How to Avoid Tax Credit Recapture After Site Suffers Casualty Loss
A tornado hits and wipes out three of the 10 buildings at your site. A flood leaves the ground-floor units at your site uninhabitable. A fire roars through two floors of your high-rise and severely damages 10 units. If one of these or a similar disaster occurs at your tax credit site, you’ll have additional financial worries associated with property loss. The owner has tax credits tied up with each of the destroyed units, and unless you know what to do to protect those credits, the owner could lose them along with the property.
Before you board up the windows and let months go by while your site sits empty, you need to know what the IRS requires if your site is suddenly or unexpectedly damaged—what the IRS calls “casualty loss.” We’ll tell you what’s at stake, how federally deemed disaster areas affect tax credits, and what you need to do to comply with tax credit rules so that you don’t lose the tax credits on the site.
What’s at Stake?
In an ideal world, a low-income housing site delivers tax credits to its owners over 10 years and earns the credits over the compliance period of 15 years. Owners receive the benefits of a dollar-for-dollar reduction of their tax liability and the program provides housing to low-income households as designed.
However, because credits are earned over 15 years and claimed over 10 years, there’s a portion of the credits being claimed in the first 10 years that has not yet been earned. These credits are often referred to as the accelerated portion of the credits.
Should the site fail to operate as planned, the accelerated credits may have to be returned to the IRS proportionate to the percentage of the property failing to operate as planned. In other words, an owner who doesn’t continue his responsibility to provide affordable housing for the full compliance period must pay back the amount of credits claimed but unearned. This is called recapture.
Therefore, if any of your tax credit units are suddenly or unexpectedly destroyed by casualty loss, you must restore or replace them within a reasonable period of time or the IRS will recapture tax credits on those units. When a portion or all of the units are destroyed, low-income households no longer occupy them, and obviously you can’t rent those units until they’re restored. If they’re not restored or replaced within a reasonable period of time, the owner can’t count them toward the percentage of units for which it claims credits. Here’s what to do to preserve the owner’s tax credits.
Promptly Report Casualty Loss
The IRS requires sites to report all reductions in eligible basis, including a casualty loss, to their state housing agency, says tax credit consultant A.J. Johnson. Once your state housing agency learns about your site’s casualty loss, it must report the loss to the IRS on Form 8823—even if you repair the damage within a reasonable time.
If you don’t promptly tell your state housing agency about a casualty loss, you’re at risk that the agency will discover the loss on its next site visit, Johnson cautions. As a result, the agency may give you less leeway in repairing damage at your site and protecting the owner’s tax credits, he points out.
Make Repairs Within Reasonable Time
If you restore or replace the destroyed or damaged tax credit units within a reasonable period of time, the IRS won’t take back the credits on those units. But if you drag your feet and unreasonably delay restoration, the IRS will recapture a portion of the owner’s credits back to the first year of the credit period.
Site is not declared major disaster area. If your site isn’t located in an area that has been declared a major disaster area by the president of the United States, the owner won’t be entitled to claim credits for the damaged units during the period those units were out of service because of the casualty loss. But if you repair your site’s damage within a reasonable time period, the owner will avoid recapture of the “accelerated portion” (that is, one-third) of its previously claimed credits.
So what’s a reasonable time period? The IRS rules don’t define a “reasonable period” of time, and experts agree that this differs with every project. But the most time allowed to restore a site is 24 months following the year in which casualty loss occurs or in which the president declares a federal disaster area.
A reasonable period within the two-year time limit can be whatever the physical and financial circumstances of the project dictate, says tax attorney Anthony S. Freedman. A restoration project’s timetable is based on, among other things, the extent of damage; the availability of contractors, subcontractors, and materials; and consent periods and other delays from insurers and lenders. Even the weather can play a part in how quickly the property is restored. For instance, if a property in Alaska is destroyed in November, it might be reasonable to delay restoration until May of the following year, says Freedman.
But you do need to keep the process moving to show the IRS that you’re doing everything you can to restore the property. Every project requires taking certain basic steps such as immediately contacting the site’s insurance company to assess the damage and hiring special consultants, such as fire restoration experts, as needed, says construction attorney Thomas Czik. While the owner is dealing with lenders and attorneys or deciding whether it makes financial sense to restore or replace the property at all, you may need to get architects to draw up plans for the owner to review, and arrange for bids from contractors, says Czik.
Whatever the particular circumstances of your restoration project, it’s vital that you keep detailed records of the restoration process, says Freedman. Keep all reports, bids, invoices, and other documentation relating to the casualty loss and restoration. Also, after you’ve had a conversation relating to the restoration project, either in person or on the telephone, follow it up with a letter or memo detailing the conversation, especially the reason for any delays. Make a copy for the file to create a paper trail of your efforts.
Site is declared major disaster area or repaired during casualty year. If you repaired your site’s damage by the end of the year in which the casualty loss occurred and your buildings’ applicable fractions weren’t lowered, the owner may be entitled to claim credits despite the loss.
You’ll also be able to claim credits during the year in which the casualty occurred if the site is in a federally declared disaster area. In these circumstances, the property must still be repaired within a reasonable time period not to exceed two years from the close of the year that the casualty loss occurred, but credits can continue to be claimed even if the repairs aren’t completed by the end of the year of loss.
Thomas D. Czik, Esq.: Counsel, Cullen & Dykman, 100 Quentin Roosevelt Blvd., Garden City, NY 11530; www.cullenanddykman.com.
Anthony S. Freedman, Esq.: Partner, Holland & Knight LLP, 10 Saint James Ave., Boston, MA 02116; www.hklaw.com.
A.J. Johnson, HCCP: President, A.J. Johnson Consulting Services, Inc., 3521 Frances Berkeley, Williamsburg, VA 23188; www.ajjcs.com.