Written by: Tanya M. Winchel
We frequently receive calls throughout the year from owners asking what the tax implications are for units out-of-service as a result of fire, flood or even theft of building components during a move-out. Unfortunately, most of these issues are discovered after the tax year-end during a project’s annual audit – when a request for IRS Form 8823 for out-of-service units is made by our staff. Knowing the consequences of having units down at year-end can save the owner or investor pure dollars and lots of headaches down the road.
Form 8823 is a tool used by state housing agencies to communicate details of down units to the IRS. It also affords them the ability to communicate when units have been placed back in service to their satisfaction. Thus, the IRS will always be aware of the timing of casualty loss events and they are increasingly well-trained in how to apply the credit disallowance rules under Section 42.
Many calamities can fall upon a low-income unit and require tenant move-out. The treatment by the IRS varies depending on if the project lies in a federally declared disaster area. In either case, the out-of-service unit immediately decreases the eligible basis of the building under Section 42. Not all is lost though, and recapture of the low-income housing tax credit is not a mandatory result.
General tax code principles allow for a reasonable period of time to get units back into service. Most agree that period is two years from the time of incident. However, the rules under Section 42 are a bit more strict. They require a down unit to be placed back in service prior to the end of the tax year. What if a unit is destroyed by fire on December 26th by a dry, brittle Christmas tree? It would be impossible to obtain contracts to fix the unit that quickly – let alone restore the unit by December 31st. The IRS admits that the rules are the rules – they did not create them, but they must enforce them. A unit down at the end of the year decreases eligible basis and results in a credit disallowance on that year’s tax return. The disallowance is for the entire tax year, not just the pro-rated portion of the credit for the time out-of-service.
There is an ounce of wiggle room in that example. If the building itself had excess eligible basis to generate the credit, then the decrease in eligible basis at year-end is reduced by the original excess basis in that building. To have that much excess basis on deals that are produced so tightly is rare.
The down unit must be repaired by the end of the tax year – period – to preserve the credit. The lost credit is not “tacked” onto the end of the credit period. It is lost forever triggering credit guarantees in partnership agreements with an investor. Recapture of the credit, meaning paying the IRS back the accelerated portion of the tax credit, does not occur if the units are placed back into service within the two-year window.
As previously discussed, the test of eligible basis occurs on the last day of the tax year. In the year of restoration, the credit is allowed for the entire year. So a unit that goes down and is restored in the same tax year can avoid credit disallowance.
If the building and project are located in a federally declared disaster area, the rules are more generous, allowing credit on the down units during the period the units are out-of-service. They still must be placed back in service within two years, but the strict end-of-tax-year restoration rules are relaxed.
The key to management of destroyed units requires constant and immediate communication by property managers to owners to keep those year-end restoration goals on the front burner. You can’t avoid credit disallowance in every situation, but some quick action can save some unintended consequences during tax filing season.
Tanya M Winchel is a tax principal at Dauby, O’Connor, & Zaleski, LLC. Tanya has worked in public and private accounting since 1994, and has been with Dauby O’Connor & Zaleski, LLC since 2006.