Investment tax credits (“ITCs”) are used to incentivize the construction and operation of certain types of real estate and energy assets. However, ITCs carry with them the possibility of recapture (i.e., clawback) in the case of certain events. In this article, we provide a brief overview of the ITC recapture rules, with a focus on recapture treatment in the event of a casualty.

Overview – Investment Tax Credits

ITCs available to taxpayers derive from the general business credit allowed under § 38.1 That section provides that a taxpayer is allowed a tax credit for a tax year in an amount equal to the sum of – (i) the business credits carried forward to the tax year, (ii) the business credit for the current year, and (iii) the business credit carryback to the tax year. However, § 38 itself does not describe a specific tax credit, but instead provides rules for computing the taxpayer’s credit for a tax year derived from other Code sections. Of relevance here, the computation under § 38 includes the investment credit described in § 46.

Like § 38, § 46 itself is not a specific credit, but rather a conglomeration of credits available under other Code sections. Specifically, the investment credit under § 46 is the sum of:

  • The § 47 rehabilitation credit;
  • The § 48 energy credit;
  • The § 48A qualifying advanced coal project credit;
  • The § 48B qualifying gasification project credit;
  • The § 48C qualifying advanced energy project credit;
  • The current § 48D advanced manufacturing investment credit;
  • The § 48E clean electricity investment credit.

Each of these credits (collectively referred to as the “ITCs”) was enacted to incentivize investment by taxpayers in certain assets. Thus, each of the credits is determined by reference to certain costs incurred in the construction or rehabilitation of specified property. For example, the § 48 energy credit is equal to a specified percentage of the tax basis of each energy property placed in service during the tax year. A taxpayer reports its ITC for the tax year on Form 3468, Investment Credit.

Leo Berwick Insights: The full amount of an ITC generally is available for the year in which the applicable property is placed in service. If a taxpayer’s ITC for a tax year exceeds the taxpayer’s tax liability for that year, the remaining portion generally can be carried back to a prior year or carried forward to a subsequent year.

Unlike net operating losses, ITCs must first be carried back to a prior year before being carried forward. The number of years to which ITCs can be carried back or carried forward may vary depending on the type of property that generates it. The mechanics of carrying unused credits to other tax years is described in § 39.

Example 1: In 2024, X places into service Property A, which qualifies as energy property under § 48. X’s basis in the property is $1,000,000, and the property qualifies for a 30% credit under § 48(a)(9). X is entitled to a $300,000 credit in 2024.3 Also assume that X’s tax liability for 2024 and the surrounding years is as follows:

In this case, X can use $100,000 of the § 48 energy credit to offset its 2024 tax liability to the extent allowed under § 38(c). The remaining $200,000 of credit is first carried back to offset X’s 2021 to 2023 combined tax liability of $50,000, with $150,000 carried forward to offset a portion of X’s 2025 tax liability.

General ITC Recapture Rules

As noted above, ITCs are intended to incentivize certain behavior (in this case, investment in particular assets). Certain events deemed inconsistent with the policy underlying the credit may subject a claimed ITC to recapture under § 50 during the five-year period after credit eligible property is placed in service (the “Recapture Period”).

Leo Berwick Insights: Section 50 provides that any ITC recapture amount increases a taxpayer’s regular income tax for a tax year.4 In essence, the amount of any previously allowed ITC is multiplied by a recapture percentage determined when the property ceased to be ITC eligible property.

Those percentages (categorized by the time within which the property ceases to be an ITC property) are:

  • One full year or less after placed in service: 100%
  • More than one, but less than two full years after placed in service: 80%
  • More than two, but less than three full years after placed in service: 60%
  • More than three, but less than four full years after placed in service: 40%
  • More than four, but less than five full years after placed in service: 20%

Example 2: Assume the same facts as in Example 1, in which in which X was entitled to a § 48 energy credit of $300,000 in 2024 as a result of its investment in Property A. Assume also that X utilized the full amount of the energy credit by reducing its 2024 tax liability by the entire $300,000. More than three full years (but less than four years) later, X sells Property A to Y (an unrelated party). Because Property A was sold more than three (but less than four) years after it was placed in service, the applicable recapture percentage is 40%. Thus, the recapture amount is $120,000 (calculated as 40% of the $300,000 energy credit taken) and X must increase its regular income tax by that amount for the tax year of the sale.

Note, if X did not use the credit to reduce its tax (because, for example, X did not have an income tax liability in Year 1 or prior years because it had a net operating loss), X would not be required to increase its tax for the year of recapture. However, X would adjust the amount of its ITC carrybacks or carryforwards to reflect the amount of the recapture.

