Federal Investment Tax Credit: Rehabilitation Credit IRC § 47

Background

 

The Federal government encourages the preservation of historic buildings through various means. One method includes federal tax incentives to support the rehabilitation of historic and older buildings. The Federal Rehabilitation Credit is an incentive provided by the Federal government’s as a cost-effective community revitalization program to help maintain historic communities' sense of identity, stability and orientation

The rehabilitation tax credit is available to the person(s) and/or the entity who holds title to a qualified rehabilitated building and incurs for qualified rehabilitation expenditures apart of its renovation. The credit is determined as a percentage of the expenditures for the rehabilitation of qualifying buildings in the year the property is placed in service. 

The federal rehabilitation credit encourages the preservation and adaptive reuse of historic and older buildings. Prior to 2018, the credit had previously consists of two separate tax credits: (1) a 20% credit for the rehabilitation costs of buildings listed on the National Register of Historic Places; and (2) a 10% credit for the rehabilitation of non-historic, non-residential buildings built before 1936.

However, the Tax Cuts and Jobs Act (TCJA), signed December 22, 2017, modified the Rehabilitation Tax Credit for amounts that taxpayers pay or incur for qualified expenditures after December 31, 2017. Public Law No: 115-97 (December 22, 2017), Section 13402, modifies the 20% Historic Rehabilitation Tax Credit, repeals the 10% tax credit for the rehabilitation of non-historic buildings, and provides transition rules for both credits. 


TCJA Impact to the Rehabilitation Credit (as of 2018):

  • Requires taxpayers take the 20% credit ratably over five years instead of in the year they placed the building into service

    • ​A 20% income tax credit is available for the rehabilitation of historic, income-producing buildings that are determined by the Secretary of the Interior, through the National Park Service, to be “certified historic structures.”

      • The State Historic Preservation Offices and the National Park Service review the rehabilitation work to ensure that it complies with the Secretary’s Standards for Rehabilitation.

      • The Internal Revenue Service defines qualified rehabilitation expenses on which the credit may be taken.

      • Owner-occupied residential properties do not qualify for the federal rehabilitation tax credit.

  • Eliminates the 10% rehabilitation credit for the pre-1936 buildings

    • A taxpayer cannot claim a 10% rehabilitation tax credit on a building which is in the National Register of Historic Places or is located within a Registered Historic District UNLESS

      • it has been certified by the National Park Service as not contributing to the significance of the district through the submission of Part 1 of the Historic Preservation Certification Application.

    • If a building is not listed in the National Register, is not located in a Registered Historic District, or is located in a Registered Historic District but has been determined to be a non-contributing structure by the Department of the Interior, a 10% rehabilitation tax credit may be utilized provided the building:

      • Was placed in service before 1936;

      • Is used for non-residential rental purposes;

      • Has not been physically moved after 1936;

      • Meets the following internal and external wall retention:

        • (a) 50% or more of the existing external walls are retained in place as external walls,

        • (b) 75% or more of the existing external walls are retained in place as internal or external walls,

        • (c) 75% or more of the existing internal structural framework is retained in place.

  • A transition rule provides relief to owners of either a certified historic structure or a pre-1936 building by allowing owners to use the prior law if the project meets these conditions:

    • The taxpayer owns or leases the building on January 1, 2018 and at all times thereafter

    • The 24 or 60 month period selected for the substantial rehabilitation test begins by June 20, 2018

In general, you are allowed a credit for qualified rehabilitation expenditures made for any qualified rehabilitated building. However, you may need to reduce your basis in applicable rehabilitation property by the amount of the credit determined for the tax year. If the adjusted basis of the building is determined in whole or in part by reference to the adjusted basis of a person other than the taxpayer, see Treas. Reg. § 1.48-12(b)(2)(viii) for additional information that must be attached.

Below summarizes key criteria and factors to investigate regarding qualification of the rehabilitation credit.

Qualified Rehabilitated Building

A qualified rehabilitated building is defined as that which has been substantially rehabilitated and was placed in service as a "building" before the beginning of the rehabilitation (as opposed to a ship, airplane, bridge, etc). See Treasury Regulation 1.48-12(b).

Treasury Regulation 1.48-1(e) defines a building as any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. The term includes, for example, structures such as apartment houses, factory and office buildings, warehouses, barns, garages, railway or bus stations, and stores."  A sports stadium is also considered a building within the definition of Treasury Regulation 1.48-1(e) in Revenue Ruling 69-170.

 

It does not include a structure which is essentially an item of machinery or equipment or where the use is solely to house an item of machinery or equipment.

Moreover, the rehabilitation tax credit can also generally be used by an individual condominium owner provided the condominium unit is held for the production of income, or is used in a trade or business. See IRS Tax Aspects of the Historic Preservation Tax Incentives - FAQs. Thus, rehabilitation expenditures otherwise qualifying will not be eligible for the credit if the property is used for the taxpayer's personal use.

To be a qualified rehabilitated building, your building must meet all five of the following requirements (I.R.C. § 47(c)(1)): 

  • 1. The building must be a "certified historic structure." 

