Section 47: The Rehabilitation Tax Credit & Recapture

The Rehabilitation Tax Credit, under Internal Revenue Code Section 47, offers a federal tax incentive for the renovation and preservation of older and historic buildings. Its purpose is to encourage private investment in the revitalization of these properties, promoting both economic development and the conservation of architectural heritage. The credit provides a dollar-for-dollar reduction of federal income tax liability, making the costs associated with renovating such structures more financially feasible.

The program supports modernizing buildings for contemporary use while maintaining their historic character. It applies to projects involving the renovation, restoration, or reconstruction of a building, but it does not cover costs for new construction or enlargements. Individuals, corporations, estates, and trusts who own an interest in a qualifying property may be eligible to claim the credit.

Qualifying for the Rehabilitation Credit

Eligible Buildings

To be eligible for the credit, a project must involve a “qualified rehabilitated building.” This term encompasses two categories. The first is a “certified historic structure,” which is a building listed in the National Register of Historic Places or located within a registered historic district and certified by the National Park Service (NPS) as being of historic significance. The NPS certification process ensures the rehabilitation work complies with the Secretary of the Interior’s Standards for Rehabilitation.

A second category for non-historic, non-residential buildings placed in service before 1936 previously existed, but the 10% credit for these properties was eliminated by the Tax Cuts and Jobs Act of 2017. For a building to qualify, the property must be used for income-producing purposes, meaning owner-occupied residences are not eligible.

The Substantial Rehabilitation Test

A project must meet the “substantial rehabilitation test” to qualify for the credit. To meet this test, the qualified rehabilitation expenditures (QREs) incurred during a measuring period must exceed the building’s adjusted basis at the beginning of that period. The measuring period is a 24-month window selected by the taxpayer that ends with or within the tax year the credit is claimed.

The adjusted basis is the purchase price of the building, excluding the cost of the land, plus the cost of any capital improvements, minus any depreciation already taken. For example, if a taxpayer purchases a building for $400,000, with the land valued at $100,000, the initial basis is $300,000. If they incur $350,000 in QREs over a 24-month period, the project meets the test because the expenditures ($350,000) exceed the adjusted basis ($300,000).

Qualified Rehabilitation Expenditures (QREs)

Qualified Rehabilitation Expenditures (QREs) are the costs that form the basis for calculating the tax credit. These are amounts for improvements that extend the life of the property, not simple repairs, and must be chargeable to a capital account. QREs are incurred in connection with the rehabilitation of a qualified building and must be depreciable as real property.

Eligible costs include:

• Work on structural components like walls, floors, and roofs
• Installation or upgrade of plumbing, electrical wiring, and HVAC systems
• Architectural and engineering fees
• Development fees and other construction-related costs

Certain expenses are excluded from QREs, including the cost of acquiring the building, any new additions that expand the building’s total volume, and site improvements like parking lots or landscaping.

Calculating and Claiming the Credit

Credit Calculation

The tax credit is calculated as a percentage of the Qualified Rehabilitation Expenditures (QREs). For a certified historic structure, the credit is 20% of the total QREs. This credit is claimed ratably over a five-year period (4% of the total credit each year), beginning in the tax year the rehabilitated property is placed in service.

For example, if a project has $500,000 in QREs, the total credit is $100,000, and the taxpayer would claim a $20,000 credit for five consecutive years. When claiming the credit, the building’s adjusted basis must be reduced by the full amount of the credit. Using the previous example, the building’s basis would be reduced by $100,000. This reduction increases the amount of gain recognized if the property is sold and reduces the annual depreciation deductions the owner can claim.

Claiming the Credit

The rehabilitation tax credit is claimed using IRS Form 3468, Investment Credit. The taxpayer must attach Form 3468 to their federal income tax return for each of the five years the credit is claimed. To complete the form, the taxpayer needs the total QREs and the date the property was placed in service.

For certified historic structures, the taxpayer must have received final certification of the completed work from the National Park Service, and a copy is attached to the first tax return claiming the credit. The credit from Form 3468 flows to Form 3800, General Business Credit, to be applied against the taxpayer’s tax liability.

Understanding Credit Recapture

Recapture Triggers

The rehabilitation tax credit has a condition to ensure the property remains in service as a qualified building. If this condition is not met, a portion of the credit must be paid back to the IRS through a process known as “recapture.” The primary trigger for recapture is the disposition of the property within five full years of the date it was placed in service.

A disposition includes events like selling the property, exchanging it, or giving it away as a gift. Recapture can also be triggered if the property ceases to be a qualified rehabilitated building within that five-year period. This could happen if a certified historic structure is altered in a way that causes the NPS to revoke its certification, or if the property is converted to personal use.

The Five-Year Recapture Period

The five-year recapture period begins on the date the qualified rehabilitated building is placed in service. The placed-in-service date is when the property is ready and available for its intended use, such as when a certificate of occupancy is issued. To avoid recapture, the taxpayer must hold and operate the property as a qualified building for five full years.

For example, if a building is placed in service on July 1, 2024, the five-year period would conclude on June 30, 2029. A disposition of the property before this date would trigger the recapture provisions.

Calculating the Recapture Amount

The amount of credit subject to recapture is calculated on a sliding scale based on how long the property was held. The recapture percentage applies only to the credit amount already claimed, not the total potential credit. If a recapture event occurs, the taxpayer also forfeits the right to claim any remaining portions of the credit.

The recapture percentage is 100% if the event occurs within the first full year the property is in service. This percentage decreases by 20% for each subsequent full year: 80% during the second year, 60% during the third, 40% during the fourth, and 20% during the fifth. After five full years, there is no recapture.

For example, a taxpayer is entitled to a $100,000 total credit, claimed as $20,000 annually. If they sell the property during the third year, they would have claimed $40,000 for the first two years. The recapture amount is 60% of the $40,000 claimed, or $24,000, which is added to their tax liability for the year of the sale. The taxpayer also forfeits the remaining $60,000 of the credit.

When a portion of the credit is recaptured, the property’s adjusted basis is increased by the amount of the recaptured credit. This adjustment partially reverses the initial basis reduction taken when the credit was first claimed.

Reporting Recapture Tax

Required Form

When a recapture event occurs, the taxpayer must report the recaptured credit to the IRS using Form 4255, Recapture of Investment Credit. The taxpayer will need to provide property details, including its original basis, the date it was placed in service, and the date of disposition. On Form 4255, the taxpayer calculates the exact amount of the credit to be recaptured based on the original credit amount and the holding period. The form uses the sliding scale percentages to determine the correct recapture tax.

Submission Process

The calculated recapture tax from Form 4255 is added to the taxpayer’s total tax liability on their income tax return for the year the recapture event occurred. For individual taxpayers, this amount is carried over to Schedule 2, “Additional Taxes,” of Form 1040. The completed Form 4255 must be attached to the taxpayer’s income tax return for that year as supporting documentation.