HAR § 18-235-110.7-16 — Exceptions to the recapture rule

(a) Transfer by reason of death. A transfer by reason of death is not considered to be a disposition of eligible property, subject to the recapture rule. This exception to the recapture rule applies to transfers by reason of death of a sole proprietor, partner, S corporation shareholder, or beneficiary of an estate or trust. (b) Example. Subsection (a) is illustrated as follows: A, a calendar-year taxpayer, places in service in 1988, eligible property with a basis of $5,000. In 1988, A takes a credit in the amount of $150 ($5,000 x 3%). A dies in 1989, and the property is transferred to A’s heir. In 1989, no credit is required to be recaptured. Further, the heir can immediately dispose of the property without the possibility of credit recapture. (c) Transaction to which I.R.C. §381(a) applies. A disposition of eligible property in a transaction to which I.R.C. §381(a) (with respect to carryovers in certain corporate acquisitions) applies is not considered to be a disposition of eligible property, subject to the recapture rule. However, if the acquiring corporation disposes of the eligible property before the close of the recapture period, there will be an early disposition and the recapture rule will be triggered. (d) Mere change in form of conducting a trade or business. (1) In general. Recapture is not required as a result of a mere change in the form of conducting a trade or business if: (A) the property is retained as eligible property in the same trade or business; (B) the transferor (or in a case where the transferor is a partnership, estate or trust, or S corporation, the partner, beneficiary, or shareholder) of eligible property retains a substantial interest in the trade or business; (C) substantially all the property (whether or not eligible property) necessary to operate the trade or business is transferred in the change of form; and (D) the basis of eligible property in the hands of the transferee is determined in whole or in part by reference to the basis of eligible property in the hands of the transferor (i.e., carryover basis). (2) Paragraph (1) shall not apply to the transfer of eligible property if I.R.C. §381 (regarding carryovers in certain corporate acquisitions) applies to the transfer. (3) “Substantial interest”, defined. For purposes of this exception, a transferor (or in a case where the transferor is a partnership, estate or trust, or S corporation, the partner, beneficiary, or shareholder) is considered to have retained a substantial interest in the trade or business if, after the change in form, the transferor’s interest in the trade or business is: (A) substantial in relation to the total income interest of all the owners; or (B) equal to or greater than the transferor’s interest prior to the change in form. A taxpayer will not be considered to have retained a substantial interest where the only basis for claiming substantial interest is that the values of the interests exchanged are equal. (A) Examples. Paragraph (3) is illustrated as follows: Example 1. A taxpayer owns a five per cent interest in a partnership. After an incorporation of the partnership, the taxpayer retains at least a five per cent interest in the corporation. In this case, the taxpayer will be considered to have retained a substantial interest in the business as of the date of the change in form. Example 2. A taxpayer exchanges a 48 per cent partnership interest for a seven per cent interest in a corporation (seven per cent of the outstanding stock), contending that the values of the interests exchanged are equal. In this case, the taxpayer will not be considered to have retained a substantial interest. (B) The determination of whether a taxpayer has retained a substantial interest in the trade or business is to be made immediately after the change in the form of conducting the trade or business, and after each time the taxpayer disposes of a portion of the taxpayer’s interest in the new enterprise. (4) S Corporation. Neither an election to be treated as an S corporation, nor a termination or loss of S corporation status automatically triggers recapture. However, recapture may result if either of the recapture events discussed in paragraph (5) occurs. In determining whether a reduction in a shareholder’s interest (for example, by a sale of stock) will result in recapture, HRS §235-110.7 §18-235-110.7-21 the 66 2/3 per cent and 33 1/3 per cent rules (as discussed in section 18-235-110.7-15(f)) apply even if the corporation is no longer an S corporation. (5) Disposition or cessation. Property ceases to be eligible property with respect to a transferor (or in a case where the transferor is a partnership, estate or trust, or S corporation, the partner, beneficiary, or shareholder), and the transferor must make a recapture determination if during the recapture period: (A) the transferee disposes of eligible property (or if eligible property otherwise ceases to be eligible property in the hands of the transferee); (B) the transferor (or in a case where the transferor is a partnership, estate or trust, or S corporation, the partner, beneficiary, or shareholder) does not retain a substantial interest in the trade or business directly or indirectly (through ownership in other entities provided that the other entities’ bases in the interests are determined in whole or in part by reference to the bases of the interests in the hands of the transferor). (6) Recordkeeping. A taxpayer who seeks to establish the taxpayer’s interest in a trade or business under this subsection must maintain adequate records to demonstrate the taxpayer’s direct or indirect interest, or both, in the trade or business after any transfer. (e) Transfer between spouses or incident to divorce. (1) In general. A transfer between spouses or incident to divorce is not considered to be a disposition, subject to the recapture rule. (2) Subsequent to a transfer between spouses or incident to divorce, a disposition by the transferee during the recapture period may result in recapture to the same extent as if the disposition had been made by the transferor at that later date. (3) Paragraphs (1) and (2) apply to transfers made after December 31, 1987, in taxable years ending after December 31, 1987. It does not apply to transfers under an instrument in effect before January 1, 1988. (f) Property destroyed by casualty. The recapture rule shall not apply to eligible property which is disposed of or otherwise ceases to be eligible property with respect to the taxpayer as a result of its destruction or damage by fire, storm, shipwreck, or other casualty, or theft. (g) Downward basis adjustment pursuant to I.R.C. §754 (regarding manner of electing optional adjustment to basis of partnership property). In the case of a partnership, a downward basis adjustment pursuant to I.R.C. §754 is not subject to recapture because the use of the property is not considered to be terminated for purposes of the credit.