    • A certified historic structure is any building

      • (a) listed in the National Register of Historic Places, or

      • (b) located in a registered historic district (as defined in section 47(c)(3)(B)) and certified by the Secretary of the Interior as being of historic significance to the district.

    • Certification requests are made through your State Historic Preservation Officer on National Park Service (NPS) Form 10-168a, Historic Preservation Certification Application. The request for certification should be made prior to physical work beginning on the building. For pre-1936 buildings under transition rule, see Transitional rule for amounts paid or incurred after 2017, later.

  • 2. The building must be "substantially rehabilitated."

    • A building is considered substantially rehabilitated if your qualified rehabilitation expenditures during a self-selected 24-month period that ends with or within your tax year are more than the greater of $5,000 or your adjusted basis in the building and its structural components.

      • The adjusted basis is determined on the first day of the 24-month period or the first day of your holding period, whichever is later. Generally speaking, the 24-month measuring period ends sometime during the year in which the property is placed in service. When comparing the taxpayer's qualified rehabilitation expenses to its basis, the expenses accrued over a 24-month period must end with or within the tax year the credit is being claimed.​​

      • If you are rehabilitating the building in phases under a written architectural plan and specifications that were completed before the rehabilitation began, substitute “60-month period” for “24-month period.” See RC § 47(c)(1)(c)(ii) & Treas. Reg. § 1.48-12(b) (1).

        • See also Treasury Regulation 1.48-12(f)(2). In an elected 60-month phased rehabilitation, the court has ruled that the tax credit could not be claimed on assumed eligibility. The substantial rehabilitation test must be met. See Ford vs. U.S. 93-1 USTC.​

    • If the substantial rehabilitation test has not been met at the time a building, or some portion of the building is actually placed in service, the building does not meet the definition of a qualified rehabilitated building. As such, placed in service is deemed to be at the point in time when the substantial rehabilitation test is actually met. See Internal Revenue Code Section 47(b)(1) and 47(c)(1)(C) and Treasury Regulation 1.48-12(f)(2) and 1.48-12(c)(6).​

  • 3. Depreciation must be allowable with respect to the building.

    • Depreciation isn't allowable if the building is permanently retired from service. If the building is damaged, it isn't considered permanently retired from service where the taxpayer repairs and restores the building and returns it to actual service within a reasonable period of time.

  • 4. The building must have been "placed in service" before the beginning of rehabilitation.

    • "Placed in service" generally means that the appropriate work has been completed which would allow for occupancy of either the entire building, or some identifiable portion of the building. See Treasury Regulation 1.46-3(d). If the property remains in service during the rehabilitation, the placed in service date will be commensurate with the project completion date.

      • This requirement is met if the building was placed in service by any person at any time before the rehabilitation began.

    • If a building was rehabilitated and placed in service, a taxpayer may be able to apply for certification and claim the rehabilitation tax credit "after the fact" dependent on the following:

      • Yes, if the building is individually listed in the National Register.

      • No, if the building is located within a registered historic district. If the building is within a registered historic district, the taxpayer must request on or before the date the property was placed in service a determination from the Department of Interior that such building is an historic structure and the Department of Interior later determines that the building is a certified historic structure. This is accomplished with the submission of Part 1 of the Historic Preservation Certification Application. If Part 1 of the application was not submitted prior to when the property was placed in service, the taxpayer would not be eligible for the rehabilitation tax credit. See Treasury Regulation 1.48-12(d)(1).

  • 5. For a building under transition rule,

    • (a) at least 75% of the external walls must be retained with 50% or more kept in place as external walls, and

    • (b) at least 75% of the existing internal structural framework of the building must be retained in place.

In general, the adjusted basis of a building is the cost of the property (excluding land) plus or minus adjustments to basis. The County Assessor's office would be able to provide a building to land value ratio. Increases to basis include capital improvements, legal fees incurred in perfecting title, zoning costs, etc. Decreases to basis include deductions previously allowed or allowable for depreciation. See Treasury Regulation 1.48-12(b)(2)(iii).

The basis of rehabilitated buildings, including certified historic structures, must be reduced by 100% of the rehabilitation credit earned regardless of whether the credit is used or carried forward. The reduction amount is added back if the credit is recaptured. See Treasury Regulation 1.48-12(e).

Moreover, the rehabilitation credit is available only if the taxpayer uses the straight-line method of depreciation. The current recovery period is 27.5 years for residential rental property and 39 years for non-residential real property. See Treasury Regulation 1.48-12(c)(8).

Qualified Rehabilitation Expenditures

In general, any expenditure for a structural component of a building may qualify for the rehabilitation tax credit. Treasury Regulation 1.48-1(e)(2) defines structural components to include walls, partitions, floors, ceilings, permanent coverings such as paneling or tiling, windows and doors, components of central air conditioning or heating systems, plumbing and plumbing fixtures, electrical wiring and lighting fixtures, chimneys, stairs, escalators, elevators, sprinkling systems, fire escapes, and other components related to the operation or maintenance of the building.

 

In addition to the above named "hard costs", there are "soft costs" which also qualify. These include construction period interest and taxes, architect fees, engineering fees, construction management costs, reasonable developer fees, and any other fees paid that would normally be charged to a capital account. See IRS Tax Aspects of the Historic Preservation Tax Incentives - FAQs.

