[Code of Federal Regulations]
[Title 26, Volume 1]
[Revised as of April 1, 2003]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.48-12]

[Page 376-395]
 
                       TITLE 26--INTERNAL REVENUE
 
     CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
 
PART 1--INCOME TAXES--Table of Contents
 
Sec. 1.48-12  Qualified rehabilitated building; expenditures incurred after December 31, 1981.

    (a) General rule--(1) In general. Under section 48(a)(1)(E), the 
portion of the basis of a qualified rehabilitated building that is 
attributable to qualified rehabilitation expenditures (within the 
meaning of section 48(g) and this section) is section 38 property. 
Property that is section 38 property by reason of section 48(a)(1)(E) is 
treated as new section 38 property and, therefore, is not subject to the 
used property limitation in section 48(c). Section 48(g)(1) and 
paragraph (b) of this section define the term ``qualified rehabilitated 
building.'' Section 48(g)(2) and paragraph (c) of this section define 
the term ``qualified rehabilitation expenditure.'' Section 48(g) 
(2)(B)(iv) and (3) and paragraph (d) of this section describe the rules 
applicable to ``certified historic structures.'' Section 48(q) and 
paragraph (e) of this section provide rules concerning an adjustment to 
the basis of the rehabilitated building. Paragraph (f) of this section 
provides guidance for coordination of these provisions with other 
sections of the Code, including rules for determining when

[[Page 377]]

the rehabilitation credit may be claimed.
    (2) Effective dates and transition rules--(i) In general. Except as 
otherwise provided in this paragraph (a)(2)(i), this section applies to 
expenditures incurred after December 31, 1981, in connection with the 
rehabilitation of a qualified rehabilitated building. (See paragraph 
(c)(3)(i) of this section for rules concerning the determination of when 
an expenditure is incurred.) If, however, physical work on the 
rehabilitation began before January 1, 1982, and the building does not 
meet the requirements of paragraph (b) of this section, the rules in 
Sec. 1.48-11 shall apply to the expenditures incurred after December 31, 
1981, in connection with such rehabilitation. (See paragraph (b)(6)(i) 
of this section for rules determining when physical work on a 
rehabilitation begins.)
    (ii) Transition rules concerning ACRS lives. (A) For property placed 
in service before March 16, 1984, and any property subject to the 
exception set forth in section 111(g)(2) of Pub. L. 98-369 (Deficit 
Reduction Act of 1984), the references to ``19 years'' in paragraph 
(c)(4)(ii) and (7)(v) shall be replaced with ``15 years'' and the 
reference to ``19-year real property'' in paragraph (c)(4)(ii) shall be 
replaced with ``15-year real property.''
    (B) Except as otherwise provided in paragraph (a)(2)(ii)(A) of this 
section, for property placed in service before May 9, 1985, and any 
property subject to the exception set forth in section 105(b) (2) and 
(5) of Pub. L. 99-121 (99 Stat. 501, 511), the reference to ``19 years'' 
in paragraph (c)(4)(ii) and (7)(v) shall be replaced with ``18 years'' 
and the references to ``19-years real property'' in paragraph (c)(4)(ii) 
shall be replaced with ``18-year real property.''
    (iii) Transition rule concerning external wall definition. 
Notwithstanding the definition of external wall contained in paragraph 
(b)(3)(ii) of this section, in any case in which the written plans and 
specifications for a rehabilitation were substantially completed on or 
before June 28, 1985, and the building being rehabilitated would fail to 
meet the requirement of paragraph (b)(1)(iii) of this section if the 
definition of external wall in paragraph (b)(3)(ii) of this section were 
used, the term ``external wall'' shall be defined as a wall, including 
its supporting elements, with one face exposed to the weather or earth, 
and a common wall shall not be treated as an external wall. See 
paragraph (b)(2)(v) of this section for the definition of written plans 
and specifications.
    (iv) Transition rules concerning amendments made by the Tax Reform 
Act of 1986--(A) In general. Except as otherwise provided in section 
251(d) of the Tax Reform Act of 1986 and this paragraph (a)(2)(iv), the 
amendments made by section 251 of the Tax Reform Act of 1986 shall apply 
to property placed in service after December 31, 1986, in taxable years 
ending after that date, regardless of when the rehabilitation 
expenditures attributable to such property were incurred. If property 
attributable to qualified rehabilitation expenditures is incurred with 
respect to a rehabilitation to a building placed in service in segments 
or phases and some segments are placed in service before January 1, 
1987, and the remaining segments are placed in service after December 
31, 1986, the amendments under the Tax Reform Act would not apply to the 
property placed in service before January 1, 1987, but would apply to 
the segments placed in service after December 31, 1986, unless one of 
the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section 
applies.
    (B) General transition rule. The amendments made by sections 251 and 
201 of the Tax Reform Act of 1986 shall not apply to property that 
qualifies under section 251(d) (2), (3), or (4) of the Tax Reform Act of 
1986. Property qualifies for the general transition rule in section 
251(d)(2) of the Act if such property is placed in service before 
January 1, 1994, and if such property is placed in service as part of--
    (1) A rehabilitation that was completed pursuant to a written 
contract that was binding on March 1, 1986, or
    (2) A rehabilitation incurred in connection with property (including 
any leasehold interest) acquired before March 2, 1986, or acquired on or 
after such date pursuant to a written contract that was binding on March 
1, 1986, if--

[[Page 378]]

    (i) Parts 1 and 2 of the Historic Preservation Certificate 
Application were filed with the Department of the Interior (or its 
designee) before March 2, 1986, or
    (ii) The lesser of $1,000,000 or 5 percent of the cost of the 
rehabilitation is incurred before March 2, 1986, or is required to be 
incurred pursuant to a written contract which was binding on March 1, 
1986.
    (C) Specific rehabilitations. See section 251(d) (3) and (4) of the 
Tax Reform Act of 1986 for additional rehabilitations that are exempted 
from the amendments made by sections 251 and 201 of the Tax Reform Act 
of 1986.
    (b) Definition of qualified rehabilitated building-- (1) In general. 
The term ``qualified rehabilitated building'' means any building and its 
structural components--
    (i) That has been substantially rehabilitated (within the meaning of 
paragraph (b)(2) of this section) for the taxable year,
    (ii) That was placed in service (within the meaning of Sec. 1.46-
3(d)) as a building by any person before the beginning of the 
rehabilitation, and
    (iii) That meets the applicable existing external wall retention 
test or the existing external wall and internal structural framework 
retention test in accordance with paragraph (b)(3) of this section.

The requirement in paragraph (b)(1)(iii) of this section does not apply 
to a certified historic structure. See paragraphs (b) (4) and (5) of 
this section for additional requirements related to the definition of a 
qualified rehabilitated building.

    (2) Substantially rehabilitated building--(i) Substantial 
rehabilitation test. A building shall be treated as having been 
substantially rehabilitated for a taxable year only if the qualified 
rehabilitation expenditures (as defined in paragraph (c) of this 
section) incurred during any 24-month period selected by the taxpayer 
ending with or within the taxable year exceed the greater of--
    (A) The adjusted basis of the building (and its structural 
components), or (B) $5,000.
    (ii) Date to determine adjusted basis of the building--(A) In 
general. The adjusted basis of the building (and its structural 
components) shall be determined as of the beginning of the first day of 
the 24-month period selected by the taxpayer or the first day of the 
taxpayer's holding period of the building (within the meaning of section 
1250(e)), whichever is later. For purposes of determining the holding 
period under section 1250(e), any reconstruction that is part of the 
rehabilitation shall be disregarded.
    (B) Special rules. In the event that a building is not owned by the 
taxpayer, the adjusted basis of the building shall be determined as of 
the date that would have been used if the owner had been the taxpayer. 
The adjusted basis of a building that is being rehabilitated by a 
taxpayer other than the owner shall thus be determined as of the 
beginning of the first day of the 24-month period selected by the 
taxpayer or the first day of the owner's holding period, whichever is 
later. Therefore, if a building that is being rehabilitated by a lessee 
is sold subject to the lease prior to the date that the lessee has 
substantially rehabilitated the building, the lessee's adjusted basis is 
determined as of the beginning of the first day of the new lessor's 
holding period or the beginning of the first day of the 24-month period 
selected by the lessee (the taxpayer), whichever is later. If, 
therefore, the first day of the new lessor's holding period were later 
than the first day of the 24-month period selected by the lessee (the 
taxpayer), the lessee's adjusted basis for purposes of the substantial 
rehabilitation test would be the same as the adjusted basis of the new 
lessor as determined under paragraph (b)(2)(vii) of this section. If a 
building is sold after the date that a lessee has substantially 
rehabilitated the building with respect to the original lessor's 
adjusted basis, however, the lessee's basis may be determined as of the 
first day of the 24-month period selected by the lessee or the first day 
of the original lessor's holding period, whichever is later, and the 
transfer of the building will not affect the adjusted basis for purposes 
of the substantial rehabilitation test. The preceding sentence shall not 
apply, however, if the building is sold to the lessee or a related party 
within the meaning of section 267(b) or section 707(b)(1).

