiable public benefit. Finally, the LAO is required to review the effectiveness of this tax credit program, on an annual basis. The credit program sunsets on December 1, 2024, and is not refundable.

3. How Effective Are Historic Tax Credit Programs in Other States? Thirty-five states offer state tax incentives of various kinds for historic preservation rehabilitation projects. In many states, the income tax credit programs are similar to the federal HTC program. Several studies conducted by Rutgers University have shown that "in many parts of the country, $1 million in historic rehabilitation yields markedly better effects on employment, income, GSP, and state and local taxes than an equal investment in new construction or many other economic activities (e.g., manufacturing or services)." ² It was concluded that states with the strongest historical preservation tax credit statutes regularly lead the nation in the use of the federal HTC, which, due to its leverage and multiplier effects, benefits both state economies and the national economy. For example, an annual report of the Ohio Historic Preservation tax credit program states that the $327 million in tax credits approved are projected to leverage more than $2 billion in private investment and federal tax credits, which translates to $6.25 of investment for every dollar of the state tax credit.³ The Ohio Historic Preservation tax credit is capped at $60 million per year and allocated to applicants. According to a 2011 economic impact study conducted by Cleveland State University, the $246 million in approved tax credits is expected to result, during the construction period alone, in nearly $10 billion in economic activities in the state between 2007 and 2025. Recognizing the economic impact and job creation of the program, the Ohio General Assembly renewed the Program in the state's fiscal year 2012-13 budget. Similarly, it was found that in Minnesota and North Carolina, respectively, every dollar of the state historic tax credit creates $8.32 in economic activity and $12.51 in economic benefit.

4. Bifurcation of the Credit. A taxpayer who uses a state tax credit to reduce his/her state tax liability generally loses the ability to take a federal deduction for the state tax paid with the use of the state historic tax credit. As such, the value of a state tax credit is less that its face value. In practice, when federal credits are allocated through a partnership to an investor, ownership interests are valued at $0.95 or more on the dollar, while the after-tax value of the state tax credits tends to be in the range of $0.50 to $0.55 on the dollar.⁴ Furthermore, a state tax credit has value only to the extent that the taxpayer holding the credit has sufficient tax liability in the state. To remedy this problem, some states have permitted an outright sale of the credit or made it refundable, while others have allowed a partnership owning the property to make a disproportionate distribution (or bifurcation) of the federal and state credits to its partners. The bifurcation approach allows investors to enter into partnership agreements where they can purchase state tax credits without the corresponding federal credits. Thus, bifurcation allows investors to join the developing partnership and be awarded the federal HTC, a state historic tax credit, or both. Consequently, investors with no federal tax liability, but sufficient state tax liability, would have an incentive to invest in a rehabilitation project that would allow them to offset unrelated state income tax liability with the state HTC.
   
   This bill requires that the credit be allocated to the partners of a partnership in accordance with the partnership agreement, regardless of how the federal HTC is allocated to the partners or whether the allocation of the state credit under the partnership agreement has "substantial economic effect." Because this bill specifically excludes any consideration of the "substantial economic effect" of the partners' distributions, it creates a divergence from long-established tax policy and potentially leads to tax shelter opportunities.
   
   A bifurcation of the proposed tax credit from the federal HTC highlights a natural tension between the need to draw more investors and investment dollars to projects that rehabilitate historic buildings and create more low-income housing units and tax policy that strives to ensure that investments have substance other than tax incentives. The bifurcation approach, with very little economic impact on investors other than tax credits, balances at the precipice of tax sheltering activities. However, this approach was already approved by the Legislature in the case of the state's low-income housing tax credit (LIHTC) program. The bifurcation has been allowed in large part due to the type of projects created from the investment and the difficulty of raising sufficient capital to create low-income housing absent the credit incentives. In that case, the Legislature determined that the benefits of increased project capital exceeded the tax policy concerns of sanctioning a state tax shelter. Traditionally, the low-income housing tax credit (LIHTC) has been administered just as though it were an allocated grant program. The Tax Credit Allocation Committee evaluates the applications and allocates the available funds (the amount of which is capped) to those investors/developers who promise to produce the most housing for the state's dollar. Although the program is in the form of a tax credit, all the participants behave virtually as though they were dealing with an allocation of grant funds. For this reason, the Legislature decided that it is unlikely that a separation of a state and federal LIHTC would result in a significant increase of tax sheltering activities. The proposed credit is intended as a tool of economic development, especially in economically distressed areas that are difficult to revitalize and in light of the recent dissolution of the redevelopment program. The Committee may wish to consider whether the proposed historic preservation tax credit program is sufficiently comparable to the LIHTC program and whether it warrants a similar treatment.