The rehabilitation tax credit generally consists of the qualified rehabilitation expenditures incurred before and during, but not after, a taxable year in which the property (i.e. "Qualified Rehabilitation Building"), or a portion thereof, was placed in service. ​

Remedial work, or expenses necessary to obtain final approval by the National Park Service, may qualify provided the substantial rehabilitation test period includes these costs. It is possible that an additional rehabilitation credit would be allowable on a new project within the same property as long as that project involves a portion of the building that was not placed in service. Alternatively, a taxpayer is allowed to perform second rehabilitation tax credit project on the same building provided the "substantial rehabilitation test" is met.​​

To be qualified rehabilitation expenditures, the expenditures must meet all six of the following requirements:

  • 1. The expenditures must be amount(s) properly chargeable to a capital account —
    see I.R.C. § 47(c)(2)(A)(i) — for property for which depreciation is allowable under section 168 and which for

    • (a) nonresidential real property;

    • (b) residential rental property (but only if a certified historic structure; see Regulations section 1.48-1(h));

    • (c) real property that has a class life of more than 12.5 years; or 

    • (d) an addition or improvement to one of the three types of eligible property types as noted above

  • 2. The expenditures must be incurred in connection with the rehabilitation of a qualified rehabilitated building. I.R.C. § 47(c)(2)(A)(ii).

  • 3. The expenditures must be capitalized and depreciated using the straight line method. I.R.C. § 47(c)(2)(B)(i).

  • 4. The expenditures can't include the costs of acquiring or enlarging any building. I.R.C. § 47(c)(2)(B)(iii).

  • 5. If the expenditures are in connection with the rehabilitation of a certified historic structure or a building in a registered historic district, the rehabilitation must be certified by the Secretary of the Interior as being consistent with the historic character of the property or district in which the property is located.

    • This requirement doesn't apply to a building in a registered historic district if

      • (a) the building isn't a certified historic structure,

      • (b) the Secretary of the Interior certifies that the building isn't of historic significance to the district, and

      • (c) if the certification in (b) occurs after the rehabilitation began, the taxpayer certifies in good faith that he or she wasn't aware of that certification requirement at the time the rehabilitation began.

  • 6. The expenditures can't include any costs allocable to the part of the property that is (or may reasonably be expected to be) tax-exempt use property (as defined in section 168(h) except that “50 percent” shall be substituted for “35 percent” in paragraph (1)(B)(iii)). 

Qualified rehabilitation expenditures do NOT include (I.R.C. § 47(c)(2)(B)):

  • Costs of acquiring the building or interest therein. See Treasury Regulation 1.48-12(c)(9).

  • Enlargement costs which expand the total volume of the existing building. Interior modeling which increases floor space is not considered enlargement. See Treasury Regulation 1.48-12(c)(10).

  • Expenditures attributable to work done to facilities related to a building such as parking lots, sidewalks and landscaping. See Treasury Regulation 1.48-12(c)(5).

  • New building construction costs. See Treasury Regulation 1.48-12(b)(2)(B)(iv)

Examples of expenses that may NOT qualify for the rehabilitation tax credit:

  • Acquisition costs

  • Appliances

  • Cabinets

  • Carpeting (if tacked in place and not glued)

  • Decks (not part of original building)

  • Demolition costs (removal of a building on property site)

  • Enlargement costs (increase in total volume)

  • Fencing

  • Feasibility studies

  • Financing fees

  • Furniture

  • Landscaping

  • Leasing Expenses

  • Moving (building) costs (if part of acquisition)

  • Outdoor lighting remote from building

  • Parking lot

  • Paving

  • Planters

  • Porches and Porticos (not part of original buildings)

  • Retaining Walls

  • Sidewalks

  • Signage

  • Storm Sewer Construction Costs

Can a rehabilitation tax credit be claimed for expenses associated with noncontributing additions?

Any expenditure attributable to an enlargement of an existing structure, i.e. a new addition, is specifically excluded from the definition of a qualified rehabilitation expenditure. See Internal Revenue Code Section 47(c)(2)(B)(iii). A building is enlarged to the extent that the total volume of the building increases. However, if the addition was made previously or over a period of time, the cost of rehabilitating this noncontributing addition may qualify for the rehabilitation tax credit

How does a cash basis taxpayer account for qualified rehabilitation expenditures?

Treasury Regulation 1.48-12(c)(3) states that an expense is incurred by the taxpayer on the date such expenditure would be considered incurred under an accrual method of accounting, regardless of the method of accounting used by the taxpayer with respect to the other items of income and expense.

What is the tax effect of grant proceeds on rehabilitation tax credit projects?
Taxpayers who receive grants must first determine if the proceeds are taxable or non-taxable.

  • If the grant money is taxable, the taxpayer has basis and the rehabilitation tax credit will be allowed on expenditures made with this money.

  • If the grant money is not taxable, taxpayers will have no basis and the rehabilitation tax credit cannot be claimed on the expenditures incurred with these proceeds.

