peer reviewed



Royce E. Chaffin


David F. Mullis

Royce E. Chaffin is an Associate Professor of   Business Administration, Richards College of Business, State University of West Georgia and David L. Mullis, an Associate Professor of Finance, School of Business and Economics, University of South Carolina at Spartanburg . Please contact Professor Chaffin if you are interested in a spreadsheet using Lotus 123 to evaluate the applicability of this program for an individual taxpayer.

In recent years, the U.S. tax code has undergone a number of changes, including an increase in the highest regular tax rate to 39.6% and an increase in the alternative minimum tax rate from 24% up to 28%. This paper addresses the impact of those changes, along with the often conflicting tax rules, as they affect individual investors in historic rehabilitation projects. (To return to the text after clicking on a link, click on the back button on your browser.)


The federal government, in an attempt to overcome the bias favoring new construction over the preservation of historical or otherwise significant properties, enacted legislation in 1976 allowing an investment tax credit (ITC) for the rehabilitation and continued use of certain of these structures.(1) Since enactment, the rules pertaining to these credits have been modified a number of times, most recently as part of the Tax Reform Act of 1986 (TRA-86).

Concurrently considered by Congress when revising tax laws was the perceived views that tax-advantaged investments (so-called tax shelters) are inherently "bad" and that high-income taxpayers should bear "their fair share" of the tax burden. These views have led Congress and the President, over the years, to enact various legislation such as Alternative Minimum Tax and Passive Loss restrictions which limit an individual taxpayer's tax "maneuvering."


The rehabilitation credit rules were enacted to encourage investors to preserve and restore eligible properties, rather than simply build new structures. The credits are available to individual taxpayers and can pass through from a partnership. Absent other active-participation real estate gains, an individual with sufficient investment may claim annual rehabilitation tax credits ranging from $3,750 (at the 15% tax bracket) to a maximum of $7,750 (at the 31% and higher brackets), based upon the investor's income level. However, after considering other tax limitations affecting ITC, the actual rehabilitation credit allowed is generally less than these amounts.


Rehabilitation tax credits are subject to a number of limitations on the amount of credit that can be taken in any one year. While unused ITC is carried back to the three prior years' returns, the amount available for use in each carryback year will be subject to limitations, depending upon the laws in effect in the year of carryback.


Rehabilitation properties that meet other requirements (shown in Appendix 1) are eligible for investment tax credits depending upon the type property. Structures that were placed in service before 1936 qualify for an investment credit of 10 percent of the rehabilitation expenditures, while those on certified historic properties qualify for a 20 percent credit.(2)


Congress' intent to limit tax sheltering devices is readily apparent in the implementation of  the "passive activity" loss rules of TRA-86. Probably no other change in the TRA-86 has had more effect on real estate than these rules restricting the individual's use of all passive losses -- which includes real estate by definition -- to offset other, non-passive activity income.(3)

The passive income rules are extremely complex, but, for the non-professional real estate investor, there are two exceptions pertaining to real estate and rehabilitation projects which are noteworthy. A taxpayer with lower income who actively participates in the operation of a real estate activity can use up to $25,000 of losses from the activity to offset non-passive income. The tax benefits of this exception are phased out as modified adjusted gross income (MAGI; AGI without considering the results of the activity) increases from $100,000 to $150,000.(4)

There is also an exception which enables passive investors in qualified rehabilitation projects to be eligible to use the ITC from these projects as though they were active participants. These individuals can use up to the equivalent of $25,000 of losses per year. (i.e., A tax credit of $7,000 at 28 percent tax bracket is equivalent to a loss of $25,000.) An important distinction is that these credits phase out at an increased MAGI level - $200,000 to $250,000.(5)

The $25,000 credit allowance comes after any other active participation allowance. Thus, if a taxpayer has qualifying property throwing off $15,000 of deductible losses, only $10,000 of equivalent loss credits ($2,800 at 28% rate) may be used.