[[Page 379]]

    (iii) Adjusted basis of the building--(A) In general. The term 
``adjusted basis of the building'' means the aggregate adjusted basis 
(within the meaning of section 1011(a)) in the building (and its 
structural components) of all the parties who have an interest in the 
building.
    (B) Special rules. In the case of a building that is leased to one 
or more tenants in whole or inpart, the adjusted basis of the building 
is determined by adding the adjusted basis of the owner (lessor) in the 
building to the adjusted basis of the lessee (or lessees) in the 
leasehold and any leasehold improvements that are structural components 
of the building. Similarly, in the case of a building that is divided 
into condominium units, the adjusted basis of the building means the 
aggregate adjusted basis of all of the respective condominium owners 
(including the basis of any lessee in the leasehold and leasehold 
improvements) in the building (and its structural components). If the 
adjusted basis of a building would be determined in whole or in part by 
reference to the adjusted basis of a person or persons other than the 
taxpayer (e.g., a rehabilitation by a lessee) and the taxpayer is unable 
to obtain the required information, the taxpayer must establish by clear 
and convincing evidence that the adjusted basis of such person or 
persons in the building on the date specified in paragraph (b)(2)(ii) of 
this section is an amount that is less than the amount of qualified 
rehabilitation expenditures incurred by the taxpayer. If no such amount 
can be so established, the adjusted basis of the building will be deemed 
to be the fair market value of the building on the relevant date. For 
purposes of determining the adjusted basis of a building, the portion of 
the adjusted basis of a building that is allocable to an addition 
(within the meaning of paragraph (b)(4)(ii) of this section) to the 
building that does not meet the age requirement in paragraph (b)(4)(i) 
of this section shall be disregarded. (See paragraph (b)(2)(vii) of this 
section for the rule applicable to the determination of the adjusted 
basis of a building when qualified rehabilitation expenditures are 
treated as incurred by the taxpayer.)
    (iv) Rehabilitation. Rehabilitation includes renovation, 
restoration, or reconstruction of a building, but does not include an 
enlargement (within the meaning of paragraph (c)(10) of this section) of 
new construction. The determination of whether expenditures are 
attributable to the rehabilitation of an existing building or to new 
construction shall be based upon all the facts and circumstances.
    (v) Special rule for phased rehabilitation. In the case of any 
rehabilitation that may reasonably be expected to be completed in phases 
set forth in written architectural plans and specifications completed 
before the physical work on the rehabilitation begins, paragraphs (b)(2) 
(i), (ii), and (vii) of this section shall be applied by substituting 
``60-month period'' for ``24-month period.'' A rehabilitation may 
reasonably be expected to be completed in phases if it consists of two 
or more distinct stages of development. The determination of whether a 
rehabilitation consists of distinct stages and therefore may reasonably 
be expected to be completed in phases shall be made on the basis of all 
the relevant facts and circumstances in existence before physical work 
on the rehabilitation begins. For purposes of this paragraph and 
paragraph (a)(2)(iii) of this section, written plans that describe 
generally all phases of the rehabilitation process shall be treated as 
written architectural plans and specifications. Such written plans are 
not required to contain detailed working drawings or detailed 
specifications of the materials to be used. In addition, the taxpayer 
may include a description of work to be done by lessees in the written 
plans. For example, where the owner of a vacant four story building 
plans to rehabilitate two floors of the building and plans to require, 
as a condition of any lease, that tenants of the other two floors must 
rehabilitate those floors, the requirements of this paragrpah (b)(2)(v) 
shall be met if the owner provides written plans for the rehabilitation 
work to be done by the owner and a description of the rehabilitation 
work that the tenants will be required to complete. The work required of 
the

[[Page 380]]

tenants may be described in the written plans in terms of minimum 
specifications (e.g., as to lighting, wiring, materials, appearance) 
that must be met by such tenants. See paragraph (b)(6)(i) of this 
section for the definition of physical work on a rehabilitation.
    (vi) Treatment of expenses incurred by persons who have an interest 
in the building. For purposes of the substantial rehabilitation test in 
paragraph (b)(2)(i) of this section, the taxpayer may take into account 
qualified rehabilitation expenditures incurred during the same 
rehabilitation process by any other person who has an interest in the 
building. Thus, for example, to determine whether a building has been 
substantially rehabilitated, a lessee may include the expenditures of 
the lessor and of other lessees; a condominium owner may include the 
expenditures incurred by other condominium owners; and an owner may 
include the expenditures of the lessees.
    (vii) Special rules when qualified rehabilitation expenditures are 
treated as incurred by the taxpayer. In the case where qualified 
rehabilitation expenditures are treated as having been incurred by a 
taxpayer under paragraph (c)(3)(ii) of this section, the transferee 
shall be treated as having incurred the expenditures incurred by the 
transferor on the date that the transferor incurred the expenditures 
within the meaning of paragraph (c)(3)(i) of this section. For purposes 
of the substantial rehabilitation test in paragrpah (b)(2)(i) of this 
section, the transferee's adjusted basis in the building shall be 
determined as of the beginning of the first day of a 24-month period, or 
the first day of the transferee's holding period, whichever is later, as 
provided in paragraph (b)(2)(ii) of this section. The transferee's basis 
as of the first day of the transferee's holding period for purposes of 
the substantial rehabilitation test in paragraph (b)(2)(i) of this 
section, however, shall be considered to be equal to the transferee's 
basis in the building on such date less--
    (A) The amount of any qualified rehabilitation expenditures incurred 
(or treated as having been incurred) by the transferor during the 24-
month period that are treated as having been incurred by the transferee 
under paragraph (c)(3)(ii) of this section, and
    (B) The amount of qualified rehabilitation expenditures incurred 
before the transfer and during the 24-month period by any other person 
who has an interest in the building (e.g., a lessee of the transferor). 
The preceding sentence shall not apply, however, unless the transferee's 
basis in the building is determined with reference to (1) the 
transferee's cost of the building (including the rehabilitation 
expenditures), (2) the transferor's basis in the building (where such 
basis includes the amount of the expenditures), or (3) any other amount 
that includes the cost of the rehabilitation expenditures. In the event 
that the transferee's basis is determined with reference to an amount 
not described above (e.g., transferee's basis in one building is 
determined with reference to the transferee's basis in another building 
under section 1031(d)), the amount of the expenditures incurred by the 
transferor and treated as having been incurred by the transferee are not 
deducted from the transferee's basis for purposes of the substantial 
rehabilitation test. If a transferee's basis is determined under section 
1014, any expenditures incurred by the decedent within the measuring 
period that are treated as having been incurred by the transferee under 
paragraph (c)(3)(ii) of this section shall decrease the transferee's 
basis for purposes of the substantial rehabilitation test.
    (viii) Statement of adjusted basis, measuring period, and qualified 
rehabilitation expenditures. In the case of any tax return filed after 
August 27, 1985, on which an investment tax credit for property, 
described in section 48(a)(1)(E) is claimed, the taxpayer shall indicate 
by way of a marginal notation on, or a supplemental statement attached 
to, Form 3468--
    (A) The beginning and ending dates for the measuring period selected 
by the taxpayer under section 48(g)(1)(C)(i) and paragraph (b)(2) of 
this section,
    (B) The adjusted basis of the building (within the meaning of 
paragraph (b)(2) (iii) or (vii) of this section) as of the beginning of 
such measuring period, and
    (C) The amount of qualified rehabilitation expenditures incurred, 
and

[[Page 381]]

treated as incurred, respectively, during such measuring period.

Furthermore, for returns filed after August 27, 1985, if the adjusted 
basis of the building for purposes of the substantial rehabilitation 
test is determined in whole or in part by reference to the adjusted 
basis of a person, or persons, other than the taxpayer (e.g., a 
rehabilitation by a lessee), the taxpayer must attach to the Form 3468 
filed with the tax return on which the credit is claimed a statement 
addressed to the District Director, signed by such third party, that 
states the first day of the third party's holding period and the amount 
of the adjusted basis of such third party in the building at the 
beginning of the measuring period or the first day of the holding 
period, whichever is later. If the taxpayer is unable to obtain the 
required information, that fact should be indicated and the taxpayer 
should state the manner in which the adjusted basis was determined and, 
if different, the fair market value of the building on the relevant 
date.
    (ix) Partnerships and S corporations. If a building is owned by a 
partnership (i.e., the building is partnership property) or an S 
corporation, the substantial rehabilitation test shall be determined at 
the entity level. Thus, the entity shall compare the amount of qualified 
rehabilitation expenditures incurred during the measuring period against 
its basis in the building at the beginning of its holding period or the 
beginning of its measuring period, whichever is later. (See section 
1223(2) for rules concerning the determination of a partnership's 
holding period in the case of a contribution of property to the 
partnership meeting the requirements of section 721.) The adjusted basis 
of the building to a partnership shall be determined by taking into 
account any adjustments to the basis of the building made under section 
743 and section 734. Any adjustments to the building's basis that are 
made under section 743 or section 734 after the beginning of the 
partnership's holding period, but before the end of the measuring 
period, shall be deemed for purposes of the substantial rehabilitation 
test to have been made on the first day of the partnership's holding 
period. However, in such case, the partnership's basis in the building 
shall be reduced by the amount of qualified rehabilitation expenditures 
incurred by the partnership. In the case of any tax return filed after 
January 9, 1989 on which a credit is claimed by a partner or a 
shareholder of an S corporation for rehabilitation expenditures incurred 
by a partnership or an S corporation, the partner or shareholder shall 
indicate on the Form 3468 on which the credit is claimed the name, 
address, and identification number of the partnership or S corporation 
that incurred the rehabilitation expenditures, and the partnership or S 
corporation shall, by way of a marginal notation on or a supplemental 
statement attached to the entity's return, provide the information 
required by paragraph (b)(2)(viii) of this section.
    (x) Examples. The following examples illustrate the application of 
the substantial rehabilitation test in this paragraph (b)(2):