Grants received by corporate taxpayers fall under the auspices of sections 118 and 362 (c) and would be considered tax-exempt contributions of capital by a non-shareholder. Consequently, no rehabilitation tax credit would be allowed for the expenditures made with these proceeds.

Grants received by non-corporate taxpayers, such as partnerships and individuals, will include the proceeds in income if they have dominion and control over the funds, unless the proceeds are provided as a general welfare grant or a National Historic Preservation Act grant.

Transitional rule (amounts paid or incurred after 2017) 

In general, the 10% credit for pre-1936 buildings no longer applies and the 20% credit for a certified historic structure is modified generally to allow 100% of qualified rehabilitation expenditures ratably over a 5-year period for amounts paid or incurred after 2017. For qualified rehabilitation expenditures paid or incurred during the transitional period stated below, the taxpayer can claim the 10% credit for pre-1936 buildings and the 20% credit for a certified historic structure (under section 47(a) as in effect before December 22, 2017).

 

The transitional rule applies to amounts paid or incurred as follows. In the case of qualified rehabilitation expenditures with respect to any building—

  • (A) owned or leased by the taxpayer during the entirety of the period after 2017, and

  • (B) with respect to which the 24-month period selected by the taxpayer under clause (i) of section 47(c)(1)(B) (as in effect after December 21, 2017), or the 60-month period applicable under clause (ii) of such section, begins not later than 180 days after December 22, 2017 ("June 20, 2018"), the transitional rule applies to expenditures paid or incurred after the end of the tax year in which the 24-month period, or the 60-period, referred to in subparagraph (B) ends.

 

If you have more than one property that qualifies for the rehabilitation credit, attach a schedule showing the type of property (pre-1936 building or certified historic structure), NPS number, date of final certification, and the partnership EIN, if applicable. Also, indicate if the transitional rule applies.

Reminders for Claiming the Rehabilitation Tax Credit

In order to claim the credit, the property must be substantially rehabilitated. This means that the qualified rehabilitation expenses must exceed the entire building's adjusted basis. If property is used for both business and personal use, the adjusted basis would include both the business and personal use portions.

 

During a 24-month period selected by the taxpayer, rehabilitation expenditures must exceed the greater of the adjusted basis of the building and its structural components or $5,000. The basis of the land is not taken into consideration. It is important to note that any expenditure incurred by the taxpayer before the start of the 24-month period will increase the original adjusted basis. See Treasury Regulation 1.48-12(b)(2).
 

If the taxpayer fails to complete the physical work of the rehabilitation prior to the date that is 30 months after the date the taxpayer filed a tax return on which the credit is claimed, the taxpayer must submit a written statement to the District Director stating such fact and shall be requested to sign an extension to the statute of limitations. See Treasury Regulation 1.48.12(f)(2)​​

If the rehabilitation is completed in phases, the same rules apply, except that instead of a 24-month period, a 60-month period is substituted. This phase rule is available only if the taxpayer meets three conditions:

  • (1) There is a written set of architectural plans and specifications for all phases of the rehabilitation.

    • (If the written plans outline and describe all phases of the rehabilitation, this will be accepted as written plans and specifications);

  • (2) The written plans must be completed before the physical work on the rehabilitation begins; and It can be reasonably expected that all phases of the rehabilitation will be completed.

  • (3) The property must be placed in service. ​​

 

Rehabilitation Tax Credit (computed when a portion of the property is not used for business)
A qualified rehabilitation expenditure must be "properly chargeable to a capital account". This means the property must be depreciable.

If a structure is used for both business and non-business (personal) use, an allocation of the rehabilitation expenditures must be made.

  • The allocation is generally made based on a square footage percentage. The only expenditures eligible for the tax credit would be those associated with the business use portion of the property.

  • When a personal residence is used also for business, the business use portion of the home (e.g. home office) would be eligible. Expenditures associated with common living areas, such as a kitchen, bedrooms, living room, bathrooms, would not be eligible because they are not used exclusively for business. If the owners of a Bed & Breakfast live on the premises, the business use portion would only be those areas which are used exclusively for business.

Rehabilitation Tax Credit (claimed on a tax return)
The credit is claimed on Form 3468. Attached to the Form 3468 ( or by way of a marginal notation), the following information must be provided. See Treasury Regulation 1.48-12(b)(2)(viii).

  • The beginning and ending dates of the measuring period selected by the taxpayer.

  • The adjusted basis of the building as of the beginning of the measuring period.

  • The amount of qualified rehabilitation expenditures incurred or treated as incurred during the measuring period.

  • A copy of the final certification of completed work by the Secretary of Interior.

  • If the adjusted basis is determined in whole or in part by reference to the adjusted basis of a person other than the taxpayer, the taxpayer must attach a statement by such third party as to the first day of the holding period, measuring period and adjusted basis calculation

Form 3468, Investment Credit, is used to claim a variety of investment credits, including the section 47 rehabilitation credit. The instructions to the Form 3468 provide detailed requirements for completing the form. The form must be attached to the return for each year in which the qualified rehabilitation tax credits are claimed. The form is not required when carrying forward or back net operating losses from a rehabilitation tax credit claimed in another tax year. 

Can the rehabilitation tax credit be used in conjunction with the low income housing tax credit?