As indicated in the example above, a sale of property with respect to which ITCs were claimed causes a recapture event. Indeed, any type of disposition – such as a sale, exchange, transfer, distribution, gift, or involuntarily conversion – will trigger the recapture provisions; however, a transfer of property at death or in a tax-free liquidation or asset reorganization of a corporation will not. A disposition includes (and thus a recapture may occur) a foreclosure on debt. This risk will likely arise more frequently in light of changes made by the Inflation Reduction Act (“IRA”). Specifically, prior to enactment of the IRA, the only way to “transfer” credits from a project sponsor to another taxpayer was through use of a tax equity partnership; those arrangement typically restricted or refrained from incurring project level term debt. Now, however, § 6418 allows the direct transfer of credits without the use of a tax equity partnership. Given this flexibility, project level debt likely will be more common because developers are more likely to retain ownership of projects without seeking third-party equity investments. With an increased number of debt-funded projects comes an increased risk of debt foreclosure (and thus an increased need to be aware of foreclosure related credit recapture).

Even if a project is not disposed of, a recapture event may nevertheless arise. Credits are subject to recapture if the property in question ceases to meet the definition of the particular type of property that gave rise to the credit (e.g., property ceases to be energy property or a building cease to qualify as a rehabilitated building). Further, recapture may be required with respect to some portion of the credit in certain situations. For example, assume that a taxpayer qualified for a 30% (rather than the base 6%) energy percentage with respect to an energy property because the prevailing wage requirements of § 48(a)(10) were initially satisfied. If the property

later fails to satisfy those requirements (and that failure is not remedied) in the Recapture Period but continues to otherwise qualify as an energy property, the taxpayer generally would be required to recapture the applicable percentage of the “excess” credit (i.e., the 24% difference between the 6% and 30% rates).6

Under § 50(b)(3), ITCs are also subject to recapture if the relevant property ceases to be eligible for ITCs under § 50.7 Thus, recapture may be required if the property becomes tax-exempt use property, which would be the case if the property is used by an organization exempt from income tax (unless the property is used by the tax-exempt organization predominately in an unrelated trade or business and thus subject to tax under § 511). Similarly, ITCs may be subject to recapture if the property becomes property used by the U.S. government, the government of any U.S. state, or (in certain situations), a foreign person. In addition, if property is owned by a partnership, it may be deemed tax-exempt use property if one or more partners are tax-exempt or tax-exempt controlled entities. Thus, project level recapture may arise if an interest in a partnership that uses the property is sold to a tax-exempt entity.

Recapture may also arise under the at-risk rules of § 49 because that section limits the basis of property that can be used to calculate the ITC. Specifically, § 49 generally provides that the credit base of investment credit property is reduced by the amount of “nonqualified nonrecourse financing” (as defined in § 49(a)(1)(D)). If a taxpayer initially qualifies for an ITC, an increase in nonqualified nonrecourse financing with respect to the property can cause ITC recapture.

Recapture from Casualty Events

One type of ITC recapture event calls for more detailed discussion; namely, ITC recapture arising from ceasing operations due to a casualty event. A casualty event is the damage or destruction of property due to a sudden, unexpected or unusual event (e.g., earthquake, hurricane, flood, or tornado). As a result of such an event, a project can be completely destroyed or merely damaged. If property is completely destroyed in a casualty event, clearly the project would cease operations. The Internal Revenue Service (the “IRS”) has ruled that recapture applies in such cases even if the property at issue is replaced within six months. But what if the property is merely damaged?

Leo Berwick Insights: Taxpayers suffering a casualty event that merely damages the ITC property may be frustrated by the lack of clear and reliable guidance as to whether recapture applies. Many practitioners take the view that ITC recapture is not triggered if the owner of the partially damaged property “makes the necessary repairs and places the property back in service.”9 However, this guidance derives from a publication issued by the IRS to guide its agents in performing audits and as information for taxpayers and practitioners.

Thus, it cannot necessarily be relied upon by a taxpayer. Moreover, this guidance addresses only the § 47 rehabilitation credit. Given the similarity between that credit and other ITCs, taxpayers may take some comfort in determining whether recapture is required.

At some point, however, one must determine how much damage is too much? In other words, at what point do repairs constitute the creation of a wholly separate – and new – asset? Again, there is a lack of direct and reliable guidance on this issue.