5. Sale or Abandonment of Partnership Interests. As discussed, many rehabilitation projects are developed by a partnership or a LLC, in which the developer is the general partner or manager with a de minimus ownership interest and investors are limited partners/members with a 99.9% ownership interest in the partnership for the tax credit compliance period. A partner who sells or exchanges his/her partnership interest recognizes a capital loss or capital gain on that sale or exchange depending on the partner's basis in the partnership and the purchase price. If a partner abandons or forfeits his/her partnership interest, he/she will recognize an ordinary loss, provided that there are no partnership liabilities from which the partner is relieved. The amount of that loss is equal to the partner's basis in the partnership.
   
   One of the concerns raised in connection with the separation of the state and federal LIHTC was that an investor would be able to offset his/her income (albeit in different tax years) with both the LIHTC and a loss realized from the abandonment or sale of his/her partnership interest. Consequently, the Legislature decided to defer a recognition of that loss until the first taxable year following the expiration of the federal credit, i.e. a 10-year period, which mitigated the negative effect of an allocation of the state credit lacking substantial economic effect. This bill would add a similar deferral provision for the recognition of loses in the context of the state historic preservation tax credit program.

6. Owner-Occupied Building. Under the federal HTC program, owner-occupied buildings are not eligible for the credit. This bill takes a different approach in that it would allow both income-producing properties and owner-occupied residential buildings to qualify for the state tax credit. However, this bill imposes an additional requirement for a taxpayer who has received the credit to rehabilitate a "qualified residence": the residence must become the taxpayer's "principal residence" within two years after the rehabilitation. Nonetheless, the Committee may still wish to consider whether a subsidy for rehabilitation of an owner-occupied building is an effective tool of economic development.

7. Tax Credit Percentages. This bill proposes tax credit percentages that are similar or higher than the federal HTC rates. The Committee may wish to consider whether the proposed percentages should be reduced in light of the fact that the California income tax rates are substantially lower than federal income tax rates.

8. Definition of a "Certified Historic Structure." It is unclear to Committee staff whether the author has intended to allow the credit for qualified expenditures incurred in rehabilitation of a historic structure located in California only. The Committee may wish to consider a clarifying amendment to specify the intent of the author.

9. Implementation Concerns. The FTB staff identified a number of implementation concerns in its analysis of this bill. The FTB staff recommends that the bill be amended to specify that a taxpayer receive an "allocation," instead of "reservation," of the credit from the CTCAC. Furthermore, the FTB staff notes that this bill lacks a mechanism to recapture the credit if the taxpayer has failed to make a "qualified residence" his/her "principal residence" within two years after the rehabilitation. Finally, the FTB staff suggests technical amendments, including a clarification of the definitions of "certified historic structure" and "qualified rehabilitation expenditure."

10. Section 41:  On September 29, 2014, Governor Brown signed SB 1335 (Leno), Chapter 845, Statutes of 2014, which added R&TC Section 41.  SB 1335 recognized that the Legislature should apply the same level of review used for government spending programs to tax preference programs, including tax credits.  Thus, Section 41 requires any bill that is introduced on or after January 1, 2015 and allows a new PIT credit to contain specific goals, purposes, and objectives that the tax credit will achieve.  In addition, Section 41 requires detailed performance indicators for the Legislature to use when measuring whether the tax credit meets the goals, purposes, and objectives so-identified.

This bill provides legislative intent to comply with the requirements of R&TC Section 41.  While this bill does not specify the goals of the proposed HTC, it does require the CTCAC to establish criteria for reserving tax credits, consistent with the criteria outlined in the bill. This bill also requires the Legislative Analyst Office to collaborate with the CTCAC to review the effectiveness of the historic building tax credit program. Nonetheless, the Committee may wish to consider whether it is appropriate to additionally articulate the purposes being served by this bill.       

2. Related Legislation.

   1. AB 1999(Atkins), of the 2013-14 Legislative Session, would have allowed a tax credit substantially similar to the credit proposed by this bill. AB 1999 was vetoed.

   2. AB 166 (Cedillo), of the 2001-02 Legislative Session, would have allowed a tax credit in an amount determined in accordance with provisions of the federal historic rehabilitation tax credit. AB 166 was held on the Assembly Appropriations Committee's Suspense File.

