When is a tax credit not a tax credit? When the IRS takes it back. If you're in the situation where you have to file IRS Form 4255, you might have to pay back a tax credit you've earned in prior years. This process, known as recapture, occurs if you claim a credit—in this case, a credit for a specific type of business investment—and then no longer qualify for that credit.
Investment tax credit
Before you can file Form 4255 to determine you’re liable for a recapture, you must earn the tax credit in the first place. The "investment tax credit" is actually five different credits used by the IRS to encourage business development in certain qualifying areas. These projects and credits all comprise the investment tax credit:
- gasification projects
- coal projects
- advanced energy projects
- the rehabilitation credit
- the energy credit
Specific uses of the credit are outlined in IRS Form 3468.
Recapture of investment tax credit
If your company no longer uses an asset that you received an investment tax credit for, you may have to forfeit part or all of the credit. According to the IRS, transactions that demonstrate that you “no longer use an asset” include the following:
- sale of an asset
- conversion of an asset from business to personal use
- theft of an asset
- casualty loss of an asset, such as a fire
- gifting of the asset to another party
Typically, you're off the hook to pay back the credit if your business has used the asset for at least five years. However, if you're still within the five-year window, you'll have to file Form 4255 to determine how much of the credit must be recaptured.
Effect on taxes
As with all tax credits, the investment tax credit reduces your tax liability on a dollar-for-dollar basis. For example, if you owe the IRS $3,000 and claim an investment tax credit of $1,000, your tax liability drops to $2,000 ($3,000 taxes you owed - $1,000 of tax credit = $2,000 total taxes owed). This is different than a deduction, which simply lowers the amount of your income that is taxed.
If you have to file for a recapture of the tax credit, the amount of tax you pay goes up, just the opposite of how you claimed the original credit. For example, if you owe $2,000 on your taxes and Form 4255 indicates a recapture of $1,000 of investment tax credit, your tax liability will rise to $3,000 ($2,000 taxes you owe + $1,000 recapture = $3,000 total taxes owed).
Adjusting cost basis
If you claim the investment tax credit, this will lower the cost basis of the assets you originally purchased. The amount will be either 50 or 100% of the credit you originally received. This can translate into a higher tax liability if you later sell the assets within the 5-year window.
For example, if you paid $10,000 for a qualifying coal project and must reduce your cost basis by 50%, from a tax perspective it will be the same as if you originally paid only $5,000.
If you later sell it for $20,000, you'll owe tax on the $15,000 gain ($20,000 - $5,000 = $15,000) rather than a $10,000 gain ($20,000 - $10,000 = $10,000).