The Lawyer’s Perspective
By Jerome A. Breed & Dawna Steelman
9 min read
Public Law No: 115-97 enacted on December 22, 2017 and commonly known as the “Tax Cuts and Jobs Act” (TCJA) maintained Section 42 of the Internal Revenue Code of 1986 as amended (the “Code”) leaving private activity bonds for housing rendering Low Income Housing Tax Credits (LIHTC) untouched. But there were other changes throughout TCJA that impact the LIHTC industry and investing. Here are six we have identified:
1.Corporate Tax Rate
The corporate tax rate is now 21 percent rather than 35 percent and the corporate alternative minimum tax has been repealed. During 2017, most of the industry had anticipated an assumed 25 percent corporate income tax rate for purposes of equity and tax credit adjuster pricing. The reduction from a 25 percent to a 21 percent corporate tax rate under TCJA results in a couple cent decrease in pricing relative to 2017 as a result of the reduction in yield. Acceleration of deductions that will arise from expensing, discussed below, will not offset the effect of the rate reduction and anticipated slower depreciation under TCJA. Some developers may prefer to maintain current pricing levels by deferring capital contributions until later in construction and operations.
2. Interest Deduction Limitations and Depreciation
A new limitation on interest deductions was enacted via an amendment to Code Section 163(j). Commencing on January 1, 2018, “business interest” deductions will be limited to the sum of (a) business interest income plus (b) 30 percent of the taxpayer’s adjusted taxable income. After January 1, 2022, “adjusted taxable income” is determined without excluding depreciation, depletion or amortization, which will result in a materially lower amount of business interest expenses that are deductible. New Code Section 163(j)(4) provides that the limitation on business interest deductions is applied at the partnership level. Partnerships owning LIHTC properties (“LIHTC Partnerships”) typically have little or no taxable income or business interest income and are likely to lose a majority of their interest deductions if the new limitation is applicable. Thankfully, however, new Code Section 168(g)(8) excludes electing partnerships that operate a “real property trade or business” (RPTOB) as defined in Code Section 469(c)(7)(c). The election to opt out is irrevocable and comes at a price. The consequence of electing to be treated as a RPTOB is mandatory use of the Alternative Depreciation System (ADS) residential building schedule of 30 years, which was reduced by TCJA from 40 years under prior law. TCJA also enhanced bonus depreciation by amending Code Section 168(k) to provide for 100 percent expensing of qualified property. This is only for property acquired after September 27, 2017 and the percentage of basis that qualifies for immediate expensing decreases by 20 percent per year after 2022. Qualified property is generally depreciable property having a recovery period of 20 years or less and so would include personal property and sitework.
The limitation on interest deductions will have a small impact on the industry. For most LIHTC Partnerships, the anticipated interest deductions would exceed business interest income, plus 30 percent of the LIHTC Partnership’s adjusted taxable income, meaning that most LIHTC Partnerships will need to make the RPTOB election in order to take the anticipated interest deductions from the transaction and will be subject to 30-year depreciation. The difference between 27.5-year depreciation and 30-year depreciation for buildings generates an insignificant impact on yield and equity pricing. For those LIHTC Partnerships with nonprofit ownership that have Code Section 704(b) capital account issues, the new 30-year ADS life eliminates the 40-year ADS of residential buildings, which was a tool the industry previously utilized to defer deductions to avoid tax credit reallocations. Despite the change in ADS, most nonprofits with ownership in LIHTC partnerships will still need to make the 168(h)(6) election in order to maintain bonus depreciation. As mentioned below, it is expected that most LIHTC partnerships will need bonus depreciation to offset the slightly longer depreciation schedule for buildings. Code Section 168(k)(7) was not changed by TCJA and LIHTC partnerships still have the opportunity to elect out of bonus depreciation.
The slightly longer 30-year ADS depreciable life, taken together with bonus depreciation will likely be yield neutral in most deals neither increasing nor decreasing equity pricing. Some LIHTC partnerships may encounter Code Section 704(b) capital account issues as a result of the accelerated bonus depreciation. The bonus depreciation, especially when paired with deferred capital contributions as a yield maintenance strategy, may cause capital account issues in the first year that can be resolved with low-risk deficit restoration obligations satisfied by subsequent scheduled capital contributions by the investors. Alternatively, LIHTC partnerships can elect out of bonus depreciation and those with nonprofit ownership can have their nonprofits refrain from making the 168(h)(6) election rendering the LIHTC partnership ineligible for bonus depreciation. Reduced equity pricing and 30-year depreciation may cause capital account issues in later years of the credit period and compliance period. Many deals will work around these issues by disaffiliating debt, including deferred development fees, and re-allocating losses after the end of the credit period. With more transactions experiencing negative capital accounts in later years, exit taxes will remain a hot button topic in exit provision negotiations.