As long as the building and rehabilitation expenditures qualify for both credits, there is no prohibition within the Internal Revenue Code for using the tax credits in tandem. The taxpayer must reduce the amount of rehabilitation expenditures eligible for the low income housing tax credit by the amount of rehabilitation tax credit allowed. The computation for annual depreciation includes a reduction of the depreciable basis by the amount of rehabilitation tax credit allowed.

Who must file

The instructions require taxpayers claiming a rehabilitation tax credit to file the Form 3468. This includes a shareholder, partner (other than a partner in an electing large partnership), or beneficiary claiming a credit through an S corporation, partnership, or trust. In addition, if an estate or trust, S corporation, or partnership is the owner of a certified historic structure, it must file a Form 3468 even if the credit is not being claimed by the entity. 

A lessor of property may elect to treat the lessee as having acquired the property. The lessee will be treated as the owner of the property required to file Form 3468. The lessor will attach a copy of the election to their return and the lessee will file Form 3468. The lessor also should provide the National Park Service project number to the lessee. 

Property or Source of Credit

If the credit claimed for a rehabilitation of a certified historic structure is claimed by the owner of the property the project number assigned by the National Park Service (NPS) must be shown on the owners return (do not use state or other identification numbers such as internal identification numbers).


Lessee of a Building or Portion of the Building Claiming the Rehabilitation Tax Credit
If a lessee incurs the cost of rehabilitating a building and the lease term is greater than the recovery period determined under Internal Revenue Code Section 168(c), (39 years for non-residential real property, 27.5 years for residential rental), the lessee can claim the rehabilitation tax credit on qualified rehabilitation expenditures provided the substantial rehabilitation test is met.

A building owner, who incurs the cost of rehabilitating an historic structure, can elect to pass the rehabilitation tax credit to its lessee(s) provided the owner is not a tax exempt entity. See Internal Revenue Code Section 48(d) and 50(d)(5). A tax exempt entity cannot pass the rehabilitation tax credit to its lessee(s) because Treasury Regulation 1.48-4(a)(1) requires that the property must be Section 38 property in the hands of the lessor; that is, it must be property with respect to which depreciation is allowable to the lessor. If a lessee is treated as the owner of the property, the lessee should complete Part 1 of the Form 3468 and provide the National Park Service project number. 

If the qualified rehabilitation expenditures are passed through to an S corporation, partnership, estate, or trust, then the employer identification number of the pass-through must be shown instead.

Date of Certification of Completed Work

Form 3468 requires the date the NPS Reviewer signed NPS Form 10-168, Part 3, Certification of Completed Work (not the dates for Part 1 or 2, the application date of Part 3 of the NPS Form 10-168, or any other date).

If the final certification hasn't been received by the time the tax return is filed for a year in which the credit is claimed, a copy of the first page of NPS Form 10-168, Historic Preservation Certification Application (Part 2—Description of Rehabilitation), with an indication that it was received by the Department of the Interior or the State Historic Preservation Officer, together with proof that the building is a certified historic structure (or that such status has been requested). Individuals filing electronically can submit the information with Form 8453. Certification information will be required in the year received.

Can a taxpayer claim the rehabilitation tax credit without receiving final approval by the National Park Service?
In general, Yes. Treasury Regulation 1.48-12(d)(7)(ii) states that if the final certification of completed work has not been issued by the Secretary of Interior at the time the tax return is filed for a year in which the credit is claimed, a copy of the first page of Part 2 of the Historic Preservation Certification Application must be attached to Form 3468 filed with the tax return. The taxpayer must reasonably expect that they will receive final approval and that their project will be certified by the National Park Service.

Final certification by the Department of Interior is required. If the taxpayer fails to receive final certification within 30 months after the date the taxpayer filed a tax return on which the credit was claimed, the taxpayer must agree to extend the period of assessment for any tax relating to the time for which the credit was claimed. If the final certification is denied by the Department of Interior, the credit will be disallowed for any taxable year in which it was claimed.

Credit Carryback / Carryforward

If the credit, or a portion of tax credit, cannot be used, the excess can be carried back one year and forward for 20 years. See Internal Revenue Code Section 39(a). Do not file Form 3468 if the credit is a carryback or a carryforward from another year. Instead report the credit on Form 3800 (and From 8582-CR if required).

Can the rehabilitation tax credit be bought and sold?
The rehabilitation tax credit, by itself, cannot be bought or sold. The rehabilitation tax credit is only available to the person or entity who holds title to the property. There can be no transfer of the credit without the requisite ownership. Syndication through limited partnerships is allowed and is a common tool to bring investors into rehabilitation projects.

Treasury Regulation 1.48-12(b)(2)(B)(vii) does allow the transfer of qualified rehabilitation expenditures to a new owner provided the previous owner did not place the property in service.

Seller of Rehabilitation Property Pass the Rehabilitation Tax Credit to a Buyer
The seller can pass the rehabilitation tax credit to a buyer provided that no one has already claimed the rehabilitation tax credit and the building acquired has not been placed in service by the seller before the date of acquisition.