REGISTERED SUPPORT / OPPOSITION:

Support

American Institute of Architects California Council

American Planning Association, California Chapter

California Association of Realtors

California Preservation Foundation

League of California Cities

Opposition

None on file

Analysis Prepared by: Oksana Jaffe / REV. & TAX. / (916) 319-2098

Date of Hearing: April 20, 2015

ASSEMBLY COMMITTEE ON REVENUE AND TAXATION

Philip Ting, Chair

ABPCA Bill Id:AB 771

Author:(Atkins) – As Introduced Ver:February 25, 2015

Majority vote. Tax levy. Fiscal committee.

SUBJECT: Personal income and corporation taxes: credits: rehabilitation

SUMMARY: Allows a temporary income tax credit for qualified costs paid or incurred by a taxpayer in rehabilitation of a certified historic structure, as defined ("the Historic Preservation Tax Credit"), in modified conformity with the federal income tax laws, subject to an aggregate annual cap of $50 million. Specifically, this bill:

1. Declares legislative intent to preserve and restore California's historic buildings, which are an important asset to communities throughout California, and to create tools to incentivize economic development and revitalize economically distressed areas.
   
   

2. Allows an income tax credit, under both the Personal Income Tax (PIT) and the Corporation Tax (CT) laws, in an amount equal to 20% of the qualified rehabilitation expenditures with respect to a certified historic structure, as defined.
   
   

3. Increases the applicable percentage to 25% in the case of a certified historic structure that meets one of the following criteria:
   
   

   1. The structure is located on federal surplus property, state, or local surplus property, as defined;
      
      

   2. The rehabilitated structure includes affordable housing for lower-income households, as defined by Health and Safety Code Section 50079.5;
      
      

   3. The structure is located in a designated census tract, as defined in Revenue and Taxation Code Section 17053.73(b)(7);
      
      

   4. The structure is a part of a military base reuse authority established pursuant to Title 7.86 commencing with Section 67800 of the Government Code; or,
      
      

   5. The structure is a transit-oriented development that is a higher density, mixed-use development within a walking distance of one-half mile of a transit station.
      
      

4. Allows the credit for taxable years beginning on or after January 1, 2016, and before January 1, 2024.
   
   

5. Provides that the term "certified historic structure" has the same meaning as defined in Section 47(c)(3) of the Internal Revenue Code and additionally as a structure in this state that is listed on the California Register of Historical Resources.
   
   

6. Defines a "qualified residence" by reference to Internal Revenue Code (IRC) Section 163(h)(4), as a residence that will be owned and occupied, or will be occupied after the rehabilitation, by an individual taxpayer as a taxpayer's principal residence, provided that the taxpayer's modified adjusted gross income is $200,000 or less.

7. Defines the term "qualified rehabilitation expenditure" by reference to IRC Section 47(c), but modifies the federal definition to provide that "qualified rehabilitation expenditures" may include both of following:

   1. Expenditures in connection with the rehabilitation of a building even if the building is, or is reasonably expected to be, tax-exempt use property.

   2. Expenditures incurred by the taxpayer with respect to a qualified principal residence for the rehabilitation of the exterior of the building or rehabilitation necessary for the functioning of the home, including, but not limited to, rehabilitation of the electrical, plumbing, or foundation of the principal residence.

8. Allows the Historic Preservation Tax Credit for qualified rehabilitation expenditures for a qualified residence only if the residence is determined jointly by the CTCAC and the OHP to have a public benefit in the year of completion. The amount of the Historic Preservation Tax Credit shall only be allowed in an amount equal to or more than $5,000, not to exceed $25,000; and the tax credit shall only be allowed to a taxpayer once every 10 taxable years.

9. Requires a taxpayer to request a reservation of the Historic Preservation Tax Credit from California Tax Credit Allocation Committee (CTCAC), in the form and manner prescribed by CTCAC.

10. Specifies that a tax credit reservation provided to a taxpayer shall not constitute a determination by CTCAC regarding a taxpayer's eligibility for the Historic Preservation Tax Credit.

11. Provides that rehabilitation must commence within 18 months of the issuance of the tax credit reservation; otherwise, the reservation shall be forfeited and the credit amount associated with the tax credit reservation shall be treated as an unused allocation tax credit amount.

12. Authorizes the California Tax Credit Allocation Committee (CTCAC) to reserve and allocate the Historic Preservation Tax Credit and requires CTCAC to do all of the following:

    1. On and after January 1, 2016, and before January 1, 2024, to reserve and allocate tax credits to applicants, as provided.
       
       

    2. Establish a procedure for applicants to file with the CTCAC a written application, on a form jointly prescribed by CTCAC and the Office of Historic Preservation (OHP) for the reservation of the tax credit.
       