3.The BEAT
The Base Erosion Anti-Abuse Tax (the “BEAT”) is a new tax that impedes corporations from generating federal income tax deductions through payments to non-U.S. affiliates while generating untaxed foreign income. Taxpayers who incur BEAT liability may lose the benefit of up to 20 percent of their LIHTC for 2018 through 2025 and may lose the benefit of up to 100 percent thereafter. They may also lose approximately 50 percent of the benefits of tax losses from investment in LIHTC Partnerships. Once a taxpayer loses the LIHTC, the credits are gone—there is no carryforward of LIHTC lost to BEAT.
LIHTC investors need to determine their exposure to BEAT. BEAT will negatively impact some of the larger banks, particularly those owned by non-U.S. parents. Industry professionals have described some substantial investors as temporarily “side-lined” as they determine the impact of BEAT on their taxes and investments. Many state and regional banks, however, continue to invest because they perceive less impact from BEAT. At this point, it is too early to determine the long-term impact of BEAT, but if fewer investors compete for deals, equity pricing in some markets may be temporarily reduced. CRA footprint markets are likely to see a decrease in equity pricing, but not beyond the few pennies that professionals have been seeing as a result of the lower corporate income tax rate. Non-CRA markets may experience a greater reduction. Having some of the larger investors temporarily out of the market, however, may provide state and regional banks opportunities to increase market share.
4.Technical Partnership Termination Repeal
The transfer of partnership interests no longer will trigger a technical termination of partnership status for federal income tax purposes. The elimination of the technical termination rules for partnerships may impact a modest number of deals that have used technical terminations as a device to defer losses and avoid tax credit reallocations. Alas, there is one less tool in the toolbox to help fix tax issues with underperforming projects.
5.Repeal of Tax-Free Non-shareholder, Capital Contributions
The elimination of tax-free Code Section 118 non-member corporate contributions as devices to channel granted funds to LIHTC projects will force developers to utilize nonprofits as conduits for governmental grant funding. Loans from nonprofits would appear to offer the only avenue to avoid income recognition or basis reduction from receipt of granted funds.
6. Impact on Pre-2018 Transactions
TCJA will impact deals that have already closed because it will be applicable to property placed in service after December 31, 2017 and will require elections that will trigger statutory provisions that have been changed by TCJA. For those projects that placed in service after September 27, 2017 but before January 1, 2018 no action is necessary to qualify for bonus depreciation. Such projects will automatically benefit from bonus depreciation unless they elect out of it. The limitation on interest deductions is effective for all taxpayers on January 1, 2018, so the majority of LIHTC Partnerships will need to make the RPTOB election. Unfortunately, under the current version of TCJA, the change in ADS from 40 years to 30 years is only effective for projects placed in service after January 1, 2018. Without a technical correction, projects placed in service prior to January 1, 2018 elect out of the limitation on interest deductions will be subject to 40-year ADS going forward. Since no policy reason supports this penalty, it is reasonable to hope for such a technical correction.
Conclusion
After an initial collective sigh of relief that Section 42 and private activity bonds for housing were unchanged, the industry started to analyze the other aspects of TCJA and the impact on the industry and particular deals. Syndicators and developers alike should assess whether closed deals should make the RPTOB election and re-run their financial models to determine the impact on capital accounts of the longer ADS depreciable life and other TCJA changes. With respect to deals in the closing process, parties have adopted the new corporate income tax rate and other TCJA changes to calculate equity pricing. Financial models are being run with bonus depreciation, and workarounds for resulting capital account issues are being implemented. As investors evaluate their BEAT exposure, pricing is uncertain in some markets and may fluctuate more than usual over the next quarter or two. Unrelated to the passage of TCJA, many developers and investors are incorporating Partnership Representative language in their documents as a result of the implementation of the new Partnership Audit guidelines and the resulting amendments or side letters may include approaches to some of the issues raised by TJCA. As we have done many times before in the last 30 years, the affordable housing community will adapt to yet another new world and continue to create much needed housing for our communities.
