Recapture is the word that gets every LIHTC investor’s attention, and for good reason: it is the mechanism that can claw back credits already claimed, plus interest. Most recapture discussions focus on noncompliance found during routine monitoring. But the trigger that matters most to anyone buying, selling, or exiting a position is different: disposition — the sale or transfer of the building or an ownership interest in it — and the rules governing disposition have significantly changed  over the life of the LIHTC program. Understanding those rules, and how they specifically interact with the Year 15 exit, is essential due diligence for anyone on either side of a transfer.

The Three Triggers of Recapture

Recapture under Section 42(j) is tied to a single underlying event, a reduction in a building’s qualified basis at the close of a tax year compared with the prior year during the 15-year compliance period. Three general situations cause that reduction: 1) ongoing noncompliance, such as renting to an ineligible household or failing a rent restriction, which is reported to the IRS via Form 8823; 2) a casualty loss that leaves a unit unsuitable for occupancy and not restored within a reasonable time; and 3) disposition of the building or an ownership interest in it. The first of these is addressed by routine compliance monitoring throughout the 15-year period. The second and third are the ones most directly relevant to a buyer or investor evaluating a transaction. Disposition is where the rules have changed the most.

Disposition Risk: How the Rules Changed in 2008

For years, an owner selling a low-income building or an interest in it during the 15-year compliance period had to either post a surety bond or establish a Treasury-backed escrow account to avoid triggering recapture on the sale itself. That requirement was repealed by the Housing and Economic Recovery Act of 2008, effective for dispositions after July 30, 2008. In its place, Section 42(j)(6) now provides that the increase in tax otherwise triggered by a disposition does not apply if it is reasonably expected that the building will continue to be operated as a qualified low-income building for the remainder of its compliance period. In exchange for eliminating the bond requirement, Congress extended the IRS’s statute of limitations for assessing recapture tax to three years after the date the IRS is notified of a reduction in eligible basis.

This is a meaningful lower-friction standard than the bond rule it replaced, but it is not a blanket exemption. The disposing owner and the buyer still need a documented, reasonable basis for expecting continued qualified operation.  This is typically demonstrated by the buyer’s assumption of the recorded land use restriction agreement (LURA), the buyer’s stated intent to continue operating the property as affordable housing, and the absence of any plan to convert the property to market rate before the compliance period ends. A transaction that lacks that basis, or where the buyer’s intentions are ambiguous, still carries real recapture exposure for the seller under the pre-2008 logic, even though no bond needs to be posted.

Foreclosure Is a Different Analysis Depending on Timing

Foreclosure, or a deed in lieu of foreclosure, is also a disposition, and its recapture treatment depends on when it happens. If foreclosure occurs during the 15-year compliance period, it is analyzed the same way as any other disposition under Section 42(j)(6): recapture is avoided only if it is reasonably expected that the building will continue to operate as qualified low-income housing afterward. Because a foreclosing lender does not always intend to continue affordable operation, foreclosure and casualty loss are the two triggers that practitioners most commonly point to as the realistic sources of recapture exposure in an otherwise well-run transaction.

If foreclosure occurs after the compliance period has ended,  that is, during the extended use period,  recapture is not implicated at all, as the credit recapture mechanism under Section 42(j) only operates during the 15-year compliance period. What foreclosure does trigger at that point is early termination of the extended use period itself under Section 42(h)(6)(E). Even then, the statute requires that for three years following the termination, the owner may not evict or terminate the tenancy of an existing low-income tenant without good cause or raise gross rent on a low-income unit beyond what Section 42 would otherwise permit. In other words, a post-Year-15 foreclosure ends the affordability restriction but with a delay,  and does not reopen recapture exposure for credits already claimed during the compliance period.

Casualty Loss: The Other Practical Trigger

A casualty event, such as  fire, flood, wind damage,  does not automatically cause recapture. A unit damaged by a casualty event only loses its qualified status and only creates recapture exposure, if it is not restored to occupiable condition within a reasonable period following the event. This is a materially more forgiving standard than the separate rule governing units left uninhabitable through ordinary neglect or deferred maintenance for more than ninety days. This can trigger recapture even without any casualty event at all since the concern is the same.  Qualified basis should reflect units that are being operated as low-income housing, not units that are vacant, damaged, or otherwise out of service.

Why the Year 15 Timing Actually Matters

For a property approaching its Year 15 exit — whether through a nonprofit’s right of first refusal, a negotiated general partner purchase option, or a sale following the qualified contract process — the disposition rules above are directly relevant, but only up until the compliance period closes. A transfer that closes before the last day of the building’s 15-year compliance period is still a disposition under Section 42(j)(6). This means the reasonably-expected-to-continue standard applies and should be documented, even though in practice it is easy to satisfy when the buyer is taking on the recorded LURA and has every intention of continuing to operate the property as affordable housing through the extended use period. A transfer that closes after the compliance period has ended does not imply Section 42(j) recapture at all as the mechanism that produces recapture no longer applies once the 15-year period is over.