    Example 1. Assume that A, a calendar year taxpayer, purchases a 
building for $140,000 on January 1, 1982, incurs qualified 
rehabilitation expenditures in the amount of $48,000 (at the rate of 
$4,000 per month) in 1982, $100,000 in 1983, and $20,000 (at the rate of 
$2,000 per month) in the first ten months of 1984, and places the 
rehabilitated building in service on October 31, 1984. Assume that A did 
not have written architectural plans and specifications describing a 
phased rehabilitation within the meaning of paragraph (b)(2)(v) of this 
section in existence prior to the beginning of physical work on the 
rehabilitation. For purposes of the substantial rehabilitation test in 
paragraph (b)(2) of this section, A may select any 24-consecutive-month 
measuring period that ends in 1984, the taxable year in which the 
rehabilitated building was placed in service. Assume that on A's 1984 
return, A selects a measuring period beginning on February 1, 1982, and 
ending on January 31, 1984, and specifies that A's basis in the building 
(within the meaning of section 1011(a)) was $144,000 on February 1, 1982 
($140,000+$4,000). (The $4,000 of rehabilitation expenditures incurred 
during January 1982 are included in A's basis under section 1011 even 
though such property has not been placed in service.) The amount of 
qualified rehabilitation expenditures incurred during the measuring 
period was $146,000 ($44,000 from February 1 to December 31, 1982, plus 
$100,000 in 1983, plus $2,000 in January 1984). The building shall be 
treated as ``substantially rehabilitated'' within the meaning of this 
paragraph (b)(2) for A's 1984 taxable year

[[Page 382]]

because the $146,000 of expenditures incurred by A during the measuring 
period exceeded A's adjusted basis of $144,000 at the beginning of the 
period. If the other requirements of section 48(g)(1) and this paragraph 
are met, the building is treated as a qualified rehabilitated building, 
and A can treat as qualified rehabilitation expenditures the amount of 
$168,000 (i.e., $146,000 of expenditures incurred during the measuring 
period, $4,000 of expenditures incurred prior to the beginning of the 
measuring period as part of the rehabilitation process, and $18,000 of 
expenditures incurred after the measuring period during the taxable year 
within which the measuring period ends (See paragraph (c)(6) of this 
section.)). The result would generally be the same if the property 
attributable to the rehabilitation expenditures was placed in service as 
the expenditures were incurred, but A would have $148,000 of qualified 
rehabilitation expenditures for 1983 and $20,000 of qualified 
rehabilitation expenditures for 1984. (See paragraph (f)(2) of this 
section).
    Example 2. Assume the same facts as in example 1, except that 
additional rehabilitation expenditures are incurred after the portion of 
the basis of the building attributable to qualified rehabilitation 
expenditures was placed in service on October 31, 1984. Such 
expenditures are incurred through the end of 1984 and in 1985 when the 
portion of the basis attributable to the additional expenditures is 
placed in service. The fact that the building qualified as a 
substantially rehabilitated building for A's 1984 taxable year has no 
effect on whether the building is a qualified rehabilitated building for 
property placed in service in A's 1985 taxable year. In order to 
determine whether the building is a qualified rehabilitated building for 
A's 1985 taxable year, A must select a measuring period that ends in 
1985 and compare the expenditures incurred within that period with the 
adjusted basis as of the beginning of the period. Solely for the purpose 
of determining whether the building was substantially rehabilitated for 
A's 1985 taxable year, expenditures incurred during 1983 and 1984, even 
though considered in determining whether the building was substantially 
rehabilitated in 1984, may also be used to determine whether the 
building was substantially rehabilitated for A's 1985 taxable year, 
provided the expenditures were incurred during any 24-month measuring 
period selected by A that ends in 1985.
    Example 3. (i) Assume the B purchases a building for $100,000 on 
January 1, 1982, and leases the building to C who rehabilitates the 
building. Assume that C, a calendar year taxpayer, places the property 
with respect to which rehabilitation expenditures were made in service 
in 1982 and selects December 31, 1982, as the end of the measuring 
period for purposes of the substantial rehabilitation test. The 
beginning of the measuring period is January 2, 1982, the beginning of 
B's holding period under section 1250(e), and the adjusted basis of the 
building is $100,000. Accordingly, if C incurred more than $100,000 of 
qualified rehabilitation expenditures during 1982, the building would be 
substantially rehabilitated within the meaning of paragraph (b)(2)(i) of 
this section.
    (ii) Assume the facts of example 3(i), except that after C begins 
physical work on the rehabilitation, but before C incurs $100,000 of 
expenditures, D acquires the building, subject to C's lease, from B for 
$200,000. D's holding period under section 1250(e) begins on the day 
after D acquired the building, and C's adjusted basis for purposes of 
the substantial rehabilitation test is $200,000, less the amount of 
expenditures incurred by C before the transfer. (See paragraphs (b)(2) 
(ii) and (vii) of this section.) Accordingly, if C incurred more than 
$200,000 (less the amount of expenditures incurred prior to the 
transfer) of qualified rehabilitation expenditures during 1982, the 
building would be substantially rehabilitated within the meaning of 
paragraph (b)(2) of this section. Under paragraph (b)(2)(ii)(B) of this 
section, however, C's adjusted basis for purposes of the substantial 
rehabilitation test would be $100,000 if C had substantially 
rehabilitated the building (i.e., incurred more than $100,000 in 
rehabilitation expenditures) prior to B's sale to D.

    Example 4. E owns a building with a basis of $10,000 and E incurs 
$5,000 of rehabilitation expenditures. Before completing the 
rehabilitation project, E sells the building to F for $30,000. Assume 
that F is treated under paragraph (c)(3)(ii) of this section as having 
incurred the $5,000 of rehabilitation expenditures actually incurred by 
E. Because F's basis in the building is determined under section 1011 
with reference to F's $30,000 cost of the building (which includes the 
property attributable to E's rehabilitation expenditures), F's basis for 
purposes of the substantial rehabilitation test is $25,000 ($30,000 cost 
basis less $5,000 rehabilitation expenditures treated as if incurred by 
F). (See paragraph (b)(2)(vii) of this section.) F would thus be 
required to incur more than $20,000 of rehabilitation expenditures (in 
addition to the $5,000 incurred by E and treated as having been incurred 
by F) during a measuring period selected by F to satisfy the substantial 
rehabilitation test.

    Example 5. G owns Building I with a basis of $10,000 and a fair 
market value of $20,000. H owns Building II with a basis of $5,000 and a 
fair market value of $20,000, with respect to which H has incurred 
$1,000 of rehabilitation expenditures. G and H exchange their buildings 
in a transaction that qualifies for nonrecognition treatment under 
section 1031. Assume that G is treated under paragraph (c)(3)(ii) of 
this section as having incurred $1,000 of rehabilitation expenditures. 
G's

[[Page 383]]

basis in Building II, computed under section 1031(d), is $10,000. G's 
basis in Building II is not determined with reference to (A) the cost of 
Building II, (B) H's basis in Building II (including the cost of the 
rehabilitation expenditures) or (C) any other amount that includes the 
cost of expenditures, but is instead determined with reference to G's 
basis in other property (Building I). Therefore, G's basis in Building 
II for purposes of the substantial rehabilitation test is not reduced by 
the $1,000 of rehabilitation expenditures treated as if incurred by G. 
(See paragraph (b)(2)(vii) of this section.) Accordingly, G's basis in 
Building II for purposes of the substantial rehabilitation test is 
$10,000, and G must incur additional rehabilitation expenditures in 
excess of $9,000 within a measuring period selected by G to satisfy the 
test.

