Spend money rehabilitating a certified historic building, and the federal government pays you a 20 percent tax

credit on what you spend on the rehab, dollar for dollar against your tax.

Add a state historic tax credit, and the benefit climbs.

Finance the building without recourse, and your personal assets never go on the line. Here is how the deal works

under current law.

The Federal Credit: 20 Percent, Delivered over Five Years

The federal rehabilitation credit is 20 percent of your qualified rehabilitation expenditures on a certified historic

structure.

You claim it in five equal annual installments: one-fifth of the credit each year, beginning in the year you place the

building in service.

You must also reduce your basis in the building by the full amount of the credit. The basis reduction gives back

part of that benefit because you now have smaller depreciation deductions while you own the building and a larger

taxable gain when you sell.

In the highest tax brackets, that depreciation cut and increased gain together can cut the federal tax credit benefit

by up to 75 percent.

Run the Numbers

You buy a property for $314,000 and spend $500,000 on the rehabilitation, for a total investment of $814,000. You

put up $174,000 in cash and take a non-recourse mortgage of $640,000.

Your federal credit is 20 percent of the $500,000 of qualified rehabilitation expenditures, or $100,000, coming to

you as $20,000 a year for five years. That returns roughly 57 percent of your cash down payment.

A state credit can push the combined total past your entire cash investment.

Build your model on the five-year schedule and the reduced depreciable basis. The credit reduces your taxes dollar

for dollar. The reduction in basis increases your taxes at your tax rate over the depreciable life of the depreciable

assets and increases your taxable gain when you sell the property.

No Cash In, No Personal Risk

With credits flowing to you and a non-recourse loan on the building, you can reach the position every real estate

investor wants: little or none of your money left in the deal, and no personal exposure if it goes wrong.

The at-risk rules permit it. You can claim the credit on property carrying qualified non-recourse financing as long as

the non-recourse portion is 80 percent or less of the credit base and the lender is a qualified person (someone

unrelated to you who is regularly in the lending business). Seller financing does not count.

What Qualifies and What Does Not

Two general rules stand between you and the credit.

First, the rehabilitation must be substantial: your qualified rehabilitation expenditures during a 24-month period you

select must exceed the greater of the building’s adjusted basis or $5,000.

Your building meets this rule easily. You paid $314,000 for the property, the building’s share of that is less still, and

you spent $500,000 on the rehabilitation.

If the rehabilitation is completed in phases under architectural plans and specifications finalized before physical

work began, the 24-month measuring period is extended to 60 months.

Second, the building must be a certified historic structure, and the secretary of the Department of the Interior must

certify the rehabilitation as consistent with its historic character.6 You apply for historic certification through your

State Historic Preservation Office (SHPO) and the National Park Service (NPS) in three parts:

• Part 1 establishes the building’s historic significance.

• Part 2 describes the proposed work.

• Part 3 requests certification of the finished project.

A single building individually listed in the National Register is deemed historic and skips Part 1.

Timing. Get Part 2 approved before construction if you can. The regulations do not require it, but owners who start

without approval proceed strictly at their own risk, because the finished project must meet the Secretary of the

Interior’s Standards for Rehabilitation to be certified.

And file Part 1 before the work is done: a project completed before its Part 1 is submitted is not eligible for the

credit.

The credit covers rehabilitating, renovating, restoring, and reconstructing. You earn nothing on the following:

• Land, parking lots, sidewalks, or landscaping

• Building acquisition costs

• Enlargements that expand the building’s volume, or new construction

• Personal property

The building must produce income.

Commercial, industrial, and agricultural buildings qualify, as do apartments and single-family rentals. Your personal

residence does not qualify, though a building housing both your home and an office or rental generates credit on

the non-residence portion. Long-term lessees can claim the credit on their own spending.

Can You Use the Credit This Year?

First, the good news: the alternative minimum tax is not a problem. The credit can offset alternative minimum tax as

well as regular tax.

The passive loss rules are the real hurdle on a rental project. The passive loss rules apply to this credit too, with

important differences explained below.

There’s a side door that may be open to you. Up to $25,000 of deduction-equivalent credit can offset your non-

passive income, and you don’t need to materially or actively participate to get this credit.14 The phaseout also sits

higher than the one for ordinary rental losses, running from $200,000 of adjusted gross income to $250,000.15

Three other routes are open:

1. Rehabilitate a building your business owns and uses, in a business where you materially participate,and the

 passive rules don’t apply.16 If a separate company you own holds the building and leases it to your business,

 you can usually reach the same result by electing to group the rental with thebusiness, as long as you own 

both in the same proportions and the business isn’t a C corporation.

2. Qualify as a tax code–defined real estate professional and materially participate in the rental, andyour credits

 escape the passive loss trap. On a joint return, one spouse alone must meet the real estate professional tests.

3. A hotel, a bed-and-breakfast, or another lodging where the average guest stays seven days or less is not a rental

 activity for passive loss purposes.19 That removes the automatic passive label, but not the passive rules themselves:

 the business is non-passive, and the credit can offset tax on your other income, but only if you materially participate

 in running it.20 Historic hospitality businesses like a bed-and-breakfast or similar project are a natural fit for the

 owner-operator, not the passive investor.

Recapture

If you dispose of the building before it has been in service for five full years, you must pay back (recapture) some

or all of the credit.

The recapture percentage starts at 100 percent and drops by 20 points for each full year you hold, and it applies to

the whole credit: you repay that percentage of the installments you’ve claimed and forgo that percentage of the

installments still to come.

Sell during the second year, and recapture is 80 percent, so you keep $20,000 of the $100,000 credit.23 After five

full years, you keep all of it.

Key point. Hold the building for five or more years after you place it in service.

If the passive loss rules trapped your credit, your sale after five years may or may not let you use all of it.To use

the full credit, the regular tax on your passive income for the year, including the gain on the sale, must at least

equal the credit.

Takeaways

The historic tax credit is 20 percent of qualified rehabilitation expenditures on a certified historic

structure, claimed at a rate of one-fifth a year over five years, and it reduces your basis.

Spending must exceed the greater of adjusted basis or $5,000 in a 24-month period.

File Part 1 with your SHPO and the NPS to establish the building’s historic significance before the

work is finished, and get Part 2 approved before construction if you can.

The alternative minimum tax does not block the credit.

If you can’t achieve real estate professional status for making use of the credits, check the $25,000

allowance, which needs no material or active participation and phases out between $200,000 and

$250,000 of adjusted gross income.