Rehabilitation Tax Credit
Rehabilitation Tax Credit is authorized for qualified expenditures for pre-1936 property for specified conditions. The Tax Cuts and Jobs Act, signed Dec 22, 2017, changed the dates for expenditures for Rehabilitation Tax Credit. The transitional rule authorizes 10% tax credit for pre-1936 buildings, owned prior to Dec 22, 2017, 26 USC §47(a). After Dec 22, 2017, the 24 or 60-month period begins not after 180 days after Dec 22, 2017, 26 USC §47(c)(1)(B)(ii).
See: The Tax Cuts and Jobs Act, Pub.L. 101-508.
If a property was originally placed in service before 1936, and owned before Dec 22, 2017, the property is qualified as a building eligible for a 10% rehabilitation tax credit, 26 USC §47(c)(1)(B), 26 USC §47(a)(1). The 10% rehabilitation tax credit is based on the amount of rehabilitation expenditures required to produce a fully functional habitable building. The rehabilitation process must leave standing over 50 percent of the existing external walls, and over 75 percent of the existing internal structural framework of the building, 26 USC §47(c)(1)(A). The qualified rehabilitation expenditures must exceed the adjusted basis of the building, 26 USC §47(c)(1)(C)(i)(I). The adjusted basis of the building does not include improvements to the property that are not classified as the building, such as landscaping, the separate garage, and offsite improvements.
The adjusted basis of building is based on the total purchase price, with segregation of value for land and improvements. The segregated expenditures are qualified rehabilitation expenditures. The rehabilitation expenditures include only building expenditures as contrasted to total improvements. Thus, expenditures for non-building improvements, such as the separate garage and landscaping are excluded.
Expenditures for areas predominately for lodging are not included, pursuant to 26 USC §50(b)(2). Rehabilitation credits are not allowed for property used for non-business lodging, 26 USC §50(b)(2). However, rehabilitation credits are allowed for property used for short-term rental as part of the business of furnishing lodging, 26 USC§50(b)(2)(B). Residential property used for short-term rentals are not classified as property used for lodging, 26 USC §168(e)(1)(A)(ii)(1).
Significantly, relevant law authorizes the 10 percent rehabilitation tax credit for pre-1936 non-residential property which is was owned prior to December 22, 2017. Non-residential property includes property which is used for short-term rentals, such as auxiliary rental units in R-1 zones.
The expenditures are chargeable as capital expenditures over their class life, pursuant to 26 USC §47(c)(2)(i)(II). The property has a class life of over 12 years; the class life for non-residential real property is 39 years. The expenditures are capitalized and depreciated using the straight-line method. One-year depreciation is authorized by 26 USC §179.
Rehabilitation expenditures do not include acquisition or enlargement. Rehabilitation is ordinarily expected to be completed in phases, as set forth in plans and specifications before the rehabilitation begins. In the discretion of the owners, the period of expenditures may be planned as 60 months or 24 months, 26 USC §47(c)(1)(C)(ii).
The expenditures may be recognized as placed in service when sufficient work has been completed which would allow occupancy, or when the project is completed. See: 26 CFR §1.47(b)(1) and 26 CFR §1.47(c)(1)(C), 26 CFR §1.48-12(f)(2), and 26 CFR §1.48-12 (c)(6). Interior rehabilitation includes a wide range of interior construction, such as relocation of interior walls, replacement of existing electrical, plumbing, plaster, doors, windows, cabinets, drywall, plaster, porcelain tile, painting, refinishing, and fixtures.
The date of substantial rehabilitation is the date of substantial completion of each phase of the construction project. The total qualified rehabilitation expenditures are required to exceed the adjusted basis of the building, pursuant to 26 USC §47(c)(1)(A).
Under current tax law, the rehabilitation tax credit is a valuable strategy for an investor who owned a pre-1936 property before December 22, 2017. Short-term rental for this type of property results in higher rental rates, 10 percent investment tax credit for qualifying rehabilitation, 26 USC §47, and one-year depreciation, 26 USC §179. These tax statutes were passed to provide an investment incentive for rehabilitation of pre-1936 properties, as a method for stimulation of the national economy. These incentives apply for operating the property as short-term rental property, as contrasted to a lease for one or more years.
By definition, non-residential property includes hotels, motels, bed and breakfast units, and short-term rental units. For short-term rentals, internet marketing is done by Airbnb or Home Away, which includes collection of credit card payments and screening of guests to protect from inappropriate guest behavior. Rental terms of less than 30 days generally require payment of a city occupancy tax. The city tax is typically in a range of 9 percent to 14 percent of gross rental income.
Pursuant to agreement with selected cities, Airbnb collects the correct amount from the guest and pays the occupancy tax for the host. Note that property which is rented for 32 nights or more are generally exempt from city ordinances which restrict or prevent short-term rentals. Also, the guest avoids the requirement to pay an occupancy tax for units rented for 32 nights or more. For many city ordinances, the occupancy tax is due for stays of 30 nights or less. To provide a safe harbor, a prudent host specifies a minimum stay of 32 nights. Generally, city rent control ordinances are not applicable to short-term rental properties.