Council's Berrima Road deviation project will not be delivered within the expected timeframe.
Councillors discussed a report, which detailed several issues with the project, at the April 10 council meeting.
The required upgrade of the Berrima Rail crossing has been considered for several years as part of the Moss Vale Enterprise Corridor.
In November 2014 council submitted an application under the National Stronger Regions Fund to the Federal Department of Infrastructure and Regional Development.
The application stated a total estimate project cost of $9.205 million in 2015 dollars with council contributing $4.603 million.
The application was successful with council entering into a Funding Agreement in May 2016.
Under the funding agreement council was required to commence construction within 12 months of signing the agreement.
Council's operations, finance and risk deputy general manager Barry Paull said significant negotiations have to be undertaken in regard to property issues, as the works are not being built on the road reserve or on council-owned property.
There are also issues related to the relocation of electrical services that continue to make it difficult for the project to progress.
Mr Paull said council would be unable to deliver the project within the specified timeframe.
"Given that we are bound by a timeline under the federal government funding, we're not going to be able to deliver the project in a timeline that meets that funding," he said.
"Effectively council really has no choice but to hand that money back to the federal government."
An amendment that the matter be deferred for further briefing on financial matters was put to a vote and lost.
A vote was won to undertake the necessary works to make the project "shovel ready" for future grant applications.
This will include finalising the relocation of existing services, property acquisitions and topsoil and seed the constructed road embankment with an estimated total cost $4.4 million for the revised project scope.
Council will also advise the Department of Infrastructure, Regional Development and Cities that council will not be able to complete the approved works by the March 31, 2020 deadline and will therefore have to let the funding agreement lapse.