What it means
State and local housing agencies can raise money by issuing tax-exempt bonds and use the proceeds to offer lower-rate mortgages to first-time or lower-income buyers. Because the bond interest is exempt from federal tax, investors accept a lower return, and that saving is passed on to the homebuyer as a cheaper mortgage.
The recapture tax exists to stop that benefit being kept as a pure windfall by owners who quickly sell for a gain and no longer need help. Three conditions generally have to be met before any tax is due.
The home must be sold within nine years of the mortgage closing, the owner must make a gain on the sale, and the owner's income in the year of sale must exceed a limit that rises over time after closing. If any of those conditions is missing, no recapture tax is owed.
When the tax does apply, its size is the lower of two amounts. One is half of the gain on the sale, and the other is a percentage of the original loan, scaled by how long the owner held the home and by how far income is above the limit.
The holding period scale builds up over the first five years and then falls away until the ninth. Finance professionals meet the concept in two ways.
Lenders and housing agencies are required to explain the possible tax at closing, and tax advisers must prepare the form that reports it in the year of sale, even when the amount due turns out to be zero. Agencies sometimes offer a worked example in the borrower's closing papers.
The nuance is that the tax is separate from capital gains tax on the sale. It is calculated in addition to any other tax on the profit, and a loss on the sale means there is no recapture.
Because the rules are set by tax law and the details are adjusted over time, an owner should always check the current instructions or ask an adviser before selling.
In practice
Real-world examples.
Example
A teacher buys her first home with a bond-funded loan of $150,000. After two years she receives a large pay rise and sells for a gain of $20,000. Her income now exceeds the limit, so she files the recapture form and pays the lower of the two calculated amounts.
Example
A young couple use the same type of loan and sell after four years because of a job move. The sale produces a loss once costs are counted, so there is no gain and no recapture tax. They still file the form to confirm that nothing is owed.
Example
A nurse keeps her bond-funded home for ten years before selling at a large profit. Because the sale is more than nine years after closing, the recapture rules no longer apply. Her tax adviser reminds her that ordinary capital gains rules still apply.
Formula
Calculation
Recapture tax = The lesser of (50% of gain) and (6.25% of highest loan balance x Holding period % x Income %)
A homeowner took a mortgage revenue bond loan of $200,000 and sells in the third year of ownership at a gain of $10,000. The maximum subsidy is 6.25% x 200,000 = $12,500. The holding period percentage for year three is 60%, so 12,500 x 0.60 = $7,500. Assume income is well above the limit, so the income percentage is 100%. Half of the gain is 0.50 x 10,000 = $5,000, and the lesser of $7,500 and $5,000 is $5,000, so the recapture tax is $5,000.Case study
Seen in the real world.
Oakmere Housing Finance is an illustrative, fictional state agency that issues bonds to fund lower-rate mortgages. Its loan officer, Dana, noticed that buyers often forgot about the recapture tax until they sold, and several had been surprised by a bill.
She introduced a one-page summary at closing showing a worked example using a loan of $180,000: the maximum subsidy is 6.25% x 180,000 = $11,250, and the amount actually due would depend on the year of sale, the gain and income. The summary also told buyers to keep records of home improvements, which raise the cost base and reduce the gain.
Within a year, the illustrative agency reported fewer complaints and more borrowers asking for advice before they sold. The lesson is that a hidden tax is much less painful when it has been explained in advance.
Watch out
Common mistakes.
- Assuming the tax applies to every home sale, when it only affects certain bond-funded mortgages sold within nine years at a gain.
- Forgetting to file the form in the year of sale, even though the tax due may turn out to be zero.
- Treating the tax as a replacement for capital gains tax, when it is a separate charge calculated by its own rules.
Questions
People also ask.
Who has to pay federal subsidy recapture?
Only owners who financed the home with a qualifying mortgage revenue bond loan, sold within nine years, made a gain and had income above the applicable limit.
Can the tax be larger than the profit on the sale?
No, the amount is capped at half of the gain, so a small profit means a small tax.
How can an owner reduce the gain?
By keeping records of capital improvements and selling costs, which increase the cost base and shrink the taxable gain.
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