Recapture – What it is and When it Occurs

Although taxpayers claim the low-income housing credit over a ten-year period, the owner of a low-income housing tax credit project is required to provide low-income housing in compliance with IRC §42 for 15 years (the compliance period). In effect, the taxpayer is claiming credit in advance of providing housing during the last five years after the credit period has ended. As a result, 1/3 of the credit claimed each year during the ten-year credit period is associated with the provision of housing during years 11 through 15 of the compliance period.

The 1/3 portion of the credit claimed each year is known as the “accelerated portion” of the credit. The accelerated portion of the credit subject to recapture decreases during the last five years of the compliance period as the taxpayer provides the housing for which the taxpayer claimed the accelerated credit during the credit period.

The recapture of accelerated credit claimed for years prior to the year of an audit is a separate adjustment and is characterized as an addition to the liability of a taxpayer. A taxpayer may self-report a credit recapture amount on IRS Form 8611, Recapture of Low-Income Housing Credit.

When is Recapture an Issue?

Under IRC §42(j)(1), if the qualified basis of a building at the close of any taxable year in the compliance period is less than the building’s qualified basis at the close of the preceding taxable year, then the taxpayer’s federal income tax for that year is increased by the credit recapture amount. Recapture may not be an issue if the taxpayer discovers the noncompliance (as opposed to discovery by the State Agency or IRS) and corrects the noncompliance within a reasonable period from when it is discovered or should have been discovered. Recapture is also not required in the event of a casualty loss (to be discussed below).

Credit Recapture Amount

The credit recapture amount is essentially equal to the accelerated credit claimed for all taxable years prior to the year of noncompliance, plus interest at the IRS established rate. The amount is reduced in the last five years of the compliance period since the accelerated credit is being earned at that point.

If the reduction in qualified basis leaves remaining qualified basis in an amount equal to or more than the maximum qualified basis identified by the state agency on Line 3a of the IRS Form 8609, then there is no reduction of credit or corresponding recapture on the decrease. This is due to what is known as “excess basis.”

Note also that the recapture rules do not apply when a credit is disallowed based on an adjustment to the applicable percentage.

Accelerated Portion of the Credit

For any year of the ten-year credit period, the accelerated portion of the credit equals one-third of the allowable annual credit.

For the first ten years, the entire accelerated portion of the credit, 5/15, is subject to recapture. As the owner provides the low-income housing associated with the accelerated portion of the credit claimed in prior years during the last five years of the compliance period, the accelerated portion of the credit subject to recapture decreases.

If there is a decrease in qualified basis during the 11th year of the compliance period, when the accelerated credit has still not been “earned,” the recapture rate remains 0.333 or 5/15. Thereafter, the recapture rate decreases 1/15 for every year the owner provides low-income housing after the end of the ten-year credit period. This is reflected as follows:

  • 4/15 or 0.267 for year 12;
  • 3/15 or 0.200 for year 13;
  • 2/15 or 0.133 for year 14; and
  • 1/15 or 0.067 for year 15.

The following example illustrates the math:

  • Decrease in qualified basis during the 13th year of the Compliance period.
  • The allocation of credit was based on a qualified basis of $1,000,000 and an applicable percentage of 0.0900 (the 9% credit). The allowable annual credit amount is $90,000.
  • The tax return for the 13th year of the compliance period is audited and the IRS determines that the correct qualified basis was $750,000. The adjustment to qualified basis is $250,000.
  • To calculated the recapture, determine the credit associated with the $250,000 basis reduction. $250,000 X .0900 = $22,500. The recapture rate in year 13 is 3/15 or 0.200.
    • $22,500 X 0.200 = $4,500 in recapture for each year of the ten-year credit period or a total recapture of $45,000.

Casualty Losses

Under IRC §42(j)(4)(E), the recapture provisions do not apply if the reduction in qualified basis results from a casualty loss if the lost qualified basis is restored by reconstruction or replacement within a reasonable time established by the Secretary of the Treasury.

Casualty loss is defined as the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual. Property damage is not considered a casualty loss if the damage occurred during normal use, the owner willfully caused the damage or was willfully negligent, or was progressive deterioration such as damage caused by termites.

If the taxpayer fails to restore or replace the lost qualified basis within a reasonable period, then the recapture provisions are applied for the tax year in which the casualty event occurred. Also, IRC §42(j)(4)(E) only provides recapture relief for casualty events; it does not provide for the allowance of credit during the period of time that the building is being restored (except in the case of a Presidentially Declared Disaster Area).

Noncompliance with the Nonprofit Set-Aside – §42(h)(5)

The §42 recapture provisions are not applicable when the rules relating to the nonprofit set-aside are violated. However, the credit may be disallowed in its entirety if the nonprofit set-aside rules are violated. For example, if a nonprofit is not materially participating in the ongoing operation of a project for two years of the credit period, the credit for those two years may be disallowed, but there will be no recapture for prior years.

Noncompliance with §42(h)(6), Extended Use Agreement

Recapture provisions are not applicable due to an owner’s violation of the tax credit extended use agreement.

Disposition Other than by Foreclosure or Transaction in Lieu of Foreclosure

Generally, the disposition of a low-income building (or interest therein) is a credit recapture event. However, the credit recapture provisions are not applicable under specific circumstances if the disposition was not by foreclosure or a transaction in lieu of foreclosure.

Credit recapture provisions are not applicable solely by reason of the disposition of a qualified low-income building (or interest therein) if it is reasonably expected that the building will continue to be operated as a qualified low-income building for the remainder of the building’s 15-year compliance period.

Disposition by Foreclosure or Transaction in Lieu of Foreclosure

In the event of a foreclosure (or transaction in lieu of foreclosure), the extended use period is terminated and the building is no longer a qualified low-income building. The termination of the extended use period results in the disallowance of the credit for the year of disposition (unless the new owner enters into a new extended use agreement by the close of the year of disposition), but does not automatically result in recapture. The disposition is treated like any other disposition of the property. The question is whether the taxpayer has a reasonable expectation that the building will continue to be operated as a qualified low-income building for the remainder of the building’s 15-year compliance period.

Summary

The critical issues to determine in order to apply the §42 recapture rules are whether the qualified basis for a building has been reduced, and if so, the applicable year of the compliance period. Not all noncompliance results in a qualified basis reduction (e.g., lack of nonprofit participation). However, much of the noncompliance resulting from management errors will lower qualified basis, such as renting to ineligible residents and charging excess rent. For this reason, the best defense against recapture is sound management and oversight of Section 42 properties.

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