The Revenue Reconciliation Act of 1993 (RRA-93) removed, for years after December 31, 1993, the passive activity loss restrictions for certain taxpayers involved in "real property trades or businesses". Individuals who provide more than 50% of their personal services and more than 750 hours of service during the tax year to the real property trades or businesses in which the individual materially participates may deduct rental real estate losses without regard to the passive loss rules.(6) These new rules may create an opportunity for certain real estate professionals who are involved in rehabilitation projects but, as discussed below, the advantage will likely be limited by alternative minimum tax rules.


With limited exceptions, all taxpayers are subject to the alternative minimum tax (AMT), which is designed to ensure that no taxpayer with substantial economic income can avoid significant tax liability by using exclusions, deductions, or credits, including rehabilitation credits.(7)

As is true for other investment tax credits, the rehabilitation credits can only be used to lower regular income tax to the level where AMT comes into play. The RRA-93 increase in AMT rate to either 26% or 28%, in effect, limits the amount of rehabilitation credits which may be used by individuals to less than the statutory limits based on $25,000 of passive losses.


In addition to the limitation due to passive loss rules and the AMT, the ITC is further constrained by the amount of tax liability. Credit cannot exceed the tax liability for the year and is further limited to $25,000 plus 25% of the amount over $25,000.(8) The latter limit shouldn't be a problem for rehabilitation credit users, as the other limitations will keep these credits far below $25,000. However, this limitation could become important where the taxpayer has other investment tax credits such as research activities, low-income housing, alcohol fuels, disabled access, jobs credits or others.


The cost or basis of property for investment credit purposes may also be limited if financing is used, and the borrower is protected against loss or if the funds are borrowed from a related person or a person who has other than a creditor interest in the business activity. The cost or basis must be reduced by the amount of this "nonqualified non-recourse financing.(9)


For a typical investor, passive loss rules limits the amount of credit only for incomes up to $50,000 and above $230,000. In between those ranges, AMT and ITC limitations restrict the amount of credit that may be claimed in any one year. The actual credit allowed is the lesser of actual tax liability, passive loss limits, or the spread between regular tax limits and the AMT limits. After $50,000, AMT controls until after the passive limits begin to phase out at $200,000.


Although the rehabilitation rules permit an otherwise passive investor to be treated as an active participant, allowing the use of up to $25,000 of losses in any one year to offset other incomes, the rehabilitation property is still subject to the normal rules of depreciation, recapture of credit, personal use, and other tax code requirements. Also, the investor may, after considering the limits and requirements below or for other valid reasons, choose not to take the credit. In such cases, the property is simply treated as conventional real estate.


The depreciable basis of rehabilitation properties must be reduced by the entire amount of the tax credit allowed -- even if not used because of the various limitations. The TRA-86 prohibited accelerated methods of depreciation and increased the depreciable life of real property. The RRA-93 further increased the depreciable life of commercial property. Thus, real property expenditures must be depreciated using the straight-line method over a life of 27.5 years for residential properties or 39 years for non-residential properties.(10)


In the event the rehabilitated property is disposed of, used for unqualified purposes, or ceases being "at-risk" before being in service for five years, a portion of the credit claimed must be recaptured in the year of disposition. The credit is "earned" at a rate of 20% per year so would require, for example, recapture of 60% of the credit if the property was disposed of after two years of service.(11)


The current law prohibits ITC for personal use property, thus the owner cannot occupy the renovated property as a personal residence. Business occupancy by the owner would be allowable.(12)


A National Park Service study made two years after the implementation of TRA-86 estimated that 240,000 buildings were potential candidates for rehabilitation. This study also reported that 20,882 buildings had been renovated using federal rehabilitation tax assistance.(13)

A special report funded by a grant from the National Endowment for the Arts and the membership of the National Trust for Historic Preservation reported that projects based on the rehabilitation credits had dropped by more than two thirds since the advent of the TRA-86 -- from about 3,000 projects per year to less than 1,000.(14)   Preservation advocates and local economic development officials primarily blame the changes in the federal tax law and declining real estate markets for the big decline. Other reasons offered were worsening local economic conditions, the high cost of rehabilitation, a diminished interest in historic preservation, and the perception that all the good projects have been done.


