Meeting the Substantial Rehabilitation test is not often an issue for most Historic Rehabilitation Tax Credit projects. Generally, when someone is entering the HTC program they are undergoing a full gut rehab of the property and investing a substantial amount of money into the property. However, there are situations that arise when the substantial rehabilitation test is problematic. The test is a threshold matter, and the Historic Tax Credits are not allowed, if the test is not met. It is important to identify and address this issue at the outset before an owner proceeds with a project.

What is the Substantial Rehabilitation Test?

A project’s qualified rehab expenses must exceed the adjusted basis of the historic building or $5,000 whichever is greater. In general, the test must be met within a 24-month period.¹

What is a building’s Adjusted Basis?

The Adjusted Basis of a building is the cost of acquiring the building (less value of the land) plus or minus adjustments to basis. Adjustments to basis are things like capital improvements (increasing the basis), or depreciation (decreasing the basis). Your accountant will be able to determine a building’s basis.

Meeting this test is not an issue for a majority of projects entering the program. Usually a building in the program has been recently acquired and soon after is undergoing a full gut rehab. ‘Buy low & rehab high’ is our saying in the historic tax credit world.

There are situations when the test can be problematic.

For example: An owner of an historic building in Rochester, NY needs to make some upgrades and wants to take advantage of historic tax credits. The upgrades will cost $300,000. The building is located in and is contributing to a historic district listed on the National Register. And, let’s assume that the owner’s planned upgrades will receive Part 2 approval from SHPO and NPS.

The building is an office building, which has a 39 year depreciation schedule. He/She purchased the building 15 years ago for $400,000. Value of the land the building sits on is $50,000. During the owner’s 5th year of ownership, he/she has made some capital improvements to the building that cost $100,000.

In this situation, the owner needs to determine the adjusted basis of the building.

If the adjusted basis is more than the cost of the planned upgrades, then the owner will not receive tax credits on the project. The owner would need to address this issue by either increasing the scope of the project (i.e. more upgrades) to meet the substantial rehabilitation test. Otherwise he/she will forgo the historic tax credits altogether.

If Substantial Rehabilitation issue is not identified and addressed at the outset of the project and the owner moves forward, they would be left with little recourse and not get the historic tax credits. This could be catastrophic, especially if the historic tax credits were intended to be used as a means for financing the project.

¹There is a 60-month period available at the election of the taxpayer, however, this is only available if they can meet the conditions set forth in IRC §47(c)(1)(C)(ii).