The Rehabilitation Tax Credit (Internal Revenue Code’s Section 47) is a tax incentive for investors to renovate and restore old and historic buildings within cities and towns. The purpose of the credit is to promote historic structures’ rehabilitation; therefore, related building reconstruction costs, including new construction, are applicable under the credit.
Under the Tax Cuts and Jobs Act (TCJA), signed in December 2017, the Internal Revenue Service (IRS) introduced amendments to the rehabilitation tax credit to clarify the tax law and determine how the credit should be allocated. These proposed changes were made to simplify the credit calculation and allow taxpayers to claim the credit over a five-year period.
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To claim the rehabilitation tax credit, the taxpayer must meet the substantial rehabilitation test in a 24-month period (or a 60-month period for phased rehabilitation projects). For a taxpayer to be eligible for the credit, the cost of rehabilitation must exceed the building’s pre-rehabilitation cost. Therefore, qualified rehabilitation expenditures (QREs) during the measuring period designated by the taxpayer must exceed the greater of:
- The taxpayer’s adjusted basis in the building (and its related structural components); or
Note: The IRS extended the measuring period deadline for the substantial rehabilitation test to account for the COVID-19 pandemic. If the two-year or five-year period ends on or after April 1, 2020, and before March 31, 2021, the last day to pay and incur related QREs is extended to March 31, 2021.
Rehabilitation Credit Regulations
Prior to the TCJA tax reform, Sec. 47(a) provided a two-tier credit for qualified rehabilitation expenditures incurred in connection with a qualified rehabilitated building (QRB):
- A 20% credit for QREs related to a certified historic structure; and
- A 10% credit for QREs related to a QRB other than a certified historic structure (certain buildings first placed in service before 1936).
Taxpayers were allowed to take the full amount of the credits in the tax year the QRB was placed in service.
Proposed Regulations Since Approved
With the TCJA signed into law, the proposed amendments sought to repeal the 10% credit for pre-1936 buildings and to modify the 20% credit rules for QREs paid or incurred after December 31, 2017. The tax law reform proposed the credit be taken over a five-year period instead of in the original first year of service. Before final regulations were released, taxpayers questioned whether the 20% credit rules for QREs were to be allocated over the five years or if five separate credits were calculated during each of the following five years.
As of September 2020, the IRS issued final regulations with no changes to the proposed regulations and clarified the credit allocation over the five years. Internal Revenue Code Sec. 47(a)(1) now provides that the rehabilitation credit must be claimed proportionally over five years, beginning in the taxable year in which a QRB is placed in service. As a result, the rehabilitation credit for any taxable year during the five years is the “ratable share.” The ratable share is 20% of the “rehabilitation credit determined” for the QRB.
For example, suppose a taxpayer incurs QREs of $300,000 on a QRB placed in service in 2021. The rehabilitation credit determined in that year is $60,000 ($300,000 x .20). For each tax year during the five-year period beginning in 2021, the ratable share is $12,000 ($60,000 x .20).
However, the rehabilitation credit amount is different if the taxpayer claims additional first-year bonus depreciation. In that case, the credit is 20% of the remaining rehabilitated basis of the QRB for the tax year the building is placed in service.
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The TCJA includes a transition rule that allows taxpayers to claim all the rehabilitation credit in the first year of service for specified qualifying QRBs. Taxpayers can use the prior tax law if the rehabilitation project meets two conditions:
- The taxpayer owned or leased the qualified rehabilitation building on or after January 1, 2018; and
- The 24- or 60-month period used for the substantial rehabilitation test must have started by June 20, 2018.
If an ongoing project meets these two conditions, it is eligible for either the 10% or the 20% credit claimable in its entirety in the year the QRB is placed in service.
Due to the COVID-19 pandemic, the IRS has granted taxpayers an extension if subject to the transition rule. If the required qualified rehabilitation expenditures are paid or incurred and satisfy the substantial rehabilitation test within the 24- or 60-month measuring period ending on or after April 1, 2020, and before March 31, 2021, the last day to pay or incur the required QREs with respect to the project is postponed to March 31, 2021.
Please contact your ORBA tax professional to help you navigate this and the other rules in the most tax-favorable manner.
For more information, contact Sarah Zambrano at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.