Because the compliance period end date is determined building by building, tied to the specific tax year each building’s credit period began, sophisticated buyers and sellers frequently confirm the exact compliance end date for every building in a multi-building transaction.  Where the timing is close, it is recommended that the  closing should  fall after the final date rather than before it. Doing so removes any need to document the reasonable-expectation standard altogether, rather than relying on it.

A Practical Recapture Diligence Checklist for Buyers and Investors

• Confirm the exact compliance period end date for each building involved, since it is determined on a building-by-building basis and controls whether a pending transfer is subject to Section 42(j)(6) at all.
• If closing before the compliance period ends, document the reasonable expectation that the buyer will continue operating the property as a qualified low-income building.   Assumption of the LURA and a stated affordability commitment are typical evidence.
• Review whether any casualty event has occurred and, if so, confirm the affected units were restored to rentable condition within a reasonable time.
• For any property with financing stress, understand that foreclosure during the compliance period is treated as a disposition subject to the same reasonable-expectation test.  Confirm how that risk is allocated between the buyer and the seller in the transaction documents.
• For a property already past Year 15, confirm that foreclosure risk is understood as an extended use period termination issue rather than a recapture issue.  Review the three-year post-termination tenant protection requirements under Section 42(h)(6)(E).

The Bottom Line

Recapture risk did not disappear when Congress repealed the bonding requirement in 2008; it simply shifted from a collateral requirement to a documentation and diligence requirement. For buyers and investors transacting around Year 15, the operative questions are timing, whether the compliance period has closed  and evidence.  whether there is a genuine, documented basis for expecting the property to keep operating as affordable housing. Getting both right is what separates a clean exit from one that leaves the seller, and potentially the buyer’s own return, exposed to a tax event years after the transaction has closed.

Sources

Internal Revenue Code Section 42, Low-Income Housing Credit — Cornell Law School Legal Information Institute:  https://www.law.cornell.edu/uscode/text/26/42

IRS Audit Technique Guide, IRC §42, Low-Income Housing Credit:  https://www.novoco.com/public-media/documents/irs_audit_technique_guide_091814.pdf

Novogradac, “Recapture Exposed”:  https://www.novoco.com/periodicals/articles/recapture-exposed

Novogradac, “Calculating Tax Credit Recapture and Interest”:  https://www.novoco.com/periodicals/articles/calculating-tax-credit-recapture-and-interest

Tax Credit Advisor, “IRS Issues Instructions on How to Retire LIHTC Recapture Bonds”:  https://www.taxcreditadvisor.com/articles/irs-issues-instructions-on-how-to-retire-lihtc-recapture-bonds/

Tax Notes, Housing and Economic Recovery Act of 2008 (P.L. 110-289), Division C — Housing Assistance Tax Act of 2008:  https://www.taxnotes.com/research/federal/legislative-documents/public-laws-and-legislative-history/housing-and-economic-recovery-act-of-2008-p.l-110-289/dthh

A.J. Johnson Consulting Services, “Recapture — What it is and When it Occurs”:  https://www.ajjcs.net/paper/main/2016/01/06/recapture-what-it-is-and-when-it-occurs/

A.J. Johnson Consulting Services, “The IRS and Extended Use Agreements”:  https://www.ajjcs.net/paper/main/2015/09/20/the-irs-and-extended-use-agreements/

Costello Compliance, “How Long LIHTC Lease Provisions Apply — Three or Thirty+ Years?”:  https://www.costellocompliance.com/blog/how-long-lihtc-lease-provisions-apply

The Tax Adviser, “Avoiding Income Tax Credit Recapture by a Corporation”:  https://www.thetaxadviser.com/issues/2013/may/casestudy-may2013/

Michigan State Housing Development Authority, LIHTC Compliance Manual, Chapter 9 — The Extended Low-Income Housing Use Period:  https://www.michigan.gov/mshda/-/media/Project/Websites/mshda/rental/Property-Managers/Compliance-for-Rental-Housing/Manuals-Policies-and-Codes/LIHTC-Compliance-Manual/CM-Chapter-9-Extended-Use-Period.pdf

HUD User, “What Happens to Low-Income Housing Tax Credit Properties at Year 15 and Beyond?”:  https://www.huduser.gov/publications/pdf/what_happens_lihtc_v2.pdf

Disclaimer: This article is provided for general informational and educational purposes only and does not constitute legal, tax, accounting, or investment advice. LIHTC recapture rules, disposition standards, and extended use period provisions are fact-specific, depending on the applicable building’s compliance period timeline and recorded land use restriction agreement and are subject to change; readers should consult qualified legal and tax counsel regarding their particular circumstances. No statement in this article should be construed as an offer or solicitation to buy or sell any security or tax credit interest.