Accounting Win for Affordable Housing: Rule Changes Make LIHTC Investments More Attractive
By Glenn Petherick
10 min read
Low-income housing tax credit (LIHTC) investments will be more attractive as the result of accounting rule changes adopted December 11 by the Financial Accounting Standards Board, according to LIHTC industry sources. But they differed as to what the future impacts are likely to be on LIHTC investment volume, housing credit pricing, and yields.
The changes culminate an industry effort to win more favorable accounting treatment for LIHTC investments that began in September 2010.
FASB expects to issue formal guidance by January 2014 to implement the changes. Companies will be able to apply the approved new accounting method, if they utilize it, to their existing LIHTC investments retroactive to January 1, 2013 as well as to any future investments. In related news, the LIHTC industry got a second boost from new interpretative guidance relating to the Community Reinvestment Act. (See article on p. 14.)
Accounting Update Ratified
At its December 11 meeting, the Financial Accounting Standards Board (FASB) ratified a proposed “accounting standards update” – approved November 14 by its Emerging Issues Task Force (EITF) – that liberalizes the rules for how publicly traded companies account for their investments in LIHTC projects on their financial statements. The new accounting rule changes will allow corporate investors, if certain conditions are met, to elect to use a new “proportional amortization” method of accounting for their LIHTC investments instead of the less favorable “equity” method.
For the affordable housing industry, the major benefit will be that LIHTC investments will no longer create a “drag” on the operating income of the companies that make the investments. Under current rules, the equity losses generated by LIHTC projects and any impairment losses related to the investment are recognized as a component of the investor’s operating income or what is commonly referred to as its “above the line” (pre-tax) earnings (see sidebar).
Under the new rules, all of the investment activity – the tax losses, the housing credits, and the amortization of the investment – will now be reflected on a net basis in the income tax expense section of the income statement. While the difference may strike some as mere optics (since the investment’s net impact on after-tax earnings will not change), the difference in presentation has major consequences. The primary reason for this is that most companies are analyzed by the investment community based on their pre-tax rather than their after-tax earnings.
Industry sources said the “hit” to pre-tax earnings from LIHTC investments accounted for on the equity method has deterred numerous companies from investing in housing tax credits, notwithstanding that they have an attractive yield compared to alternative investments. In addition, compensation of some senior corporate executives is tied to the level of pre-tax earnings.
“Imagine how difficult that has made pitching LIHTC investments to the CEO or CFO of a public company” says Fred Copeman, of CohnReznick LLP. “The internal advocate for making the investment, typically someone from the corporation’s treasury or tax function, is asking for authority to make an investment that literally will depress the company’s operating income. That has often resulted in a brief and uncomfortable conversation. But I expect that the new accounting treatment will remove that stigma and should facilitate a fair hearing on the investment’s actual merits.”
“This clearly will increase the attractiveness of investing in the low-income housing tax credit,” says San Francisco CPA Michael Novogradac, managing partner of Novogradac & Company LLP. “The question becomes how significant it will be.”
The industry sources, interviewed prior to the FASB’s vote on December 11, all welcomed the accounting change proposal as it was approved by the EITF – and subsequently by the FASB.
“It’s the appropriate way to account for [LIHTC] investments and most accurately reflects them on an investors’ financial statement,” said Rob Golden, an executive at Capital One and current president of the Affordable Housing Investors Council (AHIC). He said Capital One and AHIC both supported the change. Golden and other sources were also pleased that EITF decided not to classify LIHTC investments as the acquisition of deferred tax assets, which would have had negative consequences for banks, but rather to continue to treat them as investments or “other assets” on the investor’s balance sheets.
Golden, when interviewed December 6, said Capital One was still evaluating the accounting change proposal and hadn’t yet decided – assuming FASB adopted the proposal – whether the company would switch from the equity to the proportional amortization method of accounting for its LIHTC investments.
The new accounting standard will permit investors to elect to use the proportional amortization method or continue using their current accounting method. Current alternatives include the equity method, the cost method, and the effective yield method (for “guaranteed yield” investments).
The accounting standards update doesn’t apply to investments in projects generating new markets, historic, or renewable energy tax credits. However, the FASB directed its staff to do further research on these credit types and may address the issue in 2014.
Sources Differ on Expected Impacts
Industry sources differed in their views on the impact they expect the accounting rule changes to have on the LIHTC industry and equity market.
Ron Diner, executive chairman of Raymond James Tax Credit Funds, Inc., a LIHTC syndicator, felt that some current housing credit investors will invest more and that there will also be some new investors as a result of the accounting change. “We think this is a good thing for the industry in bringing more capital to affordable housing,” he said. “…All initial feedback that we’ve had has been favorable.”