    (3) Retention of existing external walls and internal structural 
framework--(i) In general--(A) Property placed in service after December 
31, 1986. Except in the case of property that qualifies for the 
transition rules in paragraphs (a)(2)(iv) (B) and (C) of this section, 
in the case of property that is placed in service after December 31, 
1986, a building (other than a certified historic structure) meets the 
requirement in paragraph (b)(1)(iii) of this section only if in the 
rehabilitation process--
    (1) 50 percent or more of the existing external walls of such 
building are retained in place as external walls;
    (2) 75 percent or more of the existing external walls of such 
building are retained in place as internal or external walls; and
    (3) 75 percent or more of the internal structural framework of such 
building (as defined in paragraph (b)(3)(iii) of this section) is 
retained in place.
    (B) Expenditures incurred before January 1, 1984, for property 
placed in service before January 1, 1987. With respect to rehabilitation 
expenditures incurred before January 1, 1984, for property that is 
either placed in service before January 1, 1987, or that qualifies for 
the transition rules in paragraph (a)(2)(iv) (B) or (C) of this section, 
a building meets the requirement in paragraph (b)(1)(iii) of this 
section only if 75 percent or more of the existing external walls of the 
building are retained in place as external walls in the rehabilitation 
process. If an addition to a building is not treated as part of a 
qualified rehabilitated building because it does not meet the 30-year 
requirement in paragraph (b)(4)(i)(B) of this section, then the external 
walls of such addition shall not be considered to be existing external 
walls of the building for purposes of section 48(g)(1)(A)(iii) (as in 
effect prior to enactment of the Tax Reform Act of 1986), and this 
section.
    (C) Expenditures incurred after December 31, 1983, for property 
placed in service before January 1, 1987. With respect to expenditures 
incurred after December 31, 1983, for property that is either placed in 
service before January 1, 1987, or that qualifies for the transition 
rules in paragraph (a)(2)(iv) (B) or (C) of this section, the 
requirement of paragraph (b)(1)(iii) of this section is satisfied only 
if in the rehabilitation process either the existing external wall 
retention requirement in paragraph (b)(3)(i) (B) of this section is 
satisfied, or:
    (1) 50 percent or more of the existing external walls of the 
building are retained in place as external walls,
    (2) 75 percent or more of the existing external walls are retained 
in place as internal or external walls, and
    (3) 75 percent or more of the existing internal structural framework 
of such building is retained in place.
    (D) Area of external walls and internal structural framework. The 
determinations required by paragraphs (b)(3)(i) (A), (B), and (C) of 
this section shall be based upon the area of the external walls or 
internal structural framework that is retained in place compared to the 
total area of each prior to the rehabilitation. The area of the existing 
external walls and internal structural framework of a building shall be 
determined prior to any destruction, modification, or construction of 
external walls or internal structural framework that is undertaken by 
any party in anticipation of the rehabilitation.
    (ii) Definition of external wall. For purposes of this paragraph 
(b), a wall includes both the supporting elements of the wall and the 
nonsupporting elements, (e.g., a curtain, windows or doors) of the wall. 
Except as otherwise provided in this paragraph (b)(3), the term 
```external wall'' includes any wall that has one face exposed to the 
weather, earth, or an abutting wall of

[[Page 384]]

an adjacent building. The term ``external wall'' also includes a shared 
wall (i.e., a single wall shared with an adjacent building), generally 
referred to as a ``party wall,'' provided that the shared wall has no 
windows or doors in any portion of the wall that does not have one face 
exposed to the weather, earth, or an abutting wall. In general, the term 
``external wall'' includes only those external walls that form part of 
the outline or perimeter of the building or that surround an uncovered 
courtyard. Therefore, the walls of an uncovered internal shaft, designed 
solely to bring light or air into the center of a building, which are 
completely surrounded by external walls of the building and which 
enclose space not designated for occupancy or other use by people (other 
than for maintenance or emergency), are not considered external walls. 
Thus, for example, a wall of a light well in the center of a building is 
not an external wall. However, walls surrounding an outdoor space which 
is usable by people, such as a courtyard, are external walls.
    (iii) Definition of internal structural framework. For purposes of 
this section, the term ``internal structural framework'' includes all 
load-bearing internal walls and any other internal structural supports, 
including the columns, girders, beams, trusses, spandrels, and all other 
members that are essential to the stability of the building.
    (iv) Retained in place. An existing external wall is retained in 
place if the supporting elements of the wall are retained in place. An 
existing external wall is not retained in place if the supporting 
elements of the wall are replaced by new supporting elements. An 
external wall is retained in place, however, if the supporting elements 
are reinforced in the rehabilitation, provided that such supporting 
elements of the external wall are retained in place. An external wall 
also is retained in place if it is covered (e.g., with new siding). 
Moreover, an external wall is retained in place if the existing curtain 
is replaced with a new curtain, provided that the structural framework 
that provides for the support of the existing curtain is retained in 
place. An external wall is retained in place notwithstanding that the 
existing doors and windows in the wall are modified, eliminated, or 
replaced. An external wall is retained in place if the wall is 
disassembled and reassembled, provided the same supporting elements are 
used when the wall is reassembled and the configuration of the external 
walls of the building after the rehabilitation is the same as it was 
before the rehabilitation process commenced. Thus, for example, a brick 
wall is considered retained in place even though the original bricks are 
removed (for cleaning, etc.) and replaced to form the wall. The 
principles of this paragraph (b)(3)(iv) shall also apply to determine 
whether internal structural framework of the building is retained in 
place.
    (v) Effect of additions. If an existing external wall is converted 
into an internal wall (i.e., a wall that is not an external wall), the 
wall is not retained in place as an external wall for purposes of this 
section.
    (vi) Examples. The provisions of this paragraph (b)(3) may be 
illustrated by the following examples:

    Example 1. Taxpayer A rehabilitated a building all of the walls of 
which consisted of wood siding attached to gypsum board sheets (which 
covered the supporting elements of the wall, i.e., studs). A covered the 
existing wood siding with aluminum siding as part of a rehabilitation 
that otherwise qualified under this subparagraph. The addition of the 
aluminum siding does not affect the status of the existing external 
walls as external walls and they would be considered to have been 
retained in place.

    Example 2. Taxpayer B rehabilitated a building, the external walls 
of which had a masonry curtain. The masonry on the wall face was 
replaced with a glass curtain. The steel beam and girders supporting the 
existing masonry curtain were retained in place. The walls of the 
building are considered to be retained in place as external walls, 
notwithstanding the replacement of the curtain.

    Example 3. Taxpayer C rehabilitated a building that has two external 
walls measuring 75[foot] x 20[foot] and two other external walls 
measuring 100[foot] x 20[foot]. C demolished one of the larger walls, 
including its supporting elements and constructed a new wall. Because 
one of the larger walls represents more than 25 percent of the area of 
the building's external walls, C has not satisfied the requirements that 
75 percent of the existing external walls must be retained in place as 
either internal or external walls. If however, C had not demolished the 
wall, but had converted it into an internal wall (e.g., by building a

[[Page 385]]

new external wall), the building would satisfy the external wall 
requirements.

    Example 4. The facts are the same as in example 3, except that C 
does not tear down any walls, but builds an addition that results in one 
of the smaller walls becoming an internal wall. In addition, C enlarged 
8 of the existing windows on one of the larger walls, increasing them 
from a size of 3[foot] x 4[foot] to 6[foot] x 8[foot]. Since the smaller 
wall accounts for less than 25 percent of the total wall area, C has 
satisfied the requirement that 75 percent of the existing external walls 
must be retained in place as external walls in the rehabilitation 
process. The enlargement of the existing windows on the larger wall does 
not affect its status as an external wall.

    Example 5. Taxpayer D rehabilitated a building that was in the 
center of a row of three buildings. The building being rehabilitated by 
D shares its side walls with the buildings on either side. The shared 
walls measure 100[foot] x 20[foot] and the rear and front walls measure 
75[foot] x 20[foot]. As part of a rehabilitation, D tears down and 
replaces the front wall. Because the shared walls as well as the front 
and back walls are considered external walls and the front wall accounts 
for less than 25 percent of the total external wall area (including the 
shared walls), D has satisfied the requirement that 75 percent of the 
existing external walls must be retained in place as external walls in 
the rehabilitation process.

    (4) Age requirement--(i) In general--(A) Property placed in service 
after December 31, 1986. Except in the case of property that qualifies 
for the transition rules in paragraph (a)(2)(iv) (B) or (C) of this 
section, a building other than a certified historic structure shall not 
be considered a qualified rehabilitated building unless the building was 
first placed in service (within the meaning of     Sec. 1.46-3(d)) 
before January 1, 1936.
    (B) Property placed in service before January 1, 1987, and property 
qualifying under a transition rule. In the case of property placed in 
service before January 1, 1987, and property that qualifies under the 
transition rules in paragraph (a)(2)(iv) (B) or (C) of this section, a 
building other than a certified historic structure is considered a 
qualified rehabilitated building only if a period of at least 30 years 
has elasped between the date physical work on the rehabilitation of the 
building began and the date the building was first placed in service 
(within the meaning of Sec. 1.46-3(d)) as a building by any person.
    (ii) Additions. A building that was first placed in service before 
1936 in the case described in paragraph (b)(4)(i)(A) of this section, or 
at least 30 years before physical work on the rehabilitation began in 
the case described in paragraph (b)(4)(i)(B) of this section, will not 
be disqualified because additions to such building have been added since 
