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August 09, 2016

Section 42 Myth Busters: The Costly Impact of Tax Credit Recapture

The Scenario

When a wildfire wreaked havoc in a small community in Wisconsin, section 42 developer, Todd Martin, had no idea how much his company would be impacted. First, his complex had to be evacuated. Then, all 1,000 units in the building were destroyed. Not a great scenario, but Todd was insured and hopeful it would all work out in the end.

What he could have never anticipated, was that it would take 38 months to complete the rebuild. It wasn’t that his insurance was uncooperative. Rather, the delay was largely caused by labor and lumber shortages. So many buildings in the community were destroyed that the infrastructure of area simply could not accommodate its rebuilding demands.

Then, in addition to losing massive amounts of rental income, Todd was hit with another unexpected expense: His Section 42 Tax Credit was recaptured.

How Does Tax Credit Recapture Work?

  • Properties damaged by a casualty loss, with units taken out of service, may be subject to tax credit recapture if they are not restored within a reasonable period.
  • A casualty loss is defined as a loss caused by a sudden, unexpected event such as a flood, hurricane, fire, tornado or earthquake.
  • If units are not returned to service by the end of the tax year in which the casualty loss occurred, and within a reasonable period thereafter, may be subject to tax credit recapture.
  • The recapture applies to previously claimed tax credits in the taxable year in which the loss occurred and any credits claimed during the restoration period.
  • The IRS has stated that a reasonable period is generally 24 months from the close of the tax year in which the loss occurred. There may be exceptions to the time period allotted.
  • Generally, properties located in “federally declared disaster areas” are not subject to tax credit recapture unless the recapture period is excessive.

The Dollars and Cents – $4.7 Million

In this scenario, the casualty loss (wildfire) occurred in September 2012. Therefore, the recapture trigger date was December 31, 2012. The two-year reasonable period for reconstruction ended on December 31, 2014. Reconstruction was not actually completed until November 2015.

How big of a loss did that tax credit recapture represent? Let’s do the math:

  • Todd collected an average rent per unit of $945. Multiplied by 1,000 units, his total revenue was $945,000 per year.
  • He received a 5% federal tax credit because the units fell under section 42. 5% of $945,000 = $47,250 per year.
  • The recapture applied to the year of the loss and the years in which reconstruction took place – 2012, 2013, 2014 and 2015.
  • 4 years x $47,250 per year = a potential loss of $189,000 in tax credits.

Very Real Insurance Implications

If this developer would have been insured by Heffernan Insurance Brokers’ program for Tax Credit Housing Developers, it could have been a different scenario. This coverage reimburses for tax credit recapture scenarios; so unexpected delays don’t put you under water!

Want to make sure your tax credit property is properly insured against scenarios like this? Contact the Heffernan Real Estate Practice today.

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