 

The amount of expenditures that are treated as incurred by the buyer is the lesser of:

  • the amount of expenses actually incurred before the acquisition or

  • an allocable portion of the cost of the property if it is bought for an amount less than the rehabilitation expenditures actually incurred. See Treasury Regulation 1.48-12(c)(3)(ii)(B).

Safe Harbor

On January 13, 2014, the Internal Revenue Service issued Revenue Procedure 2014-12 which establishes the circumstances under which the Internal Revenue Service will not challenge partnership allocations of § 47 rehabilitation credit by a partnership to its partners. This guidance is effective for allocations of IRC Section 47 Rehabilitation Tax Credits after December 29, 2013. However, if a building was placed in service before December 30, 2013, and the partnership and its partners satisfied all the requirements for safe harbor, the Rev. Proc. states the IRS will not challenge the partnership’s allocations of the IRC Section 47 rehabilitation tax credits.

Rev. Proc. 2014-12, 2014-3 IRB on December 30, 2013, which established a safe harbor outlines the following issues for applicability:

  • Investors Defined: This section details the definition of partnership investors, as well as the relationship allowed between master tenant partnerships and developer partnerships.

  • Partners’ Partnership Interests:

    • Principal’s minimum Partnership interest: The principal must have a minimum of 1% interest during the existence of the partnership.

    • Investor’s partnership Interest: The investor must have a minimum of 5% or more interest in each material item of partnership tax item during each taxable year.

    • Requirements regarding the investor’s partnership interest: The investor’s partnership interest must constitute a bona fide equity investment with a reasonably anticipated value.

    • Arrangements to reduce the value of the investor's partnership interest: The value of the investor’s interest may not be reduced through fees, lease payments, or other arrangements that are not reflective of fees for a real estate development project that does not qualify for Section 47 rehabilitation credits.

  • Investor's minimum unconditional contribution: The investor’s minimum unconditional contribution must equal 20% of the investor's total expected capital contributions required under the agreements relating to the partnership as of the date the building is placed in service. The investor must maintain the investor minimum contribution throughout the duration of its ownership of its partnership interest.

  • Contingent Consideration: At least 75 percent of the investor's total expected capital contributions must be fixed in amount before the date the building is placed in service.

  • Guarantees and Loans:

    • Permissible guarantees: The following unfunded guarantees may be provided to the Investor:

      • Guarantees for the performance of any acts necessary to claim the credits;

      • Guarantees for the avoidance of any act (or omissions) that would cause the Partnership to fail to qualify for the rehabilitation credits or that would result in a recapture of the credits; and,

      • Guarantees that are not described as impermissible guarantees under the Rev. Proc.

      • Examples of unfunded guarantees permitted under this section include completion guarantees, operating deficit guarantees, environmental indemnities, and financial covenants.

    • Impermissible guarantees: No person involved in any part of the rehabilitation transaction may:

      • Directly or indirectly guarantee or otherwise insure the ability to claim the credits, the cash equivalent of the credits, or the repayment of any portion of the Investor's contribution due to inability to claim credits in the event the IRS disallows the credits.

      • Guarantee that the investor will receive partnership distributions or consideration in exchange for its partnership interest except for a fair market value sale right described in the Rev. Proc.

      • Pay the Investor's costs or indemnify the investor for the investor's costs if the IRS challenges the investor's claim of the credits.

      • Offer a guarantee that is not an unfunded guarantee described in the Rev. Proc.

    • Loans: The partnership or a person involved in the transaction may not lend any investor the funds to acquire any part of the investor's interest in the partnership or guarantee or otherwise insure any indebtedness incurred or created in connection with the investor's acquisition of its partnership interest.

    • Purchase Rights and Sale Rights: Neither the principal nor the partnership may have a call option or right to purchase or redeem the Investor's interest at a future date (other than a contractual right or agreement for a present sale), and the investor may not have a contractual right to require any person involved in the rehabilitation transaction to purchase or liquidate its interest in the partnership at a future date at a price that is more than its fair market value determined at the time of exercise of the contractual right to sell.

Tax Exempt Use Property

The rehabilitation tax credit is not allowed for expenditures with respect to property that is considered be tax exempt use property. Under the tax-exempt entity leasing rules of 168(h), the threshold to determine if a disqualified lease exists has been raised to more than 50%.

In general, the rehabilitation tax credit would be of no use to a tax-exempt entity. However, in many instances, tax-exempt entities are involved in rehabilitation projects by forming a limited partnership and maintaining a minority ownership interest as a general partner. In these situations, the limited partners would be entitled to the rehabilitation tax credit and the tax exempt entity is able to ensure that their organizational goals are being met.

Claim the rehabilitation tax credit on property that is leased by a tax exempt entity, i.e. a governmental agency or a non-profit organization?
Taxpayers can lease their property to a tax exempt entity provided the lease does not result in a "disqualified lease" as defined in Internal Revenue Code Section 168(h)(1). A disqualified lease occurs when:

  • Part or all of the property was financed directly or indirectly by an obligation in which the interest is tax exempt under Internal Revenue Code Section 103(a) and such entity (or related entity) participated in the financing,

  • Under the lease there is a fixed or determinable purchase price or an option to buy,

  • The lease term is in excess of 20 years, or

  • The lease occurs after a sale or lease of the property and the lessee used the property before the sale or lease. See Internal Revenue Code Section 168(h)(1)(B)(ii).