1936 in the case described in paragraph (b)(4)(i)(A) of this section, or 
are less than 30 years old in the case described in paragraph 
(b)(4)(i)(B) of this section. Such additions, however, shall not be 
treated as part of the qualified rehabilitated building. The term 
``addition'' means any construction that resulted in any portion of an 
external wall becoming an internal wall, that resulted in an increase in 
the height of the building, or that increased the volume of the 
building.
    (iii) Vacant periods. The determinations required by paragraph 
(b)(4)(i) of this section include periods during which a building was 
vacant or devoted to a personal use and is computed without regard to 
the number of owners or the identify of owners during the period.
    (5) Location at which the rehabilitation occurs. A building, other 
than a certified historic structure is not a qualified rehabilitated 
building unless it has been located where it is rehabilitated since 
before 1936 in the case described in paragraph (b)(4)(i)(A) of this 
section. Similarly, in the case described in paragraph (b)(4)(i)(B) of 
this section, a building, other than a certified historic structure, is 
not a qualified rehabilitation building unless it has been located where 
it is rehabilitated for the thirty-year period immediately preceding the 
date physical work on the rehabilitation began in the case of a ``30-
year building'' or the forty-year period immediately preceding the date 
physical work on the rehabilitation began in the case of a ``40-year 
building.'' (See     Sec. 1.46-1(q)(1)(iii) for the definitions of ``30-
year building'' and ``40-year building.'')
    (6) Definition and special rule--(i) Physical work on a 
rehabilitation. For purposes of this section, ``physical work on a 
rehabilitation'' begins when actual construction, or destruction in 
preparation for construction, begins.

[[Page 386]]

The term ``physical work on a rehabilitation,'' however, does not 
include preliminary activities such as planning, designing, securing 
financing, exploring, researching, developing plans and specifications, 
or stabilizing a building to prevent deterioration (e.g., placing boards 
over broken windows).
    (ii) Special rule for adjoining buildings that are combined. For 
purposes of this paragraph (b), if as part of a rehabilitation process 
two or more adjoining buildings are combined and placed in service as a 
single building after the rehabilitation process, then, at the election 
of the taxpayer, all of the requirements for a qualified rehabilitated 
building in section 48(g)(1) and this section may be applied to the 
constituent adjoining buildings in the aggregate. For example, if such 
requirements are applied in the aggregate, any shared walls or abutting 
walls between the constituent buildings that would otherwise be treated 
as external walls (within the meaning of paragraph (b)(3) of this 
section) would not be treated as external walls of the building, and the 
substantial rehabilitation test in paragraph (b)(2) of this section 
would be applied to the aggregate expenditures with respect to all of 
the constituent buildings and to the aggregate adjusted basis of all of 
the constituent buildings. A taxpayer shall elect the special rule of 
this paragraph (b)(6)(ii) for adjoining buildings by indicating by way 
of a marginal notation on, or a supplemental statement attached to, the 
Form 3468 on which a credit is first claimed for qualified 
rehabilitation expenditures with respect to such buildings that such 
buildings are a single qualified rehabilitated building because of the 
application of the special rule in this paragraph (b)(6)(ii).
    (c) Definition of qualified rehabilitation expenditures--(1) In 
general. Except as otherwise provided in paragraph (c)(7) of this 
section, the term ``qualified rehabilitation expenditure'' means any 
amount that is--
    (i) Properly chargeable to capital account (as described in 
paragraph (c)(2) of this section),
    (ii) Incurred by the taxpayer after December 31, 1981 (as described 
in paragraph (c)(3) of this section),
    (iii) For property for which depreciation is allowable under section 
168 and which is real property described in paragraph (c)(4) of this 
section, and
    (iv) Made in connection with the rehabilitation of a qualified 
rehabilitated building (as described in paragraph (c)(5) of this 
section).
    (2) Chargeable to capital account. For purposes of paragraph (c)(1) 
of this section, amounts are chargeable to capital account if they are 
properly includible in computing basis of real property under Sec. 1.46-
3(c). Amounts treated as an expense and deducted in the year they are 
paid or incurred or amounts that are otherwise not added to the basis of 
real property described in paragraph (c)(4) of this section do not 
qualify. For purposes of this paragraph (c), amounts incurred for 
architectural and engineering fees, site survey fees, legal expenses, 
insurance premiums, development fees, and other construction related 
costs, satisfy the requirement of this paragraph (c)(2) if they are 
added to the basis of real property that is described in paragraph 
(c)(4) of this section. Construction period interest and taxes that are 
amortized under section 189 (as in effect prior to its repeal by the Tax 
Reform Act of 1986) do not satisfy the requirement of this paragraph 
(c)(2). If, however, such interest and taxes are treated by the taxpayer 
as chargeable to capital account with respect to property described in 
paragraph (c)(4) of this section, they shall be treated in the same 
manner as other costs described in this paragraph (c)(2). Any 
construction period interest or taxes or other fees or costs incurred in 
connection with the acquisition of a building, any interest in a 
building, or land, are subject to paragraph (c)(7)(ii) of this section. 
See paragraph (c)(9) of this section for additional rules concerning 
interest.
    (3) Incurred by the taxpayer--(i) In general. Qualified 
rehabilitation expenditures are incurred by the taxpayer for purposes of 
this section on the date such expenditures would be considered incurred 
under an accrual method of accounting, regardless of the

[[Page 387]]

method of accounting used by the taxpayer with respect to other items of 
income and expense. If qualified rehabilitation expenditures are treated 
as having been incurred by a taxpayer under paragraph (c)(3)(ii) of this 
section, the taxpayer shall be treated as having incurred the 
expenditures on the date such expenditures were incurred by the 
transferor.
    (ii) Qualified rehabilitation expenditures treated as incurred by 
the taxpayer--(A) Where rehabilitation expenditures are incurred with 
respect to a building by a person (or persons) other than the taxpayer 
and the taxpayer subsequently acquires the building, or a portion of the 
building to which some or all of the expenditures are allocable (e.g., a 
condominium unit to which rehabilitation expenditures have been 
allocated), the taxpayer acquiring such property shall be treated as 
having incurred the rehabilitation expenditures actually incurred by the 
transferor (or treated as incurred by the transferor under this 
paragraph (c)(3)(ii)) allocable to the acquired property, provided that-
-
    (1) The building, or the portion of the building, acquired by the 
taxpayer was not used (or, if later, was not placed in service (as 
defined in paragraph (f)(2) of this section)) after the rehabilitation 
expenditures were incurred and prior to the date of acquisition, and
    (2) No credit with respect to such qualified rehabilitation 
expenditures is claimed by anyone other than the taxpayer acquiring the 
property. For purposes of this paragraph (c)(3)(ii), use shall mean 
actual use, whether personal or business. In the case of a building that 
is divided into condominium units, expenditures attributable to the 
common elements shall be allocable to the individual condominium units 
in accordance with the principles of paragraph (c)(10)(ii) of this 
section. Furthermore, for purpose of this paragraph (c)(3)(ii), a 
condominium unit's share of the common elements shall not be considered 
to have been used (or placed in service) prior to the time that the 
particular condominium unit is used.
    (B) The amount of rehabilitation expenditures described in paragraph 
(c)(3)(ii)(A) of this section treated as incurred by the taxpayer under 
this paragraph shall be the lesser of--
    (1) The amount of rehabilitation expenditures incurred before the 
date on which the taxpayer acquired the building (or portion thereof) to 
which the rehabilitation expenditures are attributable, or
    (2) The portion of the taxpayer's cost or other basis for the 
property that is properly allocable to the property resulting from the 
rehabilitation expenditures described in paragraph (c)(3)(ii)(B)(1) of 
this section.
    (C) For purposes of this paragraph (c)(3)(ii), the amount of 
rehabilitation expenditures treated as incurred by the taxpayer under 
this paragraph (c) shall not be treated as costs for the acquisition of 
a building. The portion of the cost of acquiring a building (or an 
interest therein) that is not treated under this paragraph as qualified 
rehabilitation expenditures incurred by the taxpayer is not treated as 
section 38 property in the hands of the acquiring taxpayer. (See 
paragraph (c)(7)(ii) of this section.) (See paragraph (b)(2)(vii) for 
rules concerning the application of the substantial rehabilitation test 
when expenditures are treated as incurred by the taxpayer.)
    (iii) Examples. The provisions of this paragraph (c) may be 
illustrated by the following examples:

    Example 1. In 1981, A, a taxpayer using the cash receipts and 
disbursements method of accounting, commenced the rehabilitation of a 
30-year old building. In June 1981, A signed a contract with a plumbing 
contractor for replacement of the plumbing in the building. A agreed to 
pay the contractor as soon as the work was completed. The work was 
completed in December 1981, but A did not pay the amount due until 
January 15, 1982. The expenditures for the plumbing are not qualified 
rehabilitation expenditures (within the meaning of this paragraph (c)) 
because they were not incurred under an accrual method of accounting 
after December 31, 1981.
    Example 2. B incurred qualified rehabilitation expenditures of 
$300,000 with respect to an existing building between January 1, 1982, 
and May 15, 1982, and then sold the building to C on June 1, 1982. The 
portion of the building to which the expenditures were allocable was not 
used by B or any other person during the period from January 1, 1982, to 
June 1, 1982, and neither B nor any other person claimed the credit. 
Consequently, C will be treated as having incurred the expenditures

[[Page 388]]

on the dates that B incurred the expenditures.
    Example 3. D, a taxpayer using the cash receipts and disbursements 
method of accounting, begins the rehabilitation of a building on January 
11, 1982. Prior to May 1, 1982, D makes rehabilitation expenditures of 
$16,000. On May 3, 1982, D sells the building, the land, and the 
property attributable to the rehabilitation expenditures to E for 
$35,000. The purchase price is properly allocable as follows:

Land...........................................................   $5,000
Existing building..............................................   11,000
Property attributable to rehabilitation expenditures...........   19,000
                                                                --------
      Total purchase price.....................................   35,000