There have been congressional efforts to waive the passive loss rules for costs that meet the requirements of the rehabilitation tax credits. Representative Barbara Kennelly (D., Conn.) chaired a House Ways and Means subcommittee hearing on this subject.(15)  Although most of the witnesses at the lightly attended meeting were in favor of allowing the wealthy to again participate in rehabilitation projects, the Treasury Department spoke in opposition to altering passive loss rules, fearing it would open the floodgates to the manufacture of tax shelters.(16)


Since the rules of most historical societies prohibit the alteration of the exterior of a historical structure, some rehabilitation project owners have attempted to derive additional tax benefits by contributing an easement on the facade to the historical society. Revenue Ruling 89-90 holds that such a donation constitutes a partial distribution of underlying property, so that if a rehabilitation credit has been claimed on that property, it must be partially recaptured. The tax court has agreed.(17)

There are problems where less than the entire building is being rehabilitated, as could be the case with "condo-ed" apartments, lofts, etc. Taxpayers who rehabilitated one floor of a certified historic structure were not entitled to rehabilitation tax credits because those expenses did not exceed the building's adjusted basis. Additionally, the first floor did not qualify as a separate "building" for purposes of the tax code.(18)

All of the rehabilitation work does not have to be done by the same owners. A project that had not been placed in service by a series of prior owners qualified as a new building for the low-income housing credit with respect to its present owner, because only the present owner completed the project for occupancy.(19)   This case could apply to rehabilitation property if the present owner "buys" the prior owner's rehabilitation expenditures before placing the project in service.

The courts have ruled that rehabilitation projects must be done in place. If the structure is moved to another location, it will not qualify for the credit, even though it meets the 75% of-exterior-walls test. The relocated building would not "provide an economic stimulus for those areas susceptible to economic decline and abandonment" as intended by Congress.(20)


A review of the current tax laws make it apparent that the high-income investor is effectively frozen out of the rehabilitation tax credits. The $250,000 cap eliminated the segment of the population most financially able, and generally willing, to invest in these type projects. As the executive director of the Greater Hartford Architecture Conservancy noted, "(With the advent of the TRA-86) we lost probably 90 percent of the market who could buy tax credits -- the doctors and lawyers." People earning under $250,000 comprise a much more difficult market to sell, driving up the cost of syndication.(21)

The recent changes to the tax code (AGI limits for exemptions and itemized deductions, increased alternative minimum tax rates, etc.) make it even more difficult to assess the impact of rehabilitation credits on any particular individual. This study shows that the maximum benefits of rehabilitation tax credits may be obtained by a taxpayer who has no other real estate investment deductions or other passive losses and who has an income level, exclusive of the rehabilitation project, of $50,000. Since an individual with $50,000 income has a relatively low tax to begin with, he or she could not be considered an ideal candidate for such a project.


The complexity of the rehabilitation tax credits is reflected in the eight (or nine) complex forms and certifications that must be completed and filed with the tax return. A listing of the forms is shown in Appendix 2. IRS agent audit guidelines are also complex, as shown in Appendix 3.


Congress appears to have substantially achieved the goal of reducing rehabilitation credits as a tax shelter for high-income taxpayers, albeit at a cost of having a much smaller pool of  individuals who are both interested in investing in rehabilitation projects and financially able to do so. While the investor at lower income levels benefits from the rehabilitation tax credits and the exemption from passive losses, this benefit decreases as income levels increase.

It would appear that the only way a "higher income" investor will be able to materially benefit from rehabilitation projects would be to have other "active involvement real estate" incomes that could be offset by the ITC.



