(1) Since you are doing the velocity diet and workouts maybe you should ask the guy who actually designed it (Chris Shugart)
(2) Muscle doesn't replace fat nor can muscle turn into fat when you stop training. They are two different and independant tissues. Now, when you go fromn sedentary to training fairly hard and eating fairly well, you will drop some fat (because you are burning more calories than you are used to, and eating less junk) and build some muscle (because you are lifting, which you weren't used to). But it's not fat turning into muscle.
(3) After a certain time, past what we call "beginner gains" it will become hard to gain a significant amount of muscle mass while also losing a significant amount of fat. Normally you can only progress fairly fast in one of the two goals (e.g. gaining muscle while maintaining fat levels OR losing fat while maintaining muscle mass)... you can do both at the same time, but it will be a slow process.