Fiat LIHTC
By David A. Smith
4 min read
In 1887, theoretical physics faced an epochal crisis: is light a particle or a wave?
Isaac Newton thought light was a particle: it moves in straight lines, reflects off smooth surfaces, and refracts if deflected. But Newton couldn’t explain interference effects; a century later, Fresnel and Thomas Young gave wave proponents the upper hand. Yet waves need a medium in which to travel, and light travels everywhere in the universe, including through a perfect vacuum. So there had to be a substance “below” vacuum, omnipresent cosmic ether. Yet no experiment could perceive the ether – where was it?
In 2013, public accounting faced a similar crisis: If the low-income housing tax credit is a fixed-income investment like interest, where can that be shown on a public company’s financial statement? For these companies, the most important number they report to the capital markets is pre-tax earnings-per-share (EPS). If EPS rises, markets smile. Next most important is effective tax rate (ETR): combine a high EPS and a low ETR and the capital markets smile broadly. Hence a public-company CFO wants to reduce ETR but not EPS.
Lo and behold, LIHTC investments can lower ETR without reducing EPS. By investing in LIHTC, a CFO can convert cash into higher after-tax earnings. This transubstantiates a balance sheet item to an income-statement benefit, and smoothes out after-tax earnings. The CFO is lauded.
Like theoretical physicists, accountants seek to classify the financial universe into a realm of verities and binary choices. A thing is income or expense; it produces profit or loss. If it is a state, put that particle on the balance sheet; if it represents a change of state, pass that wave through the income statement. Accountants also occasionally lapse into an implied morality. Assets, income, and profits are the good for which all moral businesses strive; liabilities, expenditures, and losses are necessary evils. Hence losses and credits follow the profits allocation, profits follow cash. Any transaction whose principal purpose is tax reduction must be inherently suspect, not “economic.”
This financial morality has assumed greater significance since 2008, when Congress and the SEC made accountants guardians of public-company reporting truth. In turn, accounting has its college of cardinals, the Financial Accounting Standards Board (FASB), for whom any transaction whose principal purpose is tax reduction is inherently suspect.
Over recent months, the FASB’s Emerging Issues Task Force (EITF) has been pondering LIHTC’s proper treatment. If LIHTC is an economic investment, shouldn’t its losses reduce pre-tax earnings like any other expense? If it’s a tax investment, shouldn’t tax credits not yet received be deferred tax assets? Which is it?
Neither, said the industry. Even though corporate investors use LIHTC to convert balance sheet cash into after-tax earnings, even though tax benefits (and CRA considerations) are virtually the entire reason for investing today, and even though LIHTC investors seldom if ever get big cash back, LIHTC shouldn’t be treated as a tax play. Nor should it be treated as an economic play. LIHTC is LIHTC, a thing unto itself.
Back to 1887. Light waves had to travel through the ether, whose existence Michelson and Morley tried to prove: split a beam of light, send it two ‘upwind’ and ‘downwind’, then recombine the two beams. Alas, the experiment was a failure.
Michelson and Morley repeated the experiment. Again nothing.
There was no ether wind.
Therefore there was no ether.
Therefore light could not be a wave.
According to 1887 theoretical physics, light was impossible.
Eventually physics recovered. Light is light; there it is. It is a particle when convenient, a wave when convenient. That physicists cannot pigeonhole it neatly into a pre-existing framework makes no difference. For proving this negative, Michelson and Morley won the Nobel Prize.
In accounting terms, LIHTC is LIHTC, and there it is. Is LIHTC economically motivated, or tax motivated? It is both; the tax considerations are the economics, and these are righteous because the federal government has deemed them righteous.
On November 14, the EITF saw the light, unanimously recommending classifying LIHTC as a thing unto itself (see article on p. 6). On December 11, these changes are expected to be ratified by the full FASB.
Fiat LIHTC.
David A. Smith is Chairman of Recap Real Estate Advisors, a Boston-based real estate services firm that optimizes the value of clients’ financial assets in multifamily residential properties, particularly affordable housing. He also writes Recap’s free monthly essay State of the Market, available by emailing [email protected].
