With the numerous natural disasters that have plagued various areas of the country over the past several years, ranging from hurricanes Katrina and Sandy to the Joplin, Mo., tornadoes, many affordable housing projects and their stakeholders have felt the physical and financial effects left in the wake of these events. Among these effects is the possibility of tax credit loss and even recapture.
Here is some guidance with respect to the risk of tax credit recapture, specifically as it relates to the incidence of a casualty event or natural disaster. In summary, the tax credit recapture implications are primarily contingent on the timing of the restoration of the damaged buildings or units.
Located in Sec. 42(j)(1) of the Internal Revenue Code, the general rule regarding the recapture of low-income housing tax credits (LIHTCs) provides that if at the end of the tax year in a compliance period the amount of a building’s qualified basis is less than the amount of such basis as of the end of the previous year, the taxpayer’s tax will be increased by the recapture amount. The qualified basis is the dollar amount that is eligible for housing credits. However, Sec. 42(j)(4)(E) also provides that, in all cases, “the increase in tax under Sec. 42(j) shall not apply to a reduction in qualified basis by reason of a casualty loss to the extent such loss is restored by reconstruction or replacement within a reasonable period established by the Secretary.”
So what does this mean? Simply put, the occurrence of a casualty loss alone does not cause recapture. The affected buildings or units will typically be subject to recapture in instances where the affected buildings or units are not restored within a reasonable period of time.
Under Revenue Procedure 2007-54, the state housing finance agency has the responsibility of determining what constitutes a reasonable period. Yet, this reasonable period shall not exceed two years from the close of the year in which the casualty loss occurred.
For projects not located in a government-declared major-disaster area, failure to restore the property to its original condition by the end of the tax year in which the casualty occurs will result in the loss of credits on the damaged buildings/units for that tax year (that is, the owner will not be allowed to claim credits in the year of the casualty).
Also, in this instance, there is no recapture of credits previously claimed as long as the qualified basis is restored within a reasonable period.
Conversely, for projects located in major-disaster areas, more favorable rules apply. In these cases, credits may continue to be claimed even during the restoration period. On these projects, credit recapture will also be avoided as long as the qualified basis is restored within two years of the end of the calendar year of the major-disaster declaration.
In the event a project is faced with recapture, the maximum amount of credits to be recaptured at any given time during the credit period is limited to one-third of previous credits claimed. This limit decreases for years after the credit period but still during the compliance period.
It is important to note that the increase in tax comprises not only the credit amount, but also the interest associated with the credits taken in prior years—the latter of which can be significant.
Peter Aje is a senior manager in RubinBrown’s Tax Consulting and Real Estate Services Group. He works on a national basis primarily serving clients that develop or invest in LIHTC, New Markets Tax Credit, historic rehabilitation tax credit, and renewable energy projects and investment funds.