In Revenue Ruling 94-31,10 the IRS examined what was, in essence, the reverse question in the context of a wind facility, potentially eligible for the § 45 wind production credit. In that ruling, the IRS concluded that, when a taxpayer replaced certain parts of a wind facility, the upgraded facility would qualify as new property originally placed in service even though the facility contains some used property, provided the fair market value of the used property was not more than 20% of the total value of the upgraded facility.11 That, arguably, indicates that the IRS may believe that if more than 20% of a facility continues to be operational, then a recapture event has not occurred. Indeed, that is what the IRS seems to have concluded in Private Letter Ruling 200442014, which cited Revenue Ruling 94-31.12

In Private Letter Ruling 200442014, the IRS issued rulings relating to a facility that was eligible for the § 29 alternative fuel credit because such facility was placed in service before July 1, 1998. In particular, the taxpayer that requested the ruling was concerned that a necessary relocation or replacement of a part of the facility after June 30, 1998, would result in a new placed in service date that would render the facility ineligible for § 29 credits. In the ruling, the IRS concluded that a relocation of the facility or replacement of a part of the facility would not result in a new placed in service date provided that the fair market value of the used property was more than 20 percent of the relocated facility’s total fair market value at the time of the relocation. Implicitly, then, the IRS concluded that the relocated or updated facility would continue to be treated as operational so long as less than 80 percent of the property was replaced.

Extrapolating from the IRS’s conclusion in Private Letter Ruling 200442014 in the context of ITC property, a casualty event arguably should not trigger recapture so long as – (i) the damaged

property is repaired and once again becomes operational; and (ii) at least 20 percent of the fair market value of the repaired property is attributable to the original property. Unfortunately, the ruling was issued in the context of the § 29 credit (rather than in the context of an ITC). Moreover, § 6110(k)(3) provides that a private letter ruling may only be relied upon by the taxpayer that received the ruling. Thus, taxpayers that do not seek the same or similar ruling may not rely on the IRS’s conclusion in the ruling (although existence of this and other rulings reaching the same conclusion may indicate the IRS’s view on the issue). Thus, more reliable guidance would certainly be welcome. Regrettably, that guidance does not appear to be forthcoming, as recapture rules curiously were not addressed in proposed § 48 regulations issued in late 202313.

Conclusion

The absence of reliable guidance as to whether a casualty event triggers ITC recapture leads to frustration for taxpayers owning projects that fall victim to such an event. As the number of projects increases, the possibility of significant weather events affecting those projects increases the risk of casualty losses. As with any property owner, property and casualty insurance may be purchased to address the cost of repair or replacement (although, as is always the case when an insurance claim is made, the process may not adequately address the need). Moreover, ordinary property and casualty insurance will not cover the economic cost of lost tax credits. Thus, tax insurance for § 50 recapture risk may increasingly be used to provide certainty to tax credit purchasers as well as tax equity investors.

Footnotes:

1 All “Section” or “§” references are to the Internal Revenue Code (the “Code”) or the Treasury Regulations promulgated thereunder, as in effect on the date of this article.
2 Section 46 also includes the former § 48D qualifying therapeutic discovery project credit, which was repealed.
3 The 30% rate would apply only if a project met the prevailing wage requirements of § 48(a)(10). Otherwise, the general 6% rate would apply. As discussed below, if those requirements cease to be met, the taxpayer may be required to recapture the excess credit if those requirements cease to be met – even if the project continued to meet the requirements for a reduced credit.
4 If an ITC recapture event occurs, the increase in tax attributable to the recapture is calculated and reported on Form 4255, Recapture of Investment Credit.
5 S. Rep. No. 1881, 87th Cong., 2d Sess. (1962) 148-149.
6 In certain situations, the taxpayer may be able to “cure” the problem and avoid recapture.
7 Note, however, that § 50 recapture does apply with respect to § 45 production tax credits because § 50 applies only to credits described in § 46 to § 50.
8 See, Rev. Rul. 88-96, 1988-2 C.B. 27. This is consistent with the fact that recapture applies even if property is exchanged for like-kind property, even if the exchange qualifies for nonrecognition treatment under § 1031.
9 Market Segment Specialization Program: Rehabilitation Tax Credit, Department of the Treasury, Internal Revenue Service (2002).
10 1994-1 C.B. 16.
11 Id. (citing Rev. Rul. 68-111, 1968-1 C.B. 29, in which the IRS concluded that a railroad locomotive was new section 38 property where the cost of used materials and parts was not more than 20 percent of the total cost of materials and parts used in constructing it).
12 June 30, 2004.
13 Federal Register:: Definition of Energy Property and Rules Applicable to the Energy Credit

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