Effects of Foreclosure When Tax Credit Sites Fail

Tax credit sites tend to operate on tight margins because of the competition to obtain these credits initially and the allocating agencies’ obligation to provide the minimum amount of credit necessary to make a deal feasible. Given these constraints, it’s no surprise that some sites, by the time they've reached the end of their compliance period, have fallen into financial distress. Common reasons include poor property management practices, inadequate financial structures, deficient physical conditions of the site, and a soft rental market.

In such cases, sometimes conditions are so dire that sites cannot avoid foreclosure, a legal procedure occurring when an owner defaults on a loan and the lender takes legal action to sell the property to recover the debt. Foreclosure has special implications for site owners. It’s considered to be the premature termination of a site’s affordability and subjects owners to the recapture of tax credits and forfeiture of all future tax credit benefits from the site.

Generally, recapture of low-income tax credits occurs when, at the close of any taxable year in the compliance period, the amount of the qualified basis of any building with respect to the taxpayer is less than the amount of such basis as of the close of the preceding taxable year. As a result, the owner’s tax for the taxable year will be increased by the credit recapture.

A foreclosure (or instrument in lieu of foreclosure, such as deeding the property directly to a lender in full or partial satisfaction of the mortgage debt) would result in the taxpayer having a reduction in the basis of the building at the close of the taxable year.

Furthermore, in general, any change in the ownership of a low-income housing building during the compliance period is a recapture event, so that all dispositions of ownership interest in the building are treated as transfers for purposes of recapture.

Foreclosure’s Effects on New and Former Owners

The subject of site foreclosures was the focus of the recent IRS-issued LIHC Newsletter #55 by Grace Robertson. We’ll highlight the effects of foreclosure on new and former owners and prior agreements made with local housing agencies.

Extended use restriction agreement. IRC Section 42(h)(6) requires owners to enter into an extended use agreement to provide low-income housing for a period of not less than 30 years. The agreement is made with the allocating housing agency and is often referred to as a “land use restriction agreement.” According to Robertson, the extended use agreement terminates as of the date the building is acquired by foreclosure or instrument in lieu of foreclosure.

Effects on new owner. A new owner is under no obligation to continue operating the site as a tax credit site. But IRC Section 42(H)(6)(E)(ii) includes protections for tenants in the event of a foreclosure or transaction in lieu of foreclosure.

If a new owner chooses to operate the site in compliance with the low-income housing tax credit program, and acquired the site during the 15-year compliance period, under IRC §42(d)(7)(ii), the new owner can claim any credit that would have been allowable to the prior owner. The new owner will need to enter into a new extended use agreement with the local housing agency by the end of the taxable year for which the new owner intends to claim the credit.

Effects on former owner. According to IRS Chief Counsel Advice 201146016, foreclosures are treated as any other disposition. The advice explains that the disposition of a building will result in recapture (whether through foreclosure or otherwise) if the former owner doesn’t reasonably expect that the building will continue to be operated as a qualified low-income building for the remainder of the building’s compliance period. But if the former owner believes the building will continue to be operated as a low-income building, there will be recapture only at the point in time when there’s a decrease in qualified basis or other recapture event.

The IRS analysis focuses on the fact that the termination of the extended use period and the disposition of a building are “independent concepts.” It clarifies that the extended use period may be terminated without a disposition of the building and that a building may be disposed of without terminating the extended use period.

In other words, the termination of the extended use agreement results in the disallowance of the credit for the year of disposition (unless the owner signs a new agreement with the housing agency), but this doesn’t automatically result in recapture under IRC Section 42(j).

The advice implies, but doesn’t state, that the termination of the extended use period would prevent additional credits from being “allowable” or taken with respect to a building after the termination of the extended use period, and clearly states that any reduction in the qualified basis of the project after the foreclosure would constitute a recapture event.