Congress's new rules for investing in older structures provide key tax-planning opportunities for business owners.
If you are thinking about a new facility for your business, consider investing in a structure 30 years old or more. The liberal tax incentives contained in the Economic Recovery Tax Act of 1981 now make this an attractive option.
When Congress introduced rules in 1976 for five-year, rapid depreciation of certified historic buildings -- those formally accepted as historic structures by the National Park Service -- it marked a significant break with previous tax policy, which had encouraged new construction. But while those early guidelines generated increased interest in rehab, the appeal was still limited, primarily because relatively few buildings were eligible.
Then last summer, Congress rewrote and liberalized rehab tax law. The most attractive inducements are still reserved for bona fide historic structures, which are eligible for tax credits of 25% on all rehab costs so long as they exceed $5,000 or the adjusted "basis" of the property, whichever is greater. (The "basis" is cost of property plus capital improvements minus depreciation.) But now new tax credits can be obtained with a lot less paperwork and effort for rehab work on unregistered buildings -- as long as they are at least 30 years old and are income-producing and nonresidential.
Congress eliminated the five-year depreciation schedule for historic rehab and replaced it with new rules that cover a much wider universe. Rehab on a building more than 30 years old, for instance, can receive a 15% tax credit, and the credit jumps to 20% for anything more than 40 years old. In addition, under the old law, a building needed to be historically significant or stand in a designated historic district. Now the main criteria for receiving these tax benefits revolve around the age of a structure; the extent of the renovation, which must exceed $5,000 or the adjusted basis, whichever is greater; and the intended use, which must be commercial or industrial, except in the case of certified historic buildings, where residential rehab is also eligible.
Here's how the incentives work for the tens of thousands of noncertified buildings around the United States. Say you've purchased for $100,000 a 40-year-old structure in need of considerable work. (The $100,000 does not include the cost of the land in this example.) Only work done after January 1, 1982, qualifies for the new tax credits, which can be carried back for three years and ahead for seven years. Renovation expenses, moreover, would have to exceed the $100,000 you paid for the building and be incurred during a 24-month period in order to qualify for the 20% tax credit. For example, if you ended up spending $500,000 on a substantial rehabilitation, bringing the total project value to $600,000, your tax credit would be based only on the expenses for improvements. Thus, you would get a $100,000 credit (see chart).
In addition to the $100,000 tax credit available in the first year, you would be entitled to the 15-year, straight-line depreciation benefits available for any buildings under the new Accelerated Cost Recovery System (ACRS). Assuming a 50% tax bracket, your first year's tax benefits would come to $116,667. Compare it with the tax benefits available during the first year for any structure less than 30 years old: You'll be $96,667 ahead.
The rules for nonhistoric rehab, however, require you to deduct the amount of your tax credit from the depreciable base of the project. Instead of the $600,000, you could depreciate only $500,000. Therefore, the tax benefits flowing from depreciation during years 2 through 15 would be $3,333 less per year than for a structure for which no credit was available. Still, on a straight dollar basis, the 40-year-old building would retain an advantage of about $50,000 over the 15-year period. And considering that most of the benefits for the newer structure would be flowing in over time (in future dollars of less value even if inflation abates), the tax advantage of the 40-year-old building would actually be more substantial.
As the chart shows, rehab of a certified historic building can be even more alluring than that on a noncertified structure from a tax standpoint. In contrast to tax credit for nonhistoric buildings, the 25% tax credit does not have to be deducted from the depreciable base, so yearly depreciation benefits are greater. Nevertheless, the numbers don't tell the whole story. In order to qualify for the bountiful benefits under the rules for historic rehab, there are numerous bureaucratic hoops you have to jump through. Among other things, the building has to be properly certified as a historic structure. And plans for the rehab work -- where 75% of the external walls must be retained -- need to be approved by the National Park Service prior to certification. Furthermore, because of threatened budget cuts by the Reagan Administration, the federal and state staffs that handle the certification process may be greatly cut.
Given the potential obstacles and costs of compliance, including attorneys' and architects' fees, some real estate experts have serious doubts about whether rehab under certified historic rules is always worth the bother. In many cases, they note, the additional tax benefits might be eaten away by all the professional fees. Thus, you may indeed be better off either doing rehab on a structure that could qualify as certified historic under the less burden-some rules applying to buildings over 30 years old, or getting special permission to remove the building from the historic-certification category. Once a building has been certified, you must comply with the rules.
The new rules for rehab credits provide some key tax-planning opportunities for business owners. If you have a building that is 28 or 38 years old, you might consider delaying plans for rehabilitation for a couple of years to take advantage of available credits. In addition, if you are going ahead with a rehab project using the credits, think about whether you might want to do follow-up work within the next five years. As long as there's a chance of follow-up, you are required to put the plans for the second phase in writing in order to qualify for the subsequent credit should you go ahead with the work. Unlike the first phase, the subsequent rehab need not cost more than the depreciable basis.
You should also be aware that there are restrictions on the resale of rehab structures after you've taken the tax credit. Although you are entitled to take the credit in the first year, it actually has a five-year life. So if you sell the building during the five years, you will be subject to a recapture tax.