       

    3. Establish criteria for reserving tax credits, consistent with the requirements of the tax credit program. Criteria shall include, but not be limited to, all of the following:
       
       

       1. The number of jobs created by the rehabilitation project, both during and after the rehabilitation of the structure;
          
          

       2. The expected increase in state and local tax revenues derived from the rehabilitation project, including those from increased wages and property taxes; and,
          
          

       3. Any additional incentives or contributions included in the rehabilitation project from federal, state, or local governments.
          
          

       4. Finding of a public benefit, as determined jointly with the OHP, in the case of qualified rehabilitation expenditures with respect to a qualified residence.
          
          

    4. Determine and designate, in consultation with the OHP, applicants that meet the specified requirements to ensure that the rehabilitation project meets the Secretary of the Interior's Standards for Rehabilitation, as specified.
       
       

    5. Process and approve, or reject, all tax credit reservation applications.
       
       

    6. Allocate an aggregate amount of the tax credits, under both the PIT and the CT laws, and any carryover of unallocated credits from prior years, subject to the annual cap of $50 million.
       
       

    7. Certify tax credits allocated to taxpayers.
       
       

    8. Allocate a tax credit pursuant to the taxpayer's tax credit reservation upon receipt of a cost certification for the qualified rehabilitation expenditures. For projects with qualified rehabilitation expenditures in excess of $250,000, the cost certification must be issued by a licensed certified public accountant.
       
       

    9. Provide the Franchise Tax Board (FTB) an annual list of the taxpayers that were allocated a credit, as specified, including each taxpayer's taxpayer identification number and the amount allocated.
       
       

13. Requires CTCAC to set aside $10 million of tax credits each calendar year for taxpayers with qualified rehabilitation expenditures of less than $1 million. To the extent that this amount is not fully reserved in any calendar year, the unused portion shall become available for reservation to other taxpayers.

14. Allows the CTCAC to adopt a reasonable fee in an amount sufficient to cover its expenses and the expenses by the OHP incurred in administering the Historic Preservation Tax Credit program.
    
    

15. Authorizes the taxpayer to carry forward the tax credit to the following tax year, and succeeding seven years, if necessary, until the credit is exhausted.
    
    

16. Disallows any deduction for the amount of paid or incurred by the taxpayer for which a credit is allowed to the taxpayer.
    
    

17. Requires the basis of the property to be reduced by the amount of the Historic Preservation Tax Credit allowed.

18. Adds a five-year tax credit recapture provision, in conformity with IRC Section 50(a), when the property, or interest in the property, is sold.

19. Specify that tax credits awarded to an "S" corporation shall be allocated among the shareholders of that corporation pro-rata in accordance with their respective pro rata shares determined in accordance with specified provisions of the IRC.

20. Provides that the credit shall be allocated to the partners of a partnership owning the historic rehabilitation project in accordance with the partnership agreement, regardless of how the federal historic rehabilitation tax credit, with respect to the project, is allocated to the partners, or whether the allocation of the credit under the terms of the agreement has substantial economic effect, within the meaning of Section 704(b) of the Internal Revenue Code (IRC).
    
    

21. Allow the Historic Preservation Tax Credit to be used to reduce the taxpayer's tax liability below the tentative minimum tax.

22. Contrary to the federal law, allows the Historic Preservation Tax Credit in the case of an activity engaged in by an individual or an S corporation not for profit.

23. Requires the Legislative Analyst Office, beginning January 1, 2017, to collaborate with the CTCAC to review the effectiveness of the historic building tax credit program.
    
    

24. Provides that the review shall include an analysis of the demand for the tax credit, the types and uses of projects receiving the tax credit, the jobs created by the use of the tax credit, and the economic impact of the tax credit.
    
    

25. States the intent of the Legislature, in enacting this bill, to comply with the requirements of Section 41 of the Revenue and Taxation Code (R&TC).
    
    

26. Takes effect immediately as a tax levy.
    
    

EXISTING FEDERAL LAW:

1. Allows a two-tiered tax credit for the rehabilitation expenses of older or historic buildings. Specifically, it provides:
   
   

   1. A 10% credit for the rehabilitation expenses of non-historic buildings with an additional requirement that the building must have been originally constructed before 1936; and,
      
      

   2. A 20% credit for the rehabilitation expenses of a certified historic structure, i.e. a structure that is listed on the national Register of Historic Places or located in a Registered Historic District and determined to be of significance to the Historical District.
      
      

2. Allows a taxpayer engaged in a trade or business to deduct all expenses that are considered ordinary and necessary in conducting that trade or business.

EXISTING STATE LAW does not conform to the federal tax credit for rehabilitation expenses of older or historic buildings, but does allow taxpayers, in conformity with the federal law, to deduct ordinary and necessary business expenses.

