Editor: Albert B. Ellentuck, Esq.
A corporation that disposes of real property may be required to increase its tax liability by the amount of recaptured credits with respect to that property, specifically, via a recapture of the investment tax credit or the low-income housing credit. Fortunately, there are exceptions that can apply as well as some actions that the corporation can take during the tax year to reduce or avoid liability for recapture, which are addressed in the following paragraphs.
Recapturing the Investment Tax Credit
The Sec. 46 investment tax credit (ITC) is composed of several credits, including the credit for rehabilitation expenditures under Sec. 47 and the energy credit under Sec. 48. The ITC is subject to recapture if property is disposed of, or otherwise ceases to be investment credit property, within five years after the property is placed in service (Sec. 50(a)(1)(B)). The corporation’s tax for that year is increased by the total credit taken, multiplied by a recapture percentage based on how long the ITC property was held. The recapture amount is reduced 20% for each full year that elapses after the corporation places the property in service. Consequently, there is 100% recapture if the property is disposed of (or ceases to be investment credit property) less than one year after the property is first placed in service. There is 80% recapture after one year, 60% after two years, 40% after three years, 20% after four years, and no recapture after five years.
The recapture percentage is tied to the date the property was placed in service, not the end of the tax year in which the property was placed in service. Therefore, one simple way to eliminate liability for recapture is to wait until more than five years have passed from when the property was placed in service to dispose of the property. Similarly, waiting a little while to dispose of the property when nearing an anniversary of the date it was placed in service will reduce recapture by 20%. For example, if a corporation claimed a $10,000 credit on property that the corporation placed in service on March 1, 2011, and delayed the sale of the property from Feb. 25, 2013, to March 5, 2013, it would save $2,000 in recapture tax (60% recapture instead of 80% recapture).
Recapture is triggered by the sale of property on which the ITC was claimed, as well as a transfer of the property by foreclosure of a mortgage or other security interest on the property. However, recapture is not triggered where title to property is transferred as a security interest, such as when property is mortgaged as security for a loan (Regs. Sec. 1.47-2(a)(1)). Property that is abandoned or otherwise retired from use is considered disposed of by the taxpayer for recapture purposes (Regs. Sec. 1.47-2(d)). Loss of property due to destruction or damage by fire, storm, shipwreck, or other casualty or by reason of its theft triggers recapture (S. Rep’t No. 92-437, 97th Cong., 1st Sess., on the Revenue Act of 1971, P.L. 92-178, p. 43 (1971)). Other recapture events include the exchange or trade-in of the ITC property for other property, or a conversion of the ITC property to personal use (Regs. Sec. 1.47-2(e)).
Under Sec. 50(a)(4), recapture is not required upon a “mere change in the form of conducting the trade or business,” if the property is retained in the trade or business, and the corporation retains a substantial interest in the trade or business. Under this Code section and Regs. Sec. 1.47-3(f)(1)(ii), a mere change in the form of conducting a trade or business includes the transfer of an entire proprietorship or partnership business to a newly formed corporation. The ITC properties must be transferred to the corporation together with the trade or business in which they were used. If substantially all the assets of the trade or business are not transferred to the corporation, the credit period for the ITC properties will end for the transferor.
Furthermore, the investment credit is not recaptured when the property is transferred to an acquiring corporation before the end of the useful life (or recapture period) on which the credit was based, in a transaction to which Sec. 381(a) (relating to carryovers in certain corporate acquisitions) applies. Sec. 381 applies to the following transactions: a Sec. 332 complete liquidation of a subsidiary; a Sec. 368(a)(1)(A) statutory merger or consolidation; a Sec. 368(a)(1)(C) exchange of substantially all the properties of one corporation solely for voting stock of another corporation (or its parent); a Sec. 368(a)(1)(D) transfer of all or part of the assets of one corporation to a controlled corporation followed by complete liquidation of the corporation transferring its assets; and a Sec. 368(a)(1)(F) reorganization involving a mere change in identity, form, or place of organization of a corporation.
Observation: The Ninth Circuit held that S corporation shareholders did not have to recapture ITC under the Sec. 381(a) exception following the merger of their S corporation into a C corporation (Giovanini, 9 F.3d 783 (9th Cir. 1993)). The merger was nontaxable, Sec. 381 applied, and the S shareholders were not required to recapture ITC previously claimed on their personal tax returns, assuming that the property was not sold or disposed of before the end of its applicable recapture period, and the former S shareholders did not sell or dispose of a third or more of their interests in the acquiring corporation during the recapture period (Regs. Sec. 1.47-4(a)(2)(ii)).
Recapturing the Low-Income Housing Credit
Recapture of the low-income housing credit occurs if, at the close of any year in the compliance period (generally 15 years), the qualified basis of a building is less than it was at the close of the preceding tax year (Sec. 42(j)). However, the disposition of a building (or an interest in the building) will not cause recapture if it is reasonably expected that the building will continue to be operated as a qualified low-income building for its remaining compliance period. The otherwise applicable statute of limitation is extended until three years after the IRS is notified of noncompliance with the low-income credit rules (Sec. 42(j)(6)). This gives the IRS three years after the corporation notifies it of noncompliance to assess recapture of the accelerated portion of the low-income housing credit, plus interest.
In Letter Ruling 200021016, the IRS ruled that a company’s transfer of stock in an unrelated corporation operating a low-income housing project did not result in recapture of the transferred corporation’s low-income housing credit. In its representations to the IRS, the company stated that the purchase-and-sale agreement required the unrelated corporation to continue to operate the projects as qualified low-income housing projects (and, to the best of its knowledge, the unrelated corporation did so). In response, the IRS noted that there was little guidance on dispositions requiring recapture of the credit, so it looked to analogous provisions governing recapture of the investment tax credit.
This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 25th Edition, by Albert L. Grasso, R. Barry Johnson, Lewis A. Siegel, Richard Burris, Mary C. Danylak, James A. Keller, and Brian Martin, published by Thomson Tax & Accounting, Fort Worth, Texas, 2012 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.