Copeman, though, said, “It’s too soon to know whether this will tip some companies in the right direction and bring them into the market. I don’t expect a huge influx of new investors, but I can tell you that the brokerage firms that specialize in LIHTC investments are talking to every Fortune 1,000 company not already in the market. I expect we will see some new investors, but their cumulative impact will probably be more on the margins as opposed to a fundamental shift in the market.” Copeman thought any increased volume from current investors will more likely be from insurance companies and non-financial companies rather than the major banks.
Jack Casey, vice chairman of Meridian Investments, Inc., a broker of several types of tax credit investments including housing credits, predicted “the market is going to get bigger,” primarily because of new investors attracted to LIHTC. He felt the new investors for the most part will not be banks or insurance companies, now the predominant investors in housing credits. Rather, Casey anticipated that the first wave of new investors will be corporations with “lots of cash,” such as high-tech and pharmaceutical companies. In fact, he noted two major clients (high-tech firms) were about to go for board authorizations of $500 million and $250 million for LIHTC investments. These firms decided to begin investing in housing credits because of the pending accounting rule change, Casey said.
Casey and several others, though, cautioned that a surge in equity from new investors won’t happen quickly. It will take months to educate companies about LIHTC investments and the program, go through several rounds of meetings and approvals, and finally win a board vote authorizing a certain dollar amount for LIHTC investments. “We think it’s going to take six to twelve months before we really see corporate investment pick up,” says Casey.
Some of the sources felt that the accounting changes may improve the credit pricing for some LIHTC projects going forward.
Novogradac didn’t anticipate increased credit pricing for projects in “high CRA-driven” markets (e.g., New York City, San Francisco), where prices are already lofty because of intense competition among major banks and syndicators. But he suggested there could be increased pricing for projects in non-CRA markets because of a larger number of investors not subject to CRA willing to invest in these areas. He also felt there could be higher pricing for deals with high losses and deals financed by tax-exempt bonds.
Sources were generally uncertain as to what impact, if any, the accounting rule changes will have on the level of yield to investors from LIHTC investments going forward, particularly multi-investor funds, which tend to be popular with insurance companies and new investors.
A Result of Industry Advocacy
The FASB action caps a successful campaign by the affordable housing industry to gain approval of a more favorable accounting method for LIHTC investments that began September 15, 2010. On that day, LIHTC industry officials attended a meeting in Washington, D.C.
at which representatives from the White House, U.S. Treasury, Securities and Exchange Commission, and the U.S. Department of Housing and Urban Development asked what might be done to help the then-battered LIHTC market that would not require any statutory changes or have any cost to the federal government.
Ron Diner said he suggested a change in the accounting treatment for LIHTC investments, which was identified by most industry attendees later that day as the No. 1 priority.
The industry subsequently organized a nationwide task force of LIHTC investors and sponsors to press for the change. This task force, led by Raymond James Tax Credit Funds, Michael Beck of CohnReznick LLP, and Bentley Stanton of Novogradac & Company LLP, developed a white paper in 2012 that explained how accounting for LIHTC investments under the equity method tended to distort the operating income of the companies making these investments. The paper was presented to the SEC’s chief accountant and to the EITF, which took up the issue in March 2013 and subsequently issued an “exposure draft” proposing new accounting changes for public comment. This was followed by the EITF’s eventual recommendation to the FASB on November 14 and the FASB’s vote to accept that recommendation on December 11.
Amortization Method of Accounting
Under the new amortization method of accounting, investors will write down (amortize) the value of their LIHTC investment each year in proportion to the amount of housing credits they expect to receive over the remaining holding period. The measuring period will be the number of years over which the investor expects to receive the projected housing credits, which in most cases will be the 10-year tax credit period.
For example, if a company makes a $1 million investment and expects to receive $1 million in tax credits equally over 10 years, it would write down the balance of its investment by $100,000 each year. As a result, by the end of the tenth year the investment will be fully retired.
As a practical matter this calculation will be slightly more complex, because an investment might not start generating housing credits until the second year and might not finish generating credits until the eleventh or twelfth year.
Sidebar
The Hit from the Equity Method*
The following hypothetical example illustrates why the equity method of accounting is unattractive to corporate investors in LIHTC transactions:
Company X invests $100 million in five corporate housing tax credit funds, each of which in turn invests in 10 LIHTC project partnerships.
Assume that each of the 50 properties reports the following identical results in a given year:
— Rental Income $100,000
— Operating Expenses & Interest (-$99,000)
— Depreciation Expense (-$51,000)
— Net Loss (-$50,000)
While the properties are operating as expected and generating modest cash flow, under the equity method they will cumulatively report “book” losses of $2,500,000 to the funds that have invested in them. These book losses then flow from the fund’s audited financial statements to the income statements of the fund’s investors, including Company X, reducing their pre-tax income.
Since LIHTC buildings are depreciated over 40 years for book purposes, 15 years of depreciation-driven equity losses will not, by themselves, reduce the investment balance to zero. As a result, investors on the equity method also have to report impairment losses to fully retire the investment balance. These losses also reduce operating income.
* Provided by CohnReznick LLP