FISCAL EFFECT: The FTB staff estimates that this bill will result in an annual revenue loss of $19 million in the fiscal year (FY) 2015-16, $41 million in FY 2016-17, and $48 million in FY 2017-18.

COMMENTS:

1. The Author's Statement: The author has provided the following statement in support of this bill:

"California is one of the few states to not provide an incentive for the preservation of our historic buildings. A state tax credit for this purpose would help stimulate local economies, revitalize downtown areas and communities, promote and increase the supply of affordable housing, support smart growth through infill development, encourage property maintenance and rehabilitation, and leverage use of the federal rehabilitation tax credit.

"Additionally, it would increase construction and building industry job creation, increase state tax revenues through increased employment and wages, increase local property tax revenues through increased property values, and increase local tax revenues through sales tax and heritage tourism.

"AB 771 helps communities adjust to the phase-out of redevelopment dollars and stimulates public and private investment, all while building civic pride as we celebrate our heritage and preserve California's past."

2. Arguments in Support. The proponents state that this bill "will incentivize private investment to rehabilitate historic properties," many of which are located in "urban core areas." Upgrading these properties will support "city efforts to spur and retain economic activity in downtown areas." The proponents argue that the rehabilitation of historic properties will "increase property values, generating revenue for cities, counties, schools and special districts." In addition, this bill would provide incentives for projects that "include affordable housing and transit-oriented development."

3. Federal Historic Tax Credit (HTC). The Federal Historic Preservation Tax Incentives Program, created in 1976, is administered by the National Park Service in partnership with the State Historic Preservation Office. The goal of the program is to promote community revitalization and encourage private investment through historic building rehabilitation. Over 39,600 projects to rehabilitate historic buildings have been undertaken since the first project using the historic tax incentives was completed in 1977.¹ The HTC is claimed not only by large projects. As reported by the National Park Service, in fiscal year 2013, almost 8% of the certified projects were under $100,000, 46% were under $500,000, and the majority of all projects – 59% - involved less than $1 million in costs. (Id., p. 11.)
   
   Housing has been the single most important use for rehabilitated historic buildings under the program. Over the past five years, between 36% and 69% of the projects have included housing. Almost one-half of the projects certified in 2013, or 46%, reported housing as a final primary use, including multiple-family housing. As a result of this program, more than 130,000 of low- and moderate-income housing units have been created. According to the report issued by the National Park Service, one of the objectives of the program is to create and retain affordable housing. (Id., p. 12.) Other incentives utilized by developers, in addition to the HTC, include the New Market Tax Credit Program, Tax Increment Financing, and local property tax abatements.
   
   To qualify for the historic tax credit, a project must satisfy the requirements of IRC Section 47 and related regulations, as well as architectural standards regulated by the National Parks Service. Certification of Historic Significance is the first step in establishing eligibility for the HTC. A building must be individually listed in the national Register of Historic Places or be certified as contributing to a registered historic district in order to qualify for the 20% credit. A building that has been certified as non-significant (i.e., not contributing to a National Register historic district), but was built before 1936, can qualify for a 10% tax credit if it is rehabilitated for income-producing, non-residential purposes. A developer must submit an application detailing the plans and specifications for the rehabilitation. The plans must satisfy the Secretary of Interior Standards for Rehabilitation.
   
   Once the project is completed, a request for certification of completion is submitted. If the request is granted, the rehabilitation is considered a "certified rehabilitation." A certification of a completed project is issued only when all work has been finished on the certified historic building. Generally, the HTC must be claimed in the tax year in which the rehabilitated building is placed in service. However, the credit may be claimed before the date the property is placed in service under the rules for qualified progress expenditures (IRC Section 47(d).) Existing federal law contains a so-called "recapture provision," which provides that a portion of the tax credit must be recaptured (returned to the Federal Government) if the rehabilitated building is sold or otherwise ceases to qualify within five years from the date the building is placed in service.

4. The Financing Structure. In order to raise funds for rehabilitation of historic buildings, the owners, in most cases, enter into various financing transactions with private entities using the HTC, among other tax and financial incentives. A property owner, because of his/her tax position, may elect to syndicate the HTC to a third party through the issuance of partnership or limited liability company (LLC) interests. The financing of a historic building rehabilitation using the HTC requires the participation of a private investor (mostly a taxable corporation) that could take advantage of the credits to reduce its income tax liability. A typical arrangement is to match a corporate tax credit investor entity with a project developer, creating a partnership (such as a LLC) where the investor is allocated the tax credits in exchange for cash and the developer acts as a managing partner (or member). Usually, the percentage of allocated tax credits matches the percentage of allocated profits. Thus, if an investor entity is allocated all of the tax credits, then that entity will also receive all or nearly all of the profits for at least five years. In exchange, the developer will receive a developer fee or other distributions. An investor must retain ownership of the property (i.e. remain in the partnership) for at least five years after the project is placed in service in order to receive the full benefit of the tax credits, or the tax credits will be subject to recapture. At the end of this period, either the developer will buy out the investor or the investor will sell its interest in the partnership.
   