    The property attributable to the rehabilitation expenditures is 
placed in service by E on September 5, 1982. E may treat a portion of 
the $35,000 purchase price as rehabilitation expenditures paid or 
incurred by him. Since the rehabilitation expenditures paid by D 
($16,000) are less than the portion of the purchase price properly 
allocable to property attributable to these expenditures ($19,000), E 
may treat only $16,000 as rehabilitation expenditures paid or incurred 
by him. The excess of the purchase price allocable to rehabilitation 
expenditures ($19,000) over the rehabilitation expenditures paid by D 
($16,000), or $3,000, is treated as the cost of acquiring an interest in 
the building and is not a qualified rehabilitation expenditure treated 
as incurred by E.
    Example 4. The facts are the same as in example 3, except that the 
purchase price properly allocable to the property attributable to 
rehabilitation expenditures is $15,000. Under these circumstances, E may 
treat only $15,000 of D's $16,000 expenditures as rehabilitation 
expenditures paid by D. The excess of the rehabilitation expenditures 
paid by D ($16,000) over the purchase price allocable to rehabilitation 
expenditures ($15,000), or $1,000, is treated as the cost of acquiring 
an interest in the building and is not a qualified rehabilitation 
expenditure treated as incurred by E.

    (4) Incurred for depreciable real property--(i) Property placed in 
service after December 31, 1986. Except as otherwise provided in 
paragraph (c)(4)(ii) of this section (relating to certain property that 
qualifies under a transition rule), in the case of property placed in 
service after December 31, 1986, an expenditure is incurred for 
depreciable real property for purposes of paragraph (c)(1)(iii) of this 
section, only if it is added to the depreciable basis of depreciable 
property which is--
    (A) Nonresidential real property,
    (B) Residential rental property,
    (C) Real property which has a class life of more than 12.5 years, or
    (D) An addition or improvement to property described in paragraph 
(c)(4)(i) (A), (B), or (C) of this section.

For purposes of this paragraph (c)(4)(i), the terms ``nonresidential 
real property'', ``residential rental property'', and ``class life'' 
have the respective meanings given to such terms by section 168 and the 
regulations thereunder.
    (ii) Property placed in service before January 1, 1987, and property 
that qualifies under a transition rule. In the case of property placed 
in service before January 1, 1987, and property placed in service after 
December 31, 1986, that qualifies for the transition rules in paragraph 
(a)(2)(iv) (B) or (C) of this section, an expenditure attributable to 
such property shall be a qualified rehabilitation expenditure only if 
such expenditure is incurred for property that is real property (or 
additions or improvements to real property) with a recovery period 
(within the meaning of section 168 as in effect prior to its amendment 
by the Tax Reform Act of 1986) of 19 years (15 years for low-income 
housing) and if the other requirements of this paragraph (c) are met. 
For purposes of this section, an expenditure is incurred for recovery 
property having a recovery period of 19 years only if the amount of the 
expenditure is added to the basis of property which is 19-year real 
property or 15-year real property in the case of low-income housing. For 
purposes of this section, the term ``low-income housing'' has the 
meaning given such term by section 168(c)(2)(F) (as in effect prior to 
the amendments made by the Tax Reform Act of 1986).
    (5) Made in connection with the rehabilitation of a qualified 
rehabilitated building. In order for an expenditure to be a qualified 
rehabilitation expenditure, such expenditure must be incurred in 
connection with a rehabilitation (as defined in paragraph (b)(2)(iv) of 
this section) of a qualified rehabilitated building. Expenditures 
attributable to work done to facilities related to a building (e.g., 
sidewalk,

[[Page 389]]

parking lot, landscaping) are not considered made in connection with the 
rehabilitation of a qualified rehabilitated building.
    (6) When expenditures may be incurred. An expenditure is a qualified 
rehabilitation expenditure only if the building with respect to which 
the expenditures are incurred is substantially rehabilitated (within the 
meaning of paragraph (b)(2) of this section) for the taxable year in 
which the property attributable to the expenditures is placed in service 
(i.e., the building is substantially rehabilitated during a measuring 
period ending with or within the taxable year in which a credit is 
claimed). (See paragraph (f)(2) of this section for rules relating to 
when property is placed in service.) Once the substantial rehabilitation 
test is met for a taxable year, the amount of qualified rehabilitation 
expenditures upon which a credit can be claimed for the taxable year is 
limited to expenditures incurred:
    (i) Before the beginning of a measuring period during which the 
building was substantially rehabilitated that ends with or within the 
taxable year, provided that the expenditures were incurred in connection 
with the rehabilitation process that resulted in the substantial 
rehabilitation of the building;
    (ii) Within a measuring period during which the building was 
substantially rehabilitated that ends with or within the taxable year, 
and
    (iii) After the end of a measuring period during which the building 
was substantially rehabilitated but prior to the end of the taxable year 
with or within which the measuring period ends.
    (7) Certain expenditures excluded from qualified rehabilitation 
expenditures. The term ``qualified rehabilitation expenditures'' does 
not include the following expenditures:
    (i) Except as otherwise provided in paragraph (c)(8) of this 
section, any expenditure with respect to which the taxpayer does not use 
the straight line method over a recovery period determined under section 
168 (c) and (g).
    (ii) The cost of acquiring a building, any interest in a building 
(including a leasehold interest), or land, except as provided in 
paragraph (c)(3)(ii) of this section.
    (iii) Any expenditure attributable to an enlargement of a building 
(within the meaning of paragraph (c)(10) of this section).
    (iv) Any expenditure attributable to the rehabilitation of a 
certified historic structure or a building located in a registered 
historic district, unless the rehabilitation is a certified 
rehabilitation. (See paragraph (d) of this section which contains 
definitions and special rules applicable to rehabilitations of certified 
historic structures and buildings located in registered historic 
districts.)
    (v) Any expenditure of a lessee of a building or a portion of a 
building, if, on the date the rehabilitation is completed with respect 
to property placed in service by such lessee, the remaining term of the 
lease (determined without regard to any renewal period) is less than the 
recovery period determined under section 168(c) (or 19 years in the case 
of property placed in service before January 1, 1987, and property 
placed in service that qualifies under the transition rules in paragraph 
(a)(2)(iv)(B) or (C) of this section).
    (vi) Any expenditure allocable to that portion of a building which 
is (or may reasonably be expected to be) tax-exempt use property (within 
the meaning of section 168 and the regulations thereunder), except that 
the exclusion in this paragraph (c)(7)(vi) shall not apply for purposes 
of determining whether the building is a substantially rehabilitated 
building under paragraph (b)(2) of this section.
    (8) Requirement to use straight line depreciation--(i) Property 
placed in service after December 31, 1986. The requirement in section 
48(g)(2)(B)(i) and paragraph (c)(7)(i) of this section to use straight 
line cost recovery does not apply to any expenditure to the extent that 
the alternative depreciation system of section 168(g) applies to such 
expenditure by reason of section 168(g)(1) (B) or (C). In addition, the 
requirement in section 48(g)(2)(B)(i) and paragraph (c)(7)(i) of this 
section applies only to the depreciation of the portion of the basis of 
a qualified rehabilitated building that is attributable to qualified 
rehabilitation expenditures.
    (ii) Property placed in service before January 1, 1987, and property 
placed in

[[Page 390]]

service after December 31, 1986, that qualifies for a transition rule. 
In the case of expenditures attributable to property placed in service 
before January 1, 1987, and property that qualifies for the transition 
rules in paragraph (a)(2)(iv) (B) or (C) of this section, the term 
``qualified rehabilitation expenditure'' does not include an expenditure 
with respect to which an election was not made under section 168(b)(3) 
as in effect prior to its amendment by the Tax Reform Act of 1986, to 
use the straight line method of depreciation. In such case, the 
requirement that an election be made to use straight line cost recovery 
applies only to the cost recovery of the portion of the basis of a 
qualified rehabilitated building that is attributable to qualified 
rehabilitation expenditures. See section 168(f)(1), as in effect prior 
to its amendment by the Tax Reform Act of 1986, for rules relating to 
the use of different methods of cost recovery for different components 
of a building. In addition, such requirement shall not apply to any 
expenditure to the extent that section 168(f)(12) or (j), as in effect 
prior to the amendments made by the Tax Reform Act of 1986, applied to 
such expenditure.
    (9) Cost of acquisition. For purposes of paragraph (c)(7)(ii) of 
this section, cost of acquisition includes any interest incurred on 
indebtedness the proceeds of which are attributable to the acquisition 
of a building, an interest in a building, or land open which a building 
exists. Interest incurred on a construction loan the proceeds of which 
are used for qualified rehabilitation expenditures, however, is not 
treated as a cost of acquisition.
    (10) Enlargement defined--(i) In general. A building is enlarged to 
the extent that the total volume of the building is increased. An 
increase in floor space resulting from interior remodeling is not 
considered an enlargement. The total volume of a building is generally 
equal to the product of the floor area of the base of the building and 
the height from the underside of the lowest floor (including the 
basement) to the average height of the finished roof (as it exists or 
existed). For this purpose, floor area is measured from the exterior 
faces of external walls (other than shared walls that are external 
walls) and from the centerline of shared walls that are external walls.
    (ii) Rehabilitation that includes enlargement. If expenditures for 
property only partially qualify as qualified rehabilitation expenditures 
because some of the expenditures are attributable to the enlargement of 
the building, the expenditures must be apportioned between the original 
portion of the building and the enlargement. The expenditures must be 
specifically allocated between the original portion of the building and 
the enlargement to the extent possible. If it is not possible to make a 
specific allocation of the expenditures, the expenditures must be 
allocated to each portion on some reasonable basis. The determination of 
a reasonable basis for an allocation depends on factors such as the type 
of improvement and how the improvement relates functionally to the 
