On May 21, 2020 the IRS released proposed regulations to provide clarity in order to implement the new five-year period credit rules created by the Tax Cuts and Jobs Act (TCJA) enacted in December 2017. Specifically, the regulations aimed to provide guidance for the following:
- General rule for calculating the rehabilitation credit
- Definitions of ratable share and rehabilitation credit determined
- Calculation of tax credit recapture
To rewind quickly, under the pre-TCJA rules 100% of the rehabilitation credit was taken in the year the qualified rehabilitation expenditures (QREs) were placed in service. The TCJA provided transition rules that if a taxpayer owned or had a qualifying long term lease in place as of Jan. 1, 2018 and could meet the substantial rehabilitation test with a start date no later than 180 days from the enactment of TCJA (June 2019) then the taxpayer could follow the pre-TCJA rules. This means if it is a non-phased (24-month period) project the substantial rehabilitation test needs to be met by June 2020 and placed in service by the end of 2020. For phased (60-month period) projects the substantial rehabilitation test needs to be met by June 2023 and placed in service by the end of 2023. As the result of the COVID-19 pandemic, there are non-phased projects where construction has been slowed down and some are facing the risk of not meeting the 2020 substantial rehabilitation test. This will have significant impacts on syndicated historic tax credit deals, as there are significant equity adjusters for projects that do not meet the transition rules. For those that this issue may apply to there may be some hope as there are industry groups lobbying the Treasury to extend the transition rule dates so stay tuned.
General rule for calculating the rehabilitation credit
Practitioners have questioned whether the rehabilitation credit is determined in the year the QREs are placed in service and allocated ratably over the 5-year period or if there should be five separate rehabilitation credits created for a single qualified rehabilitated building (QRB), one for each year of the 5-year period. The proposed regulations confirm that the rehabilitation credit is determined in the year the QREs are placed in service and allocated ratably over the 5-year period. This ensures that the 5-year compliance period is not extended beyond 5 years after the initial placed in service date.
Definitions of ratable share and rehabilitation credit determined
The proposed regulations state that the ratable share is defined as the amount equal to 20% of the rehabilitation credit determined for each taxable year during the five-year period. Previously there had been some uncertainty as to whether ‘ratably’ meant that the rehabilitation credit would be calculated on a pro rata basis based on the placed in service date. For example, if a QRB was placed in service in December of a calendar year fiscal year there was a question as to whether the first year credit would be 1/60th or would it be 20% of the rehabilitation credit determined. The proposed regulations have confirmed that 20% of the rehabilitation credit determined is available in year placed in service regardless of when it is placed in service during the fiscal year.
Rehabilitation credit determined is defined as the amount equal to 20% of the QREs, consistent with section 47(c)(2) and 1.48-12(c), for the taxable years in which the QRB is placed into service, but the regulations point out one distinction when it comes to bonus depreciation by providing that the QREs are reduced for any additional first year depreciation. This is not a new development, but this is relevant considering the recent clarification on qualified improvement property (QIP) in the CARES Act. QIP’s useful life has been corrected so that it is now 15-year MACRS property meaning that it is eligible for bonus depreciation. This creates additional structuring opportunities in the case either the building owner or a syndicated tax credit investor finds it more valuable to utilize accelerated losses versus taking credits over the five-year period on the bonus eligible QREs.
Calculation of tax credit recapture
The method for calculating the tax credit recapture is provided in Example #3 of the proposed regulations. The example lays out a scenario in which a recapture event occurs in year three of the five-year recapture period triggering a 60% recapture percentage, which is no different than under the old rules in section 50(a)(1)(B)(iii). It further goes on to explain that the recapture is applied by increasing the current year’s taxable income for 60% of the credits taken in the previously two years and that the taxpayer would continue to take 60% of the annual credit for the remaining three years of the five-year period. This has come as a bit of a surprise to the industry as some suspected that the 60% recapture period would be applied to the total rehabilitation credit determined in the year of the recapture.
The rehabilitation credit rules are complex. Accordingly, we advise consultation with a tax advisor with experience in claiming this credit before committing funds to a rehabilitation project.