An exception under the Treasury Regulations provides that property is not considered tax exempt use property if 50% or less of the property is leased to tax exempt entities in disqualified leases.

Alternative Minimum Tax

For qualified rehabilitation credits determined under Internal Revenue Code Section 47 attributable to qualified rehabilitation expenses properly taken into account for periods after December 31, 2007 the alternative tax rules are not applicable. Thus, a taxpayer may use the rehabilitation tax credit to offset his regular tax liability. See the instructions on Form 3468, Investment Credit, for more information.

Place of Filing Notice

If you have claimed a rehabilitation tax credit and the entire project is not completed 30 months after you have claimed the credit and you have not received final certification from the Department of Interior, you must provide written notice to the Internal Revenue Service. The notice must be provided before the last day of the 30 months. The notice as required under Regulation Section 1.48-12(d)(7) is to be mailed to the address shown and you must consent to extend the statute of limitations.

Facade Easements

For information on donating an easement on a historic building see the Conservation Easement Audit Techniques Guide IRS link.

Can the rehabilitation tax credit be used in conjunction with a facade easement contribution?
In general, yes. Once the building and rehabilitation are "certified" by the Department of Interior, the owner of the building can donate the facade easement. Generally these donations are made to qualified organizations under Internal Revenue Code Section 170 and are considered to be donated in perpetuity.

 

The rehabilitation tax credit and depreciable basis are reduced and no credit or depreciation can be taken on that portion of the building. If the donation occurs after the building is placed in service, the credit recapture provisions of Internal Revenue Code Section 50(a) apply. (See Rome I Ltd. v. Commissioner, 96 T.C. No. 29) By donating the façade easement, the taxpayer may be allowed a charitable contribution deduction pursuant to Internal Revenue Code Section 170(h) and Treasury Regulation 1.170A-14. The value of the facade easement is measured by the difference between the value of the property before and after the easement was conveyed.

A donation can be made by a subsequent owner of a certified historic structure as long as the facade was not donated by the previous owner.

Passive Activity Restriction

Certain provisions within the Internal Revenue Code can impact the full use of the rehabilitation tax credit. The such as the passive activity rules. Consequently, taxpayers may not be able to use the entire tax credit available to them in one tax year. In situations where the tax credit can not be used the unused credit can be carried back or forward. The passive activity rules, however, allow unused credit only to be carried forward.

 

Form 3800, General Business Credit, will guide you through a series of computations to determine how much, if any, of the rehabilitation tax credit can be used in the current year. To alleviate any surprises, tax planning should include a "what if" scenario using Form 3800 as a guide to determine the anticipated tax credit.

What are Passive Activity Restrictions?
The Tax Reform Act of 1986 introduced tax law changes which indirectly impacted the rehabilitation tax credit. One of these changes, the "Passive Activity Provisions," was intended to stop "abusive tax shelters." Although not directly related, these changes have impacted the availability of the rehabilitation tax credit for certain types of investors.

 

Modifications to the Passive Activity provisions under the Omnibus Budget Reconciliation Act of 1993, (effective for taxable years after December 31, 1993), provides some relief. The Act provides that deductions and credits, from rental real estate in which an eligible taxpayer materially participates, are not subject to limitation under the passive loss rules. An individual taxpayer is eligible if more than one-half of the taxpayer's business services for the taxable year, amounting to more than 750 hours of services, are performed in real property trade or business in which the taxpayer materially participates.

How do the passive activity restrictions affect taxpayers with adjusted gross income greater than $250,000?
Individuals, including limited partners, with adjusted gross income greater than $250,000 who invest in a rehabilitation tax credit project cannot use the tax credit to offset income tax in that tax year. The credit is suspended and carried forward and will be available when either income falls below $200,000 (it is partially available when income falls between $200,000 and $250,000) or there exists net passive income sufficient to offset the passive losses generated by the rehabilitation project.

 

A computation is required to figure the regular tax liability allotted to passive activities. In other words, even if a taxpayer has net passive income, they might not be able to utilize all of the rehabilitation tax credit. Please see net passive income example below.

If a taxpayer's investment is passive and income is below $200,000, how is the tax credit affected?
Generally, rental real estate losses up to $25,000 may be deducted in full by anyone whose modified adjusted gross income is less than $100,000. For investors in rehabilitation projects, this income level is raised to $200,000. The rehabilitation tax credit, however, is limited to the credit equivalent of $25,000. This does not mean that the taxpayer can deduct a credit of $25,000. Instead a taxpayer is allowed the tax equivalent of $25,000 for the rehabilitation tax credit. Thus, a taxpayer in the 36% tax bracket could use $9,000 of tax credits per year (36% x $25,000 = $9,000). Unused credits can be carried forward indefinitely until they can be used.

If a taxpayer has net passive income, could the full use of the rehabilitation credit be restricted?
Perhaps, as illustrated in the following example:

John rehabilitates a certified historic structure used in a business in which he does not materially participate and generates a rehabilitation tax credit of $43,000. He files a joint return in 1996 reflecting $160,000 in taxable income. Of this total, $40,000 is from a passive activity (commercial rental). John's total tax liability on the $160,000 taxable income is $42,095. 