building. For example, in the case of expenditures for an air-
conditioning system or a roof, a reasonable basis for allocating the 
expenditures among the two portions generally would be the volume of the 
building, excluding the enlargement, served by the air-conditioning 
system or the roof relative to the volume of the enlargement served by 
the improvement.
    (d) Rules applicable to rehabilitations of certified historic 
structures--(1) Definition of certified historic structure. The term 
``certified historic structure'' means any building (and its structural 
components) that is--
    (i) Listed in the National Register of Historic Places (``National 
Register''); or
    (ii) Located in a registered historic district and certified by the 
Secretary of the Interior to the Internal Revenue Service as being of 
historic significance to the district.

For purposes of this section, a building shall be considered to be a 
certified historic structure at the time it is placed in service if the 
taxpayer reasonably believes on that date the building will be 
determined to be a certified historic structure and has requested on or 
before that date a determination from the Department of Interior that 
such building is a certified historic structure within the meaning of 
this

[[Page 391]]

paragraph (d)(1)(i) or (ii) and the Department of Interior later 
determines that the building is a certified historic structure.
    (2) Definition of registered historic district. The term 
``registered historic district'' means any district that is--
    (i) Listed in the National Register, or
    (ii) (A) Designated under a statute of the appropriate State or 
local government that has been certified by the Secretary of the 
Interior to the Internal Revenue Service as containing criteria that 
will substantially achieve the purpose of preserving and rehabilitating 
buildings of historic significance to the district, and (B) certified by 
the Secretary of the Interior as meeting substantially all of the 
requirements for the listing of districts in the National Register.
    (3) Definition of certified rehabilitation. The term ``certified 
rehabilitation'' means any rehabilitation of a certified historic 
structure that the Secretary of the Interior has certified to the 
Internal Revenue Service as being consistent with the historic character 
of the building and, where applicable, the district in which such 
building is located. The determination of the scope of a rehabilitation 
shall be made on the basis of all the facts and circumstances 
surrounding the rehabilitation and shall not be made solely on the basis 
of ownership. The Secretary of the Interior shall take all of the 
rehabilitation work performed as part of a single rehabilitation, 
including any post-certification work, into account in determining 
whether the rehabilitation complies with the Department of Interior 
standards for rehabilitation and whether the certification should be 
granted, revoked, or otherwise invalidated.
    (4) Revoked or invalidated certification. If the Department of 
Interior revokes or otherwise invalidates a certification after it has 
been issued to a taxpayer, the basis attributable to rehabilitation of 
the decertified property shall cease to be section 38 property described 
in section 48(a)(1)(E). Such cessation shall be effective as of the date 
the activity giving rise to the revocation or invalidation commenced. 
See section 47 for the rules applicable to property that ceases to be 
section 38 property.
    (5) Special rule for certain buildings located in registered 
historic districts. The exclusion in paragraph (c)(7)(iv) of this 
section does not apply to a building in a registered historic district 
if--
    (i) Such building was not a certified historic structure during the 
rehabilitation process; and
    (ii) The Secretary of the Interior certified to the Internal Revenue 
Service that such building was not of historic significance to the 
district.

In general, the certification referred to in paragraph (d)(5)(ii) of 
this section must be requested by the taxpayer prior to the time that 
physical work on the rehabilitation began. If, however, the 
certification referred to in paragraph (d)(5)(ii) of this section is 
requested by the taxpayer after physical work on the rehabilitation of 
the building has begun, the taxpayer must certify to the Internal 
Revenue Service that, prior to the date that physical work on the 
rehabilitation began, the taxpayer in good faith was not aware of the 
requirement of paragraph (d)(5)(ii) of this section. The certification 
referred to in the previous sentence must be attached to the Form 3468 
filed with the tax return for the year in which the credit is claimed.
    (6) Special rule for certain rehabilitations begun before an area is 
designated as a registered historic district. In general, the exclusion 
from the definition of qualified rehabilitation expenditure in paragraph 
(c)(7)(iv) of this section applies to any rehabilitation expenditures 
that are incurred after a building becomes a certified historic 
structure within the meaning of section 48 (g)(3)A) and paragraph (d)(1) 
of this section or the area in which a building is located becomes a 
registered historic district within the meaning of section 48 (g)(3)(B) 
and paragraph (d)(2) of this section. Rehabilitation expenditures 
incurred prior to such date, however, are not disqualified. In addition, 
rehabilitation expenditures made after the date the area in which a 
building is located becomes a registered historic district shall not be 
disqualified under paragraph (c)(7)(iv) of this section in any case in 
which physical work on the rehabilitation of a building begins prior to 
the date the taxpayer knows or has reason to know of an intention to

[[Page 392]]

nominate the area in which such building is located as a registered 
historic district. For purposes of this paragraph (d)(6), the taxpayer 
knows or has reason to know of such an intention if there is (A) a 
communication (written or oral) to the owner of any building within the 
district from the Department of the Interior, or any agency or 
instrumentality of the appropriate state or local government (or a 
designee of such agency or instrumentality) that the district in which 
the building is located is being considered for designation as a 
registered historic district, (B) a legal notice of such consideration 
published in a newspaper, or (C) a public meeting held to discuss such 
consideration. In order to take advantage of the special rule of this 
paragraph (d)(6), the taxpayer must attach to the Form 3468 filed for 
the taxable year in which the credit is claimed a statement that the 
taxpayer in good faith did not know, or have reason to know, of an 
intention to nominate the area in which the building is located as a 
registered historic district.
    (7) Notice of certification--(i) In general. Except as otherwise 
provided in paragraph (d)(7)(ii) of this section, a taxpayer claiming 
the credit for rehabilitation of a certified historic structure (within 
the meaning of section 48(g)(3) and paragraph (d)(1) of this section) 
must attach to the Form 3468 filed with the tax return for the taxable 
year in which the credit is claimed a copy of the final certification of 
completed work by the Secretary of the Interior, and for returns filed 
after January 9, 1989, evidence that the building is a certified 
historic structure.
    (ii) Late certification. If the final certification of completed 
work has not been issued by the Secretary of the Interior at the time 
the tax return is filed for a year in which the credit is claimed, a 
copy of the first page of the Historic Preservation Certification 
Application--Part 2--Description of Rehabilitation (NPS Form 10-168a), 
with an indication that it has been received by the Department of the 
Interior or its designate, together with proof that the building is a 
certified historic structure (or that such status has been requested), 
must be attached to the Form 3468 filed with the return. A notice from 
the Department of the Interior or the State Historic Preservation 
Officer, stating that the nomination or application has been received, 
or a date-stamped nomination or application shall be sufficient 
indication that the nomination or application has been received. The 
building need not be either listed in the National Register or be 
determined to be of historic significance to a registered historic 
district at the time the return is filed for the year in which the 
credit is claimed. (See paragraph (d)(1) of this section.) The taxpayer 
must submit a copy of the final certification as an attachment to Form 
3468 with the first income tax return filed after the receipt by the 
taxpayer of the certification. If the final certification is denied by 
the Department of Interior, the credit will be disallowed for any 
taxable year in which it was claimed. If the taxpayer fails to receive 
final certification of completed work prior to the date that is 30 
months after the date that the taxpayer filed the tax return on which 
the credit was claimed, the taxpayer must submit a written statement to 
the District Director stating such fact prior to the last day of the 
30th month, and the taxpayer shall be requested to consent to an 
agreement under section 6501(c)(4) extending the period of assessment 
for any tax relating to the time for which the credit was claimed. The 
procedure permitted by the preceding sentence shall be used whenever the 
entire rehabilitation project is not fully completed by the date that is 
30 months after the taxpayer filed the tax return upon which the credit 
was claimed (e.g. a phased rehabilitation) and the Secretary of the 
Interior has thus not yet certified the rehabilitation.
    (iii) Effective dates. Paragraph (d)(7)(i) of this section applies 
to returns for taxable years beginning before January 1, 2002. The 
requirement in the fourth sentence of paragraph (d)(7)(ii) of this 
section applies only if the first income tax return filed after receipt 
by the taxpayer of the certification is for a taxable year beginning 
before January 1, 2002. For rules applicable to returns for taxable 
years beginning after December 31, 2001, see paragraph (d)(7)(iv) of 
this section.

[[Page 393]]

    (iv) Returns for taxable years beginning after December 31, 2001--
(A) In general. Except as otherwise provided in paragraph (d)(7)(ii) of 
this section and this paragraph (d)(7)(iv), a taxpayer claiming the 
credit for rehabilitation of a certified historic structure (within the 
meaning of section 47(c)(3) and paragraph (d)(1) of this section) for a 
taxable year beginning after December 31, 2001, must provide with the 
return for the taxable year in which the credit is claimed, the NPS 
project number assigned by, and the date of the final certification of 
completed work received from, the Secretary of the Interior. If a credit 
(including a credit for a taxable year beginning before January 1, 2002) 
is claimed under the late certification procedures of paragraph 
(d)(7)(ii) of this section and the first income tax return filed by the 
taxpayer after receipt of the certification is for a taxable year 
beginning after December 31, 2001, the taxpayer must provide the NPS 
project number assigned by, and the date of the final certification of 
completed work received from, the Secretary of the Interior with that 
return.
    (B) Reporting and recordkeeping requirements. The information 
required under paragraph (d)(7)(iv)(A) of this section must be provided 