   In the case of a HTC, a certified historic structure, i.e. a building, must be owned by either the entity that utilizes the credit or a master tenant that leases the entire building from the owner. In a case of a master tenant partnership structure, the corporate entity will be allocated most, if not all, of the credit and profits. The corporate entity will also likely to receive an annual priority return, the amount of which is equal to a very small percentage of the investor's equity in the project. In exchange, the investor will contribute cash to the partnership to provide financing for the rehabilitation project. It is expected that after the expiration of the five-year recapture period the financing structure will be unwound and the property owner will directly own the historic building.

5. Tax Incentives: Do They Work? Generally, advocates for tax incentives, such as Arthur Laffer and N. Gregory Mankiw, argue that reduced taxes allow taxpayers to invest money that would otherwise be paid in taxes to better use, thereby creating additional economic activity. “Supply-siders” posit that higher taxes do not result in more government revenue; instead, they suppress additional innovation and investment that would have led to more economic activity and, therefore, healthier public treasuries, under lower marginal tax rates. Industry-specific credits complement this theory by lowering tax costs for industries that provide positive multiplier effects, such as stimulating economic activity among suppliers and increasing economy-wide purchasing power resulting from hiring additional employees.

Critics, however, assert that tax incentives rarely result in additional economic activity. Companies locate in California because of its competitive advantages, namely its environment, weather, transportation infrastructure, access to ports, highways, and railroads, as well as its highly skilled workforce and world class higher education system. These advantages trump perceived disadvantages resulting from California's tax structure and other policies. Additionally, critics argue that industry-specific tax incentives do not actually effect business decisions; instead, enhanced credits and deductions reward firms for investments they would have made anyway. [See, e.g., D. Neumark, J. Zhang, and J. Kolko, Are Businesses Fleeing the State? Interstate Business Location and Employment Change in California, (a PPIC report showing that, while California loses jobs due to firms leaving the state, these losses have a minimal effect on the economy); D. Neumark and J. Kolko, Are California Companies Shifting Their Employment to Other States? (finding that, while California companies have shifted jobs to other states, out-of-state firms have offset these losses by hiring more in California).]

As noted by the Legislative Analyst Office (LAO) in the presentation at this Committee's hearing "Assessing Tax Expenditure Programs in Light of California's Fiscal Challenges" on February 22, 2012, "Policymakers should regard many TEPs [tax expenditure programs] evaluations with skepticism." It was further explained that, "Analysis of alternative uses of public funds is difficult and often omitted entirely from . . . studies [of TEPs]. These studies also usually rely on extensive and sometimes subjective assumptions which, if changed, can produce very different results . . . . It is rare that the value of TEPs can be demonstrated conclusively compared to these alternate uses of tax dollars. If the Legislature wishes to use TEPs, despite these challenges, it is important that TEPs be used cautiously, structured carefully, and reviewed regularly to consider if they operate in an effective and cost-efficient manner."

2. The Proposed Historic Preservation Tax Credit: a Different Kind of Credit? This bill creates a historic preservation tax credit program modeled after the federal HTC. Unlike the federal HTC, however, the proposed credit is not permanent; the credit is allowed for seven taxable years, beginning with the 2016 tax year. This bill also provides for an increased tax credit rate of 20% and allows an additional 5% for certain projects, such as low-income housing; a transit-oriented development; and a structure located on federal, state, or local surplus property, in a designated census tract, on a specified military base. A building that is not included in the National Register of Historic Places may still qualify for the state credit if it appears on the California Register of Historical Resources.
   
   The proposed credit is different from other state tax credits, where a certain class of individuals or businesses may claim a credit based on membership in a certain industry or business location. In contrast to many tax incentives in California, the proposed tax credit is targeted, is capped at $50 million per calendar year, and is required to be allocated to taxpayers by the CTCAC on a competitive basis. In many respects, it is similar to a grant program. This bill prescribes certain criteria for CTCAC to utilize in determining whether a project should be awarded the state HTC, including the estimated number of jobs and potential state and local tax revenues to be generated by the project. Thus, the proposed credit is intended to result in a quantifiable public benefit. Finally, the LAO is required to review the effectiveness of this tax credit program, on an annual basis. The credit program sunsets on December 1, 2024, and is not refundable.

