Qualified rehabilitation expenditures (QREs) are expenditures related to rehabilitation or restoration of a qualifying structure. Expenditures that qualify as QREs are eligible for a 20% general business tax credit of the total QREs.
In the industry, this is commonly known as the “Historic Tax Credit” or the “Investment Credit.”
With passthrough entities, the total QREs are passed through on Schedule K-1 to their partner’s or shareholder’s. The total amount of the credit (20% of the QREs) reduces the depreciable basis of the asset and the partner’s tax capital account or shareholder’s tax basis in a single tier structure. A partner or shareholder reports the QREs on Form 3468 which calculates the Investment Credit amount. This Investment Credit amount flows to Form 3800 for the general business credit allowable credit calculation.
Both forms are filed with the partner’s or shareholder’s personal income tax return.
All the general business tax credits reported on Form 3800 (in total) that an individual is eligible for are subject to the allowable credit calculation on the individual income tax return. An individual is allowed to use their general business tax credits only to reduce net income tax computed in the allowable credit section on Form 3800.
Generally, other taxes on Form 1040, such as self-employment tax, are not eligible to be reduced by the general business credit tax credits. However, for QREs incurred after 2007 the Investment Credit may reduce AMT.
Generally, an individual is required to recapture the Investment Credit if the property is disposed of or ceases to be a business-use property by the individual during the five-year recapture period. A reduction of ownership interest by more than one-third would result in a proportional disposition of the property.
The recapture period typically starts the first day of the month the property was placed into service. Potential recapture of the Investment Credit is reduced by 20% for each full year an individual is qualified for that tax credit. Each full year is based on the first day of the month the property was placed into service with the respective QREs.
Each individual taxpayer situation will be different for general business tax credits allowed (or allowable) and Investment Credits passed through to them.
Prior to the 2017 Tax Cuts and Jobs Act (TCJA), taxpayers were allowed to claim 100% of the Investment Credit in the year the building for which the QREs were incurred was placed into service. After the TCJA, taxpayers are now required to claim the Investment Credit over five years (20% each year) unless a transition rule applies. This new rule applies to QREs on buildings acquired after December 31, 2017.
The impact on taxpayers investing in such projects has been a bit of a double-edged sword. On one hand, spreading the Investment Credit over five years helps mitigate the potential recapture issue for investors. On the other hand, the new five-year spread reduces the benefit of the Investment Credit to investors because the tax benefit is extended over five years.
It is important to consider any Investment Credit recapture issues, at the entity level, before initiating any ownership changes or disposition of the restored building. Substantial savings to the partner or shareholder could result by taking the recapture period into account.
Not all is lost when Investment Credits are recaptured. In the event of recapture, the amount of the recaptured tax credit is added back to the cost basis of the building. This provides the benefit of increased depreciation deductions with respect to the building.
However, this means that the new basis increment will need to be depreciated over the life of the building which is not nearly as beneficial as the tax credit that was previously allocated.
Each state has their own Investment Credit rules including potential Investment Credit recapture to consider.
If you have any questions regarding QREs general business tax credit recapture for an individual taxpayer, please reach out to Kyle Krenske at Mahoney CPAs and Advisors.