While the IRS no longer requires a disposition bond (IRS form 8693) to avoid tax credit recapture in the event of ownership disposition in a Low Income Housing Tax Credit Section 42 project, the tax credit recapture exposure still exists.
Many institutional investors refuse to dispose of ownership before the 15 year federal compliance period is up or require some type of collateral to protect them from tax credit recapture.
CMR Risk & Insurance Services, Inc. has developed an exclusive surety product to protect against tax credit recapture and interest penalties due to any non-compliance that they may arise after disposition. This product is provided by an A+ “superior” rated insurance company and covers the entire compliance and audit discovery period.
The quick response is YES. While recapture risk for general operational risks is low as state housing agencies really work with operators to keep affordable housing affordable the primary exposures that lead to recapture are foreclosure and casualty losses.
It is estimated that 80% of all LIHTC assets operate at little to no cash flow. When a property or partnership interest is purchased it is often financed with new debt. Any change in economic conditions around a property (manufacturing retraction, employment center relocating, etc.) or a spike in any of the major operating expense categories (interest rates, insurance rates, etc.) can have a serious affect on a project that was operating with close to no positive cash flow. This razor thin margin can turn into a not worthwhile project in a short time.
While foreclosure in itself may not lead to recapture it often does as this will extinguish the Land Use Restriction Agreement (LURA), which is a requirement to be in compliance with Section 42, and a lender has little incentive to attempt to reinstate a LURA after all credits have been claimed. Even if the desire is there they may not be able to operate quickly enough within the required time frame to request a LURA reinstatement.
A large exposure for recapture risk is casualty loss. While casualty loss in itself does not lead to tax credit recapture, it will if the project is not restored to the same condition within a “reasonable” period of time. The issue here is that it may not be possible or worthwhile to rebuild to the same condition.
Building and Zoning laws change. Ten to Twelve years after construction new laws could exist requiring greater set backs or height restrictions that make it impossible to rebuild back to the same size, which would lead to tax credit recapture.
In addition, catastrophe insurance such as Earthquake, Hurricane/Windstorm always comes along with a percentage deductible in exposed areas that can range from 2% wind/hail in minor exposed areas to 15% Earthquake near a fault line. Therefore while a project may be properly insured it may not make economical sense to come out of pocket ~10% of the total reconstruction costs on a zero cash flow project with little to no equity due to new debt levels.
CMR has partnerships with insurance companies to issue the bond that are rated at least A+ (Superior) XV (greater than $2 billion in capital/surplus) by A.M. Best with substantial surety departments that are part of large national insurance conglomerates.
The bond form itself offers extremely broad protection. The form is merely 2 pages and responds to recapture due to any non-compliance event, as long as the event occurs post ownership disposition, and has no specific time limitation as to when the bond expires or when a claim can be made.
Some highlights of the bond coverage form include:
➢ Bond responds to recapture due to any reason (including foreclosure) as long as the non-compliance event takes place post transaction date
➢ Bond is non-cancellable for up to 5 years from date of issuance; impossible to cancel once issued even if malfeasance by buyer
➢ Bond will still respond to claims for non-compliance events taking place during the bonds effective period even if the bond has been cancelled (same as not being cancelled as long as non-cancelation period extends beyond the compliance period)
➢ Prompt payment requirement = within 45 days of making a claim
➢ Traditional surety/insurance therefore insurer is subject to bad faith penalties if claim is not promptly processed/paid versus legal expense & time arguing with buyer to pay recapture/enforce your own indemnity
➢ Surety companies underwriting/indemnity with the buyer has no affect or correlation with bond payment obligations. Once the bond is issued it is locked in for the entire non-cancelation period.
➢ Bond is effective for entire compliance period and any audit discover period (actual time is not specified so protection will still apply if code changes)
➢Copyrighted form accepted by all syndicators and investors
➢Form responds to all non-compliance issues including foreclosure
➢Able to perform recapture analysis and immediate premium quotes
CMR has been issuing bonds for the past 15 years and we have relationships with all major syndicators and investors. Please contact our office if you are interested in reviewing actual bond forms. We use two bond forms, one for property sales and one for partnership interest assumptions however all benefit language is the same between both bond forms.