on Form 3468 (or its successor) filed with the taxpayer's return. In 
addition, the taxpayer must retain a copy of the final certification of 
completed work for as long as its contents may become material in the 
administration of any internal revenue law.
    (C) Passthrough entities. In the case of a credit for qualified 
rehabilitation expenditures of a partnership, S corporation, estate, or 
trust, the requirements of this paragraph (d)(7)(iv) apply only to the 
entity. Each partner, shareholder or beneficiary claiming a credit for 
such qualified rehabilitation expenditures from a passthrough entity 
must, however, provide the employer identification number of the entity 
on Form 3468 (or its successor).
    (e) Adjustment to basis--(1) General rule. Except as otherwise 
provided by this paragraph (e), if a credit is allowed with respect to 
property attributable to qualified rehabilitation expenditures incurred 
in connection with the rehabilitation of a qualified rehabilitated 
building, the increase in the basis of the rehabilitated property that 
would otherwise result from the qualified rehabilitation expenditures 
must be reduced by the amount of the credit allowed. See section 48(q) 
and the regulations there under for other rules concerning adjustments 
to basis in the case of section 38 property.
    (2) Special rule for certain property relating to certified historic 
structures. If a rehabilitation investment credit is allowed with 
respect to property that is placed in service before January 1, 1987, or 
property that qualifies for the transition rules in paragraph (a)(2)(iv) 
(B) or (C) of this section, and such property is attributable to 
qualified rehabilitation expenditures incurred in connection with the 
rehabilitation of a certified historic structure, the increase in the 
basis of the rehabilitated property that would otherwise result from the 
qualified rehabilitation expenditures must be reduced by one-half of the 
amount of the credit allowed.
    (3) Recapture of rehabilitation investment credit. If during any 
taxable year there is a recapture amount determined with respect to any 
credit that resulted in a basis adjustment under paragraph (e) (1) or 
(2) of this section, the basis of such building (immediately before the 
event resulting in such recapture) shall be increased by an amount equal 
to such recapture amount. For purposes of the preceding sentence, the 
term `'recapture amount'' means any increase in tax (or adjustment in 
carrybacks or carryovers) determined under section 47(a)(5).
    (f) Coordination with other provisions of the Code--(1) Credit 
claimed by lessee for rehabilitation performed by lessor. A lessee may 
take the credit for rehabilitation performed by the lessor if the 
requirements of this section and section 48(d) are satisfied. For 
purposes of applying section 48(d), the fair market value of section 38 
property described in section 48(a)(1)(E) shall be limited to that 
portion of the lessor's basis in the qualified rehabilitated building 
that is attributable to qualified rehabilitation expenditures. In the 
case of a portion of a building that is divided into more

[[Page 394]]

than one leasehold interest, the qualified rehabilitation expenditures 
attributable to the common elements shall be allocated to the individual 
leasehold interests in accordance with the principles of paragraph 
(c)(10)(ii) of this section. Furthermore, a leasehold interest's share 
of the common elements shall not be considered to have been placed in 
service prior to the time that the particular leasehold interest is 
placed in service.
    (2) When the credit may be claimed--(i) In general. The investment 
credit for qualified rehabilitation expenditures is generally allowed in 
the taxable year in which the property attributable to the expenditure 
is placed in service, provided the building is a qualified rehabilitated 
building for the taxable year. See paragraph (b) of this section and 
section 46(c) and Sec. 1.46-3(d). Under certain circumstances, however, 
the credit may be available prior to the date the property is placed in 
service. See section 46(d) and Sec. 1.46-5 (relating to qualified 
progress expenditures). Solely for purposes of section 46(c), property 
attributable to qualified rehabilitation expenditures will not be 
treated as placed in service until the building with respect to which 
the expenditures are made meets the definition of a qualified 
rehabilitated building (as defined in section 48(g)(1) and paragraph (b) 
of this section) for the taxable year. Accordingly, in the first taxable 
year for which the building becomes a qualified rehabilitated building, 
the property described in section 48(a)(1)(E) attributable to 
expenditures described in paragraph (c) of this section, shall be 
considered to be placed in service, if such property was considered 
placed in service under section 46(c) and the regulations thereunder 
without regard to this paragraph (f)(2)(i) in that taxable year or a 
prior taxable year. For purposes of the preceding sentence, the 
requirement of section 48(g)(1)(A)(iii) and paragraph (b)(3) of this 
section, relating to the definition of a qualified rehabilitated 
building shall be deemed to be met if the taxpayer reasonably expects 
that no rehabilitation work undertaken during the remainder of the 
rehabilitation process will result in a failure to satisfy the 
requirements of paragraph (b)(3) of this section. If the requirements of 
paragraph (b)(3) of this section, are not satisfied, however, the credit 
shall be disallowed for the taxable year in which it was claimed. If a 
taxpayer fails to complete physical work on the rehabilitation prior to 
the date that is 30 months after the date that the taxpayer filed a tax 
return on which the credit is claimed, the taxpayer must submit a 
written statement to the District Director stating such fact prior to 
the last day of the 30th month, and shall be requested to consent to an 
agreement under section 6501(c)(4) extending the period of assessment 
for any tax relating to the item for which the credit was claimed.
    (ii) Section 38 property described in section 48(a)(1)(E). In the 
case of section 38 property described in section 48(a)(1)(E), the 
section 38 property is not the building. Instead, the section 38 
property is the portion of the basis of the building that is 
attributable to qualified rehabilitation expenditures. Therefore, for 
example, for purposes of the determination of when such section 38 
property is placed in service, a determination must be made regarding 
when property attributable to the portion of the basis of the building 
attributable to qualified rehabilitation expenditures is placed in 
service. The issue of when the building is placed in service is thus not 
relevant. In fact, under this test, the building itself may never have 
been taken out of service during the rehabilitation process. If the 
building is rehabilitated over several years in stages (e.g., by 
floors), section 38 property attributable to qualified rehabilitation 
expenditures to a qualified rehabilitated building placed in service in 
each taxable year shall, generally, be treated as a separate item of 
section 38 property.
    (iii) Example. The application of this paragraph (f)(2) may be 
illustrated by the following example:

    Example. Assume that A, a calendar year taxpayer, purchases a four-
story building on January 1, 1983, for $100,000, and incurs $10,000 of 
qualified rehabilitation expenditures in 1983 to rehabilitate floor one, 
$50,000 of qualified rehabilitation expenditures in 1984 to rehabilitate 
floor two, $70,000 of qualified rehabilitation expenditures in 1985 to 
rehabilitate floor three, and $60,000 of qualified

[[Page 395]]

rehabilitation expenditures in 1986 to rehabilitate floor four. Assume 
further that A places the property attributable to these expenditures in 
service on the last day of the year in which the respective expenditures 
were incurred and that the building is never taken out of service since 
as each floor is rehabilitated, the other three floors are occupied by 
tenants. Under the rule in this paragraph (f)(2), the portion of the 
basis of the building that is attributable to qualified rehabilitation 
expenditures incurred with respect to floor one and two are deemed to be 
placed in service in 1985, because that is the first year that the 
substantial rehabilitation test described in paragraph (b) of this 
section is met ($120,000 of expenditures incurred by A during a 
measuring period ending on December 31, 1985 is greater than the 
$110,000 basis at the beginning of the period). Assume that as of 
December 31, 1985, at least 75 percent of the external walls of the 
building have been retained during the rehabilitation process and that A 
has a reasonable expectation that no work during the remainder of the 
rehabilitation process will result in less than 75 percent of the 
external walls being retained. A may claim a credit for A's 1985 taxable 
year on $130,000 of qualified rehabilitation expenditures ($10,000 in 
1983, $50,000 in 1984, and $70,000 in 1985). (See paragraph (c)(6) of 
this section for rules applicable to when qualified expenditures may be 
incurred. In addition, see section 46 (d) and Sec. 1.46-5 for rules 
relating to qualified progress expenditures.) The fact that the building 
was a qualified rehabilitated building for A's 1985 taxable year, 
however, has no effect on whether the building is a qualified 
rehabilitated building for A's 1986 taxable year. In order to determine 
whether A is entitled to claim a credit on A's 1986 return for the 
$60,000 of qualified rehabilitation expenditures incurred in 1986, A 
must select a measuring period ending in 1986 and must determine whether 
the building is a qualified rehabilitated building for that year. Solely 
for purposes of determining whether the building was substantially 
rehabilitated, expenditures incurred in 1984 and 1985, even though 
considered in determining whether the building was substantially 
rehabilitated for A's 1985 taxable year, may be used in addition to the 
expenditures incurred in 1986 to determine whether the building was 
substantially rehabilitated for A's 1986 taxable year, provided the 
expenditures were incurred during any measuring period selected by A 
that ends in 1986.

    (3) Coordination with section 47. If property described in section 
48(a)(1)(E) is disposed of by the taxpayer, or otherwise ceases to be 
``section 38 property,'' section 47 may apply. Property will cease to be 
section 38 property, and therefore section 47 may apply, in any case in 
which the Department of Interior revokes or otherwise invalidates a 
certification of rehabilitation after the property is placed in service 
or a building (other than a certified historic structure) is moved from 
the place where it is rehabilitated after the property is placed in 
service. If, for example, the taxpayer made modifications to the 
building inconsistent with Department of Interior standards, the 
Secretary of the Interior might revoke the certification. In addition, 
if all or a portion of a substantially rehabilitated building becomes 
tax-exempt use property (see paragraph (c)(7)(vi) of this section) for 
the first time within five years after the credit is claimed, the credit 
will be recaptured under section 47 at that time as if the building or 
portion of the building which becomes tax-exempt use property had then 
been sold.

[T.D. 8233, 53 FR 39592, Oct. 11, 1988; 53 FR 43866, Oct. 31, 1988, as 
amended by T.D. 8989, 67 FR 20030, Apr. 24, 2002; T.D. 9040, 68 FR 4920, 
Jan. 31, 2003]