What Developers Need to Know about the Substantial Rehabilitation Test for Historic Tax Credits
The historic tax credit (HTC) substantial rehabilitation test may seem straightforward, but there are some important nuances of which even experienced developers may not be fully aware.
But first, the basics of the substantial rehabilitation test: To qualify for the federal HTC, a historic rehabilitation project must undergo a substantial rehabilitation. That means the qualified rehabilitation expenditures (QREs) incurred during the substantial rehabilitation period must exceed the greater of $5,000 or the adjusted basis of the building and its structural improvements within a given measurement period.
Why does the Substantial Rehabilitation Test Matter?
First and foremost, if a certified structure is eligible for HTCs, the substantial rehabilitation test must be met in order to claim the credits. Second, the test is an important tool to maximize the amount of tax credits a developer can claim. Since the test is fluid, it allows a developer some flexibility in construction planning to choose the allowable period that maximizes QREs and still meet the substantial rehabilitation test.
In addition, for those that might be identifying a property to purchase that is eligible for HTCs, a developer can still meet the substantial rehabilitation test and take credits on the QREs even if the property is already under construction and the developer has not yet purchased the property.
As such, understanding all the ins and outs of the substantial rehabilitation test is essential.
Is Meeting the Substantial Rehabilitation Test Difficult?
Very often, developers have enough renovation costs to meet the requirements of the substantial rehabilitation test, meaning that the developer would incur enough QREs to meet the adjusted basis of the building.
But sometimes, construction budgets and other factors make meeting the test more challenging.
For example, consider a developer restoring a historic hotel has $20 million in acquisition costs and $18 million in hard costs. Based on these figures alone, the developer is unsure if they will meet the test. However, upon closer inspection the team identifies some soft costs that were capitalized during the construction period, specifically construction period interest on a construction loan. Those costs qualify for the substantial rehabilitation test and make the needed difference.
Conversely, not all of the $18 million in hard costs may be deemed to be eligible QREs. Cetain hard costs are excluded from the definition of a QRE, like costs related to enlargement, sitework, and furniture, fixtures and equipment.
Developers, especially those new to the HTC, are encouraged to partner with an experienced team so those nuances can be uncovered. A keen understanding of the substantial rehabilitation test can make the difference in whether a developer is able to claim HTCs.
How Long does a Developer have to Meet the Substantial Rehabilitation Test?
To meet the substantial rehabilitation test, a taxpayer must incur QREs within any 24-month period. Again, QREs must exceed the greater of $5,000 or the adjusted basis of the building at the start of this 24-month period.
An important aspect of the 24-month test is that the test is any 24-month period that the developer chooses. It is a common misconception that the beginning of this 24-month measurement period needs to start with either the property acquisition date or the construction start date. However, that's not the case. The developer can choose any 24-month period. But, the 24-month period needs to end within the taxable year in which the expenditures are placed in service.
Once that test is met within that the 24-month period, the developer incurs QREs that exceed the beginning adjusted building basis at the beginning of the 24-month period, then the developer is able to claim credits not only on the QREs within those 24 months, but the developer can also claim credits on any QREs incurred prior to the 24-month period and also at the end of the period through the end of the calendar taxable year. Basically, the test is only looking at the QREs incurred within that 24-month window and comparing those QREs to the adjusted building basis at the beginning of the 24-month period. Note that included in that adjusted building basis are additional QREs incurred since construction commencement. If you meet the 24-month test, you can count the QREs incurred prior to the 24-month window for tax credit purposes. Also, if your 24-month window ended within a taxable year, you can still include any additional QREs after that 24-month window through the taxable year end for tax credit purposes.
Is the 24-month Test always 24 Months?
There is an exemption for HTC developments that are done in multiple phases. For a phase rehabilitation project, the developer gets to use a 60-month measurement period as opposed to the standard 24-month period.
But the caveat is that the rehabilitation must be reasonably expected to be completed in phases that are set forth in the architectural plans and specifications before the rehabilitation begins. It should be noted that this 60-month exception is not a fallback provision just in case a developer fails a 24-month test. Rather, it should be clear from the beginning that this is a phased project.
If a developer can demonstrate that the project is completed in phases, then the developer can use that 60-month exception. Often, working with architects and HTC consultants helps the developer support the use of the 60-month exception.
Can a Developer Take Over a Project During Rehabilitation?
A developer can, in fact, acquire a historic property after the previous owner has started making some improvements to the property and still claim HTCs on qualifying costs that have been incurred by the previous owner. The new owner can also meet the substantial rehabilitation test in this instance.
However, it’s important to point out that the new owner’s adjusted basis in the building will be determined as of the beginning of the 24-month period that’s being used by the seller of the property or as of the first date of the new owner’s holding period. In other words, the purchase date.
So, if the new owner decides to use the holding period date, or the purchase date, then the basis in the purchaser's building is essentially the purchase price of the building, less any QREs incurred by the seller during the 24 months.
The buyer of a historic property should make sure to discuss clearly with the seller what work the seller has already done or has in progress. That way, the buyer can allocate some portion of the purchase price to those costs.
The buyer must also understand that of the costs that have been incurred by the seller, that none of these costs have been previously placed in service because if those costs have been previously placed in service, it would just simply be part of the acquisition price. As a result, the buyer will not be able to claim credits on those otherwise qualifying costs.
How Can Novogradac Help?
Novogradac has several resources available to learn more about the substantial rehabilitation test and various other nuances of the HTC program. The substantial rehabilitation test was discussed in detail on the May 17, 2022, episode of the Tax Credit Tuesday Podcast. Or, take an even deeper dive into the substantial rehabilitation test and various other HTC regulations with the Novogradac Historic Rehabilitation Handbook. Finally, be sure to reach out to a partner on Novogradac’s HTC team with specific questions.