John's taxable income reduced by net passive activity income is $120,000 ($160,000-$40,000). Tax on $120,000 is $29,080. Tax liability applicable to the passive activity is $13,015 ($42,095-$29,080). John can use passive credits up to $13,015 and carry forward unused credits of $29,985 ($43,000-$13,015). Simply stated, the more passive income, the more tax credit can be used. The less passive income, the less tax credit can be used.

 

Note: Credits generated from non-passive rehabilitation projects will not be limited.

Under what circumstances would a taxpayer's rehabilitation tax credit not be limited?

  • Material Participation.

    • Generally if a taxpayer either works more than 500 hours a year or performs substantially all of the work in a business, he or she is deemed to be materially participating, and losses and/or income are non-passive. However, the material participation rules do not apply to long-term rental real estate activities. Real estate rental is passive by definition regardless of the 500-hour test.

    • Example: John is an architect and rehabilitates a certified historic structure. If John uses the building for his architectural business, the credit is not limited because it is stemming from a non-passive activity. (Non-passive credit)

      • If John rehabilitates the same building and rents the space to a restaurant, the rehabilitated building is now rental real estate (passive by definition) and will be limited. (Passive credit)

  • Real Estate Professionals.

    • If more than one half of a taxpayer's personal services in all business are in real property businesses (property development, construction, acquisition, conversion, rental, management, leasing, or brokering) and the taxpayer spends more than 750 hours a year in real property trade or businesses, the taxpayer is a real estate professional. If this is the case, any rehabilitation project the taxpayer is involved with, including rental real estate, will generate non-passive rehabilitation tax credits.

  • Short-term rentals.

    • If a taxpayer rehabilitates an historic building and uses it for short term rental, such as a Bed & Breakfast or a Hotel/Motel, and materially participates in the operation of the business (i.e. spends more than 500 hours), the rehabilitation tax credit generated from this project is deemed to be non-passive, and the credit will not be restricted.

  • Corporate entity.

    • While the passive activity loss rules do not generally apply to regular C- Corporations, they do apply to personal service corporations and to closely held corporations in a limited way. For personal service corporations and closely held corporations, material participation is determined based on the level of participation of the shareholders. One or more individuals who hold more than 50% of the outstanding stock must materially participate in the activity in order for the corporation to meet the material participation standard.

Can a taxpayer's involvement be non-passive in one year and passive in the next year?
Yes, passive activity rules are applied on a year-by-year basis. A taxpayer could materially participate in a business generating a rehabilitation tax credit in one year, use the rehabilitation tax credit and have a passive interest in the business operation the following year.

Recapture Rules

The rehabilitation credits are subject to recapture if the building is sold or ceases to be business use property. No recapture is required after five years. The amount of such recapture is reduced by 20% for each full year that elapses after the property is placed in service. Thus there is a 100% recapture if the property is disposed of less than one year after the property is first placed in service; an 80% recapture after one year, a 60% recapture after two years; a 40% recapture after three years; and a 20% recapture after four years. See Internal Revenue Code Section 50(a).

 

If a partner sells his interest in a partnership will this trigger recapture?
When rehabilitated property is owned by a partnership and a partner sells or disposes of all or a part of his partnership interest tax credit recapture may be required. Treasury Regulation 1.47-6(a)(2) states that if a partner's interest in the partnership is reduced to less than two-thirds of what it was when the property for which the rehabilitation tax credit is claimed was placed in service, the reduction is treated as a proportional disposition of the property.

 

Example:

A limited partner has an 80% interest in a limited partnership that rehabilitated an historic structure in 1996. This limited partner's share of the rehabilitation tax credit amounted to $100,000. If the limited partner's interest is reduced to 50% in 1999, three years from when the property was first placed in service, credit recapture is required. Since the limited partner's interest was reduced below two thirds (62.5%), the partner is considered to have disposed of 30/80 or 37.5% of the property.

 

Recapture is computed as follows:

$100,000 x 37.5% = $37,500

$37,500 x 40% (recapture %) = $15,000

If rehabilitation tax credit property is destroyed by casualty, will this trigger recapture?
When a building that qualified for the rehabilitation tax credit is destroyed by a casualty (i.e. hurricane, flood, tornado, earthquake), within five years of first claiming the credit, the recapture provisions of Internal Revenue Code Section 50(a) apply.

Unlike the provisions set forth in Internal Revenue Code Section 42(j)(4)(E) which does not require recapture of low income housing tax credit property when it is completely destroyed but replaced within a reasonable amount of time, rehabilitation tax credit property would be subject to full recapture.

Partially damaged property would not trigger recapture if the owner makes the necessary repairs and places the property back in service. If historic property in which the rehabilitation tax credit was claimed is destroyed and it is beyond the recapture period (five years from when building was placed in service), no recapture of rehabilitation credit would be required

See IRS Link for additional background:
Need more details? Contact us

We are here to assist. Contact us by phone, email or via our Social Media channels.