3. How Effective Are Historic Tax Credit Programs in Other States? Thirty-five states offer state tax incentives of various kinds for historic preservation rehabilitation projects. In many states, the income tax credit programs are similar to the federal HTC program. Several studies conducted by Rutgers University have shown that "in many parts of the country, $1 million in historic rehabilitation yields markedly better effects on employment, income, GSP, and state and local taxes than an equal investment in new construction or many other economic activities (e.g., manufacturing or services)." ² It was concluded that states with the strongest historical preservation tax credit statutes regularly lead the nation in the use of the federal HTC, which, due to its leverage and multiplier effects, benefits both state economies and the national economy. For example, an annual report of the Ohio Historic Preservation tax credit program states that the $327 million in tax credits approved are projected to leverage more than $2 billion in private investment and federal tax credits, which translates to $6.25 of investment for every dollar of the state tax credit.³ The Ohio Historic Preservation tax credit is capped at $60 million per year and allocated to applicants. According to a 2011 economic impact study conducted by Cleveland State University, the $246 million in approved tax credits is expected to result, during the construction period alone, in nearly $10 billion in economic activities in the state between 2007 and 2025. Recognizing the economic impact and job creation of the program, the Ohio General Assembly renewed the Program in the state's fiscal year 2012-13 budget. Similarly, it was found that in Minnesota and North Carolina, respectively, every dollar of the state historic tax credit creates $8.32 in economic activity and $12.51 in economic benefit.

4. Bifurcation of the Credit. A taxpayer who uses a state tax credit to reduce his/her state tax liability generally loses the ability to take a federal deduction for the state tax paid with the use of the state historic tax credit. As such, the value of a state tax credit is less that its face value. In practice, when federal credits are allocated through a partnership to an investor, ownership interests are valued at $0.95 or more on the dollar, while the after-tax value of the state tax credits tends to be in the range of $0.50 to $0.55 on the dollar.⁴ Furthermore, a state tax credit has value only to the extent that the taxpayer holding the credit has sufficient tax liability in the state. To remedy this problem, some states have permitted an outright sale of the credit or made it refundable, while others have allowed a partnership owning the property to make a disproportionate distribution (or bifurcation) of the federal and state credits to its partners. The bifurcation approach allows investors to enter into partnership agreements where they can purchase state tax credits without the corresponding federal credits. Thus, bifurcation allows investors to join the developing partnership and be awarded the federal HTC, a state historic tax credit, or both. Consequently, investors with no federal tax liability, but sufficient state tax liability, would have an incentive to invest in a rehabilitation project that would allow them to offset unrelated state income tax liability with the state HTC.
   
   This bill requires that the credit be allocated to the partners of a partnership in accordance with the partnership agreement, regardless of how the federal HTC is allocated to the partners or whether the allocation of the state credit under the partnership agreement has "substantial economic effect." Because this bill specifically excludes any consideration of the "substantial economic effect" of the partners' distributions, it creates a divergence from long-established tax policy and potentially leads to tax shelter opportunities.
   
   A bifurcation of the proposed tax credit from the federal HTC highlights a natural tension between the need to draw more investors and investment dollars to projects that rehabilitate historic buildings and create more low-income housing units and tax policy that strives to ensure that investments have substance other than tax incentives. The bifurcation approach, with very little economic impact on investors other than tax credits, balances at the precipice of tax sheltering activities. However, this approach was already approved by the Legislature in the case of the state's low-income housing tax credit (LIHTC) program. The bifurcation has been allowed in large part due to the type of projects created from the investment and the difficulty of raising sufficient capital to create low-income housing absent the credit incentives. In that case, the Legislature determined that the benefits of increased project capital exceeded the tax policy concerns of sanctioning a state tax shelter. Traditionally, the low-income housing tax credit (LIHTC) has been administered just as though it were an allocated grant program. The Tax Credit Allocation Committee evaluates the applications and allocates the available funds (the amount of which is capped) to those investors/developers who promise to produce the most housing for the state's dollar. Although the program is in the form of a tax credit, all the participants behave virtually as though they were dealing with an allocation of grant funds. For this reason, the Legislature decided that it is unlikely that a separation of a state and federal LIHTC would result in a significant increase of tax sheltering activities. The proposed credit is intended as a tool of economic development, especially in economically distressed areas that are difficult to revitalize and in light of the recent dissolution of the redevelopment program. The Committee may wish to consider whether the proposed historic preservation tax credit program is sufficiently comparable to the LIHTC program and whether it warrants a similar treatment.

