Federal Recapture Tax Demystified

There I sat, at my busy, messy, yet highly efficient desk, minding my own business when out of the blue the phone rang jarring me out of my stress induced catatonia. The java, all seventeen cups, triggered a sudden barrage of heart palpitations - I was ready for the day. I made my first executive decision of the day and hit the flashing line fully prepared for any potential meltdown awaiting me on the other end of the line. Steeled for anything, I heard the voice of lovely Suzy Escrow Officer - from the unnaturally high pitch of her voice, I vibed all was not well in the LBC (Long Beach, CA).

"Hello? Yes, I have a borrower at the table who will not sign her loan documents?" ending her declarative statement as if asking a question.

"Mmmm, hmm -- whyyy?" I asked dryly, lips pursed, weary of borrowers who refused to sign docs at the table for a variety of reasons.

"Well, it appears there is a tax form in the loan documents that her loan officer did not tell her about. It's called a 'Federal Recapture Tax Disclosure Form' and she refuses to sign it. What should I do?"

I carefully pondered my response. Should I hunt down the loan officer, smack him (or her), lovingly of course, then insist the loan officer deal with the situation directly and possibly lose the customer while betwixt and between escrow and the loan officer all points bulletin OR should I go against my best judgment, speak with the borrower directly and risk being barraged with additional questions totally unrelated to the issue at hand and possibly lose the customer anyway? In a flash, I knew what must be done; the escrow officer must translate through me the material points on federal recapture tax. Brilliant! Suffice it to say, the buyer eventually signed the required form and escrow ultimately closed.
Yes, the oh so threatening sounding FEDERAL RECAPTURE TAX, a provision associated with programs created through the issuance and sale of tax-exempt mortgage revenue bonds, is not the big scary monster lurking in the shadows to swallow you, your family, dog and cat in one fell swoop if one should sell his/her home within nine years from the purchase date. Not even close. In fact, it is more likely a spaceship manned by little grey men will land in your front yard and throw a barbeque kegger before any punishment may be meted out by way of federal recapture tax provisions associated with public benefit subsidy programs (although partying with little grey aliens in your front yard would be way cool).

OK, back on point. In the context of tax-exempt mortgage revenue bond programs and mortgage credit certificates, borrowers receive what is defined by the Internal Revenue Service as a federal subsidy benefit or public benefit. Receiving a lower than market rate interest rate is a public benefit/public subsidy (as is the case with tax-exempt mortgage revenue bond programs). Receiving a tax credit by way of lowering one's tax liability and then applying that credit to a new mortgage to facilitate qualifying is a public benefit/public subsidy (as is the case with mortgage credit certificates or MCCs). And don't forget about the bond investors who originally purchased tax-exempt mortgage revenue bond paper from which the capital was raised to create these special first-time home buyer programs. The principal and interest portion of the borrower's mortgage payment is extracted, so to speak, then passed through to the original bond investor as tax free income.

So, the federal recapture tax provision was established and written into tax law by the IRS and Congress in order to "recapture" a portion of the aforementioned public benefit subsidies and tax breaks. How does this work exactly? The maximum potential recapture tax penalty that may be assessed is equal to the lesser of 6.25% of the original loan amount borrowed or 50% of the home seller's future net proceeds on the sale of his home.

Recapture tax triggers upon the passing of a very specific set of events: 1) The home is sold within nine years from the original purchase date and 2) the home is sold at a profit and 3) the borrower's income exceeds federal income thresholds established in the year the home was originally purchased. In the event all three of the aforementioned conditions exist simultaneously upon sale of the home, recapture tax will trigger however it is a very rare circumstance indeed when all three conditions exist simultaneously. In fact, in my six years working as a bond administrator for a national mortgage bank, I witnessed only a handful of cases where recapture tax actually triggered on the sale of a home. That may be due to the fact that homes closed with 100% financing are not turned over at the traditional pace (5 to 7 years) like in years past as home owners are keeping their first homes for longer periods of time before moving out and up to larger homes. Another reason may be attributed to federal income thresholds which must be surpassed before recapture tax may potentially trigger. Those thresholds are set at the maximum moderate income limit established the year the home was originally purchased. It is possible, yet observedly unlikely, one's income will exceed maximum federal income thresholds or exceed the 5% per year allowed for incomes to increase under this provision.

If at time of sale conditions 1), 2) and 3) do not apply, will recapture tax trigger? No. In the event the home is sold in year nine and one day yet conditions 2) and 3) do apply, will recapture tax trigger? No. In the event the home is refinanced, will recapture tax trigger or go away? After a refinance, recapture tax will not trigger however, the recapture tax provision will not magically disappear after a refinance either. The recapture tax provision will remain attached to the property for the full nine year window period even through multiple refinances.

There are other special circumstances where recapture tax will not trigger: 1) transfer to spouse due to divorce where no sales transaction takes place 2) transfer due to the death of the homeowner 3) home is sold at a loss to the homeowner 4) home is lost due to a catastrophic event like a fire or flood (other conditions apply).

Please note, if the home is transferred to another party through an assumption or simply transferred outright, the home is deemed sold and recapture tax may trigger. As such, the home's fair market value as of the date of transfer will be considered the sales price. Also, the assuming party should be aware the nine year recapture window will begin anew upon completing the assumption process.

In all cases, in the context of the subject matter of this article, borrowers are strongly urged to consult an income tax professional for advice on tax benefits associated with tax-exempt mortgage revenue bond loans, tax implications specific to an individual case and filing of IRS Form 8828, if applicable.

In conclusion, when one encounters the Federal Recapture Tax Disclosure Form in a set of loan documents, it must be reviewed, completed and signed by the first-time home buyer on any purchase money real estate transaction funded with tax-exempt mortgage revenue bond program funds or closed with a mortgage credit certificate program. For more on programs specifically created for first time homebuyers of low to moderate income, go to FTHBGuru.com for an electronic copy.

Copyright 2007

Esperanza Creeger resides in Dallas, TX. A 21-year mortgage industry veteran, Esperanza's first original work, "First Time Home Buyer's Guide: Below Market Interest Rate and Down Payment Assistance Programs" is available to the general public at FTHBGuru.com. Esperanza is currently completing her second manuscript written for the big screen, "An Akakshic Tale". Contact 469 438 9659 or Ecreeger@hotmail.com

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