Understand Three Events to Minimize Tax Credit Recapture Liability
One of the biggest concerns owners and managers face is housing tax credit recapture. Under Section 42 of the Internal Revenue Code, low-income housing tax credits are allocated to a site annually over a 10-year period. But these tax credits are subject to a 15-year compliance period. This means, 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 hasn’t yet been earned. These unearned credits in the first 10 years are referred to as the accelerated portion of the credits.
The 15-year compliance period is a significant amount of time during which a site may face events that can lead to recapture of the accelerated portion of the credits previously taken, as well as the loss of future tax credits. To better understand the recapture risks and what needs to be done to avoid the recapture of precious housing tax credits, we’ll highlight the three recapture scenarios.
Event #1: Building Disposition
The sale or foreclosure of a tax credit building could trigger recapture of the credits previously claimed by the original owner. As a result of the sale, the original owner isn’t earning the accelerated portion of the credits claimed because he’s not fulfilling his duty to operate the low-income site for the remainder of the compliance period.
If the buyer isn’t expected to continue operations as a low-income site, a decrease to zero in the site’s qualified basis will occur. The qualified basis is the base that’s multiplied by the credit percentage to determine the annual credit. The qualified basis equals the applicable fraction times the eligible basis. The applicable fraction is the percentage of a building that’s treated as low-income use and generally eligible for the LIHTC.
However, if the buyer is reasonably expected to continue site operations as low-income site, the Housing Act of 2008 provides an exception to recapture triggered through disposition of a building. The act indicated that buildings disposed of after July 30, 2008, can avoid recapture if it’s reasonably expected that the building will continue to be operated as a low-income building for the remaining compliance period.
However, according to the IRS, if there’s any reduction in the qualified basis of a low-income building that results in an increase in tax under the recapture rules in the year of the disposition or any subsequent tax year, then the statutory period for assessing any deficiency with respect to such increase in tax will not expire before the expiration of three years from the date the owner notifies the IRS of such reduction in qualified basis, notwithstanding any other law or rule of law that would otherwise prevent assessment.
The old requirement of posting a surety bond equal to the amount specified on Form 8693, Low-Income Housing Credit Disposition Bond, to avoid recapture applies to dispositions that occurred before July 30, 2008. As a practical matter, these surety bonds were difficult and costly to obtain. Because of the amount of the bond needed and the inability of the seller to assure that the property would continue to comply, sureties were likely to require either full collateral or very high creditworthiness from the bonded party. IRS Revenue Procedure 99-11 established a collateral program as an alternative to providing a surety bond to avoid or defer recapture of low-income housing tax credits. Under this program, taxpayers pledged certain U.S. Treasury securities to the IRS as collateral.
The IRS could “call a bond” to recapture credit if it subsequently determined that the new owner did not continue to operate the building as a qualified low-income building for the remainder of the compliance period.
Event #2: Noncompliance
A decrease in the applicable fraction of a building occurs when previously qualified units no longer qualify for the program. This can happen for a number of reasons such as a unit not being occupied by a qualified household, overcharging rents above the appropriate limit, violating the student rule, or other compliance-related problems. These noncompliance items are reported to the IRS by the state allocating agency on Form 8823.
You can avoid this type of recapture trigger by simply keeping all units in compliance. Have a system in place for ensuring households are qualified and household files are complete. Knowing that there are no perfect systems, the IRS provides some leeway. Noncompliance should be corrected as soon as possible to avoid recapture. If not corrected by year-end, these types of noncompliance mentioned above would lead to both a loss of credits and recapture of the previously accelerated credits.
Actual noncompliance will occur if the potential noncompliance isn’t corrected within a “reasonable” time period. The term “reasonable” isn’t defined, and is determined by the IRS on a case-by-case basis. Housing agencies are required to file IRS Form 8823, “Low-income Housing Credit Agencies Report of Non-Compliance,” with the IRS no later than 45 days after the end of the correction period and no earlier than the end of the correction period, whether or not the noncompliance or failure to certify is corrected.
Event #3: Casualty Loss or Units Not Suitable for Occupancy
If a natural disaster such as a fire, flood, or hurricane were to damage some or all of the units in a building, there would be a decrease in the building’s eligible basis. An eligible basis includes the cost of new construction/rehabilitation or the cost of acquisition of an existing building.
Casualty losses don’t automatically trigger recapture. Instead, units damaged by a casualty event would lose credits only if the units were not back in service by Dec. 31 (the end of the taxable year in which the event occurred), and recapture would occur only if the repairs were not made within a reasonable time. In other words, if the loss isn’t restored by the end of the taxable year in which it occurred, then the owner shouldn’t claim credits for that year, but there’s no recapture of credits previously claimed as long as the repairs are made within a reasonable time period.
The IRS has stated that a reasonable period is generally a period not to exceed two years from the close of the year of the casualty loss. Additionally, major disaster areas are offered an exception that allows credits to continue to be claimed. However, the property must still be repaired within the IRS guidelines. Revenue Procedures 2014-49 and 2014-50 were issued to provide further guidance related to major disasters and qualified low-income properties.
Not only could casualty loss events, such as flood, fire, and wind lead to recapture if repairs are not made in time, but so could a dilapidated unit or unit not suitable for occupancy. Unlike a decrease in eligible basis from a casualty loss, an uninhabitable unit due to deferred maintenance and disrepair would lead to a decrease in qualified basis as a result of a decrease in the low-income applicable fraction. Uninhabitable units from owner neglect would lead to a loss of current-year credits and recapture the previously accelerated credits.