There are certain structural requirements that must be met to qualify for rehabilitation ITC properties. Non-historic structures, for instance, must retain at least 75 percent of the external walls as either external or internal walls with a minimum of 50 percent being retained as external walls. In addition, at least 75 percent of the building's internal structural framework must be retained in place.(22)

The building qualifying for the ITC must be substantially rehabilitated during a 24-month period ending on the last day of the taxable year in which the credit is to be claimed. Substantial rehabilitation is defined as being either expenditures of $5,000 or the adjusted basis of the property as of the first day of the 24-month qualifying period, whichever is greater.(23)

Although qualified rehabilitation expenditures may include reconstruction, it does not include any expenditures on a building that is tax exempt nor does it include any costs incurred in expanding the building.(24)  Except for certified historic structures, properties predominantly used to provide lodging are not eligible for the credit.(25)


The age-qualifying structure's primary qualification requirement is that it must have been placed into service prior to 1936. Additionally, while the original use is immaterial, it must not be used predominantly for residential purposes after the completion of rehabilitation.

The remaining method of qualifying requires being designated as a "historic structure",(26) which results from either:



At a minimum, the following forms must be completed to claim the rehabilitation tax credits. The IRS estimated time to learn about the form and to prepare and send the form to the IRS is shown in parentheses in the format of Hours:Minutes.

1. Form 8582-CR, Passive Activity Credit Limitations: (4:01, 5:02) This form is used to determine the amount of any passive activity credits for the current tax year. It is a 40-line, two page form requiring the completion of the instructions package (seven worksheets, requiring as many as 15 steps and schedules) before the form can be completed. The results are carried to Form 3468.

2. Form 3468, Computation of Investment Credit: (3:28, 3:50) This form is used to compute the amount of ITC available from current year rehabilitation expenditures. The results are carried to Form 3800.

3. Form 3800, General Business Credit: (0:35, 0:48) This form combines the current year investment credit from Form 3468 with other current year credits from jobs credit, alcohol fuels, research activities, low-income housing and the newly enacted enhanced oil recovery, disabled access, and renewable electricity production. These current year general business credits are then limited by passive activity rules (requiring reference to Form 8582-CR) and combined with carryover of other credits to determine the tentative general business credit.

The tentative general business credit is further limited to the amount that net regular tax (regular income tax less certain other credits) exceeds the alternative minimum tax (requiring reference to Form 6251), subject to the regular credit maximum limitations of $25,000 plus 25% of the amount over $25,000.

4. Form 8582, Passive Activity Loss Limitations: (1:43, 1:34) (Authors' comment: We question the time allocation. The instructions alone amount to 11 pages plus six interconnected worksheets. The regulations addressing passive losses are made up of hundreds of paragraphs of guidelines.) This form must be completed to determine the passive activity losses allowed. If there are passive losses other than the rehabilitation tax credits, they must be shown here. Rental real estate activities have a direct impact on the amount of rehabilitation credits allowed on Form 8582-CR.

5. Form 6251, Alternative Minimum Tax - Individuals: (1:16, 3:00) This form must be completed since the ITC cannot reduce taxes below the alternative minimum tax (AMT) amount. The tentative AMT is carried to Form 3800.

6. Form 6198, At-Risk Limitations: (0:59, 1:25) This form is to be filed by individuals who use borrowed funds to finance the rehabilitation project. Only those properties "at-risk" will qualify for ITC.

7. National Park Service Certificate: This certificate must be attached to the return if the credit is from certified historic structures.

8. Form 1045, Application for Tentative Refund: (0:31, 7:34) This form should be used to carryback any unused ITC to the three prior years. If the carryback isn't accomplished within one year, Form 1040X, Amended U.S. Individual Income Tax Return, (0:20, 1:46) must be used. The use of Form 1040X will allow the IRS to make the refund at their convenience, rather than within 90 days, as obtained using Form 1045.

9. Form 4255, Recapture of Investment Credit: (2:23, 2:37) Used to figure the increase in current-year tax for the recapture of ITC when the rehabilitation property is no longer qualified because of disposition, change of use, or becoming not at risk.