5. Sale or Abandonment of Partnership Interests. As discussed, many rehabilitation projects are developed by a partnership or a LLC, in which the developer is the general partner or manager with a de minimus ownership interest and investors are limited partners/members with a 99.9% ownership interest in the partnership for the tax credit compliance period. A partner who sells or exchanges his/her partnership interest recognizes a capital loss or capital gain on that sale or exchange depending on the partner's basis in the partnership and the purchase price. If a partner abandons or forfeits his/her partnership interest, he/she will recognize an ordinary loss, provided that there are no partnership liabilities from which the partner is relieved. The amount of that loss is equal to the partner's basis in the partnership.
   
   One of the concerns raised in connection with the separation of the state and federal LIHTC was that an investor would be able to offset his/her income (albeit in different tax years) with both the LIHTC and a loss realized from the abandonment or sale of his/her partnership interest. Consequently, the Legislature decided to defer a recognition of that loss until the first taxable year following the expiration of the federal credit, i.e. a 10-year period, which mitigated the negative effect of an allocation of the state credit lacking substantial economic effect. This bill would add a similar deferral provision for the recognition of loses in the context of the state historic preservation tax credit program.

6. Owner-Occupied Building. Under the federal HTC program, owner-occupied buildings are not eligible for the credit. This bill takes a different approach in that it would allow both income-producing properties and owner-occupied residential buildings to qualify for the state tax credit. However, this bill imposes an additional requirement for a taxpayer who has received the credit to rehabilitate a "qualified residence": the residence must become the taxpayer's "principal residence" within two years after the rehabilitation. Nonetheless, the Committee may still wish to consider whether a subsidy for rehabilitation of an owner-occupied building is an effective tool of economic development.

7. Tax Credit Percentages. This bill proposes tax credit percentages that are similar or higher than the federal HTC rates. The Committee may wish to consider whether the proposed percentages should be reduced in light of the fact that the California income tax rates are substantially lower than federal income tax rates.

8. Definition of a "Certified Historic Structure." It is unclear to Committee staff whether the author has intended to allow the credit for qualified expenditures incurred in rehabilitation of a historic structure located in California only. The Committee may wish to consider a clarifying amendment to specify the intent of the author.

9. Implementation Concerns. The FTB staff identified a number of implementation concerns in its analysis of this bill. The FTB staff recommends that the bill be amended to specify that a taxpayer receive an "allocation," instead of "reservation," of the credit from the CTCAC. Furthermore, the FTB staff notes that this bill lacks a mechanism to recapture the credit if the taxpayer has failed to make a "qualified residence" his/her "principal residence" within two years after the rehabilitation. Finally, the FTB staff suggests technical amendments, including a clarification of the definitions of "certified historic structure" and "qualified rehabilitation expenditure."

10. Section 41:  On September 29, 2014, Governor Brown signed SB 1335 (Leno), Chapter 845, Statutes of 2014, which added R&TC Section 41.  SB 1335 recognized that the Legislature should apply the same level of review used for government spending programs to tax preference programs, including tax credits.  Thus, Section 41 requires any bill that is introduced on or after January 1, 2015 and allows a new PIT credit to contain specific goals, purposes, and objectives that the tax credit will achieve.  In addition, Section 41 requires detailed performance indicators for the Legislature to use when measuring whether the tax credit meets the goals, purposes, and objectives so-identified.

This bill provides legislative intent to comply with the requirements of R&TC Section 41.  While this bill does not specify the goals of the proposed HTC, it does require the CTCAC to establish criteria for reserving tax credits, consistent with the criteria outlined in the bill. This bill also requires the Legislative Analyst Office to collaborate with the CTCAC to review the effectiveness of the historic building tax credit program. Nonetheless, the Committee may wish to consider whether it is appropriate to additionally articulate the purposes being served by this bill.       

2. Related Legislation.

   1. AB 1999(Atkins), of the 2013-14 Legislative Session, would have allowed a tax credit substantially similar to the credit proposed by this bill. AB 1999 was vetoed.

   2. AB 166 (Cedillo), of the 2001-02 Legislative Session, would have allowed a tax credit in an amount determined in accordance with provisions of the federal historic rehabilitation tax credit. AB 166 was held on the Assembly Appropriations Committee's Suspense File.

REGISTERED SUPPORT / OPPOSITION:

Support

American Planning Association, California Chapter

California Association of Realtors

League of California Cities

Opposition

None on file

Analysis Prepared by: Oksana Jaffe / REV. & TAX. / (916) 319-2098