The IRS provides guidelines for examiners for Qualified Rehabilitation Credit (Certified Historic Structures) in Internal Revenue Manuals. While these guides are not mandatory, they may give an idea of what the examining officer will be looking for. The guidelines from IRM 4231, Chapter-61-14-91 follows:

a) Look for rental income to determine if the property was placed in service.

b) Be wary of property placed in service late in the tax year.

c) Review the balance sheet for unusual accruals (all tests may not have been met or perhaps expenses were never paid).

d) Check the amount reflected on Form 3468 against the amount of the basis of the building before rehabilitation, and if it is less, it's possible the taxpayer failed to perform the work.

a) Qualifying expenses would include:

b) Expenses which do not qualify include:

a) Disguised syndication fees,

b) Improper accounting methods,

c) Transactions between related parties,

d) Contingent liabilities; and

e) Developer fees (distributions to partners).



Over the years, there have been a number of federal, state, and local programs to use tax credits as incentive to promote various activities. Overall, the impact of these efforts has been somewhat mixed. Some suggested further readings can be found at the endnotes references below.

Cities and states have used -- and continue to use -- credits to lure new industries (and major sports teams), but some studies have shown there is little impact, since the businesses have to consider the overall state tax -- not just the incentives. Other studies have shown that tax incentives, including credits, are a factor in relocation decisions. A location with competitive taxes would gain little from these incentives, while a site with burdensome taxes probably doesn't gain too much since the overall impact must be examined.(27)

In addition to the rehabilitation credits, federal tax credits have been used to encourage purchases of new equipment (at times restricted to only U.S. manufactured goods); hire new workers (a variation is still in effect for certain hard-to-place workers)(28); research and development of new products (still in effect)(29); develop alternative energy sources (currently a heated political battle rages over credits for production of ethanol)(30); to provide handicapped access under the Americans Disabilities Act(31), and to provide low-income housing for families (still in effect).


1. Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986. (643)

2. Internal Revenue Code (IRC) Section 46(b)(4)(A); IRC Sec. 48(g)(1)(B)

3. IRC Sec. 469

4. IRC Sec. 469(i)

5. IRC Sec. 469(i), Sec. 469(j)

6. IRC Sec. 469(1)

7. IRC Sec. 55

8. IRC Sec. 38( c)

9. IRC Sec. 46(c)(8)(A), Sec. 465

10. IRC Sec. 167

11. IRC Sec. 47

12. IRC Sec. 48(g)(1)(A)

13. Quoted in "Rehab Takes a Fall", Historic Preservation, Vol. 42, No. 2, (Sep./Oct. 1990), p. 57.

14. Cited in "Rehab Takes a Fall", p. 53, 57

15. House Ways and Means Select Subcommittee meeting on 6/6/89.

16. Cited in Tax Notes (June 12, 1989), p. 1313.

17. Rome I, Ltd., CCH (Dec. 47), 324, p. 47, 946

18. Alexander III, TC CCH   (Dec 47) ,521, p. 48,143

19. Private Letter Ruling 8950057

20. G. Nalle, III, et ux, et al, 99 TC No. 9

21. Quoted in "Rehab Takes a Fall", p. 58.

22. IRC Sec. 46(g)(1)

23. IRC Sec. 48(g)(2)

24. IRC Sec. 46(g)(3)

25. IRC Sec. 48(g)(3)(A)

26. IRC Sec. 48(g)(3)(A)

27. For additional readings on state and local tax incentives, please see:

28. Many companies are finding it difficult to hire and retain workers meeting the criteria. See: "Work opportunity tax credit "extender" has limited window for opportunity". Herb Lemaster. The Tax Adviser (Dec 1996), 27, n12, p. 722(3)

29. For additional readings on the research and development tax credit, see:

30. For additional readings on the ethanol controversy, see:

31. For further reading on the Americans with Disabilities Act tax credits see: