To Deduct Interest or Depreciation?

The Tax Cuts and Jobs Act of 2017 (TCJA) changed some guidelines for housing. As I noted in the Housing USA column in this issue, it capped the state and local tax (SALT) deduction at $10,000, and limited the deduction on mortgage debt interest, two measures that mostly impacted wealthy homeowners.

But another provision of TCJA more relevant to housing developers utilizing Low Income Housing Tax Credits, was the law’s disallowance on business interest deductions. It has proven to be costly for large-scale developers through 2018 and 2019, but they may be able to get a refund thanks to the Consolidated Appropriations Act of 2021 (CAA), known popularly as the $2.3 trillion stimulus relief bill signed this past December.

For these last couple years, TCJA has indeed left large-scale developers and property owners with a choice during tax season: deduct interest or, under Section 163(j), deduct depreciation on their properties. Kenneth Silverberg, senior counsel with law firm Nixon Peabody’s corporate practice, says that this tradeoff was instituted to prevent revenue shortfalls. After all, the Congressional Budget Office has revenue balance standards for tax reductions; and because TCJA would authorize a broad income tax cut, revenue collection had to be made up for from somewhere. That somewhere turned out to be large taxpayers with annual gross receipts exceeding $25 million, who now have limits on deductions for business interest expenses.

“TCJA increased taxes on certain highly-leveraged businesses,” says Silverberg, noting that some LIHTC developers and financiers fit this category. “You could say that the affordable housing sector was disproportionately hurt.”

Taxpayers in this situation were given another choice: calculate depreciation within an alternate depreciation schedule (ADS) of 30 years for properties built after 2018, but 40 years for those built prior to 2018. (Usually multifamily properties are depreciated over a 27.5-year period.)

The accounting firm Nisivoccia elaborates on its company blog, “Businesses that opt out [of the limitation of their interest deduction] must use the ADS for certain property (generally, real property with a recovery period of ten or more years) used in the business, regardless of when the property was placed in service. Moreover, businesses that opt out can’t claim bonus depreciation for affected property, and the opt-out election is irrevocable.”

While the threshold for this limitation may be $25 million, this impacts more LIHTC-related businesses than one might think, according to Crowe Financial Services. That’s because the “small business exception” only applies to those entities that can use cash receipts accounting, which excludes most LIHTC partnerships. This is on top of the fact that TCJA had negative consequences on LIHTC to begin with: the 14 percent drop in corporate income tax rates reduced write-off potential, making purchases of LIHTC less lucrative. Pillsbury Law stated after the law was implemented, “This rate reduction will negatively impact the yield on existing LIHTC deals by reducing the value of post-2017 losses from 35 cents per dollar of losses to 21 cents per dollar (although the value of the LIHTC itself is unchanged—a dollar of tax credit is still worth a dollar).”

That placed developers in a bind, Silverberg argues, because a developer’s eligibility to finance a LIHTC deal is tied to the availability of capital.

“When you take a dollar of depreciation as an expense, that reduces your capital. The difference between an affordable housing investor and someone who’s not taking a tax credit is the tax credit guys might be concerned about burning off their capital too fast.” As a result, “[depreciation] may cost them tax credits that they’ve already counted on. So they have to watch two things simultaneously.”

For this reason, says Silverberg, most affordable housing developers have opted for the interest deduction. The initial COVID-19 relief legislation added an exception for properties built after 2018, but no relief was made available for older properties. Furthermore, adjustable taxable income, which figures into the deduction cap, will not allow for depreciation adjustments starting in 2022, according to Crowe Financial.

One point of the CAA is to create a more streamlined and faster depreciation window, reducing the depreciation period from 40 years to 30. Silverberg, who wrote a thorough piece on CAA for Nixon Peabody, says that the prior structure was identified as too burdensome for investors, and that this change will be mainly beneficial for large-scale properties, which are at the midpoint of their useful life.

“The whole purpose of this is to ease some of the charges that were put on residential rental property owners to pay for the tax cuts of 2017,” reducing the burden placed on debt-financed businesses with physical assets. The revenue returned could be significant; Silverberg writes that “the Joint Committee on Taxation estimated the federal budget impact of this change to be over $1.2 billion in 2021 alone; presumably, most of this amount would come from amended-return-refunds paid to RRP rental businesses.”

The main benefit following CAA is that more investors have two viable deduction options. According to Silverberg, developers and investors should consider filing amended returns for the period from 2018 to 2021, in order to deduct depreciation.

“That doesn’t mean [a] check in the mail tomorrow…it may be a year before you see the cash; but it gives you the ability to reconsider the election.”

For partnerships, the situation could be particularly complex, as the IRS uses a specific method for amending partnership returns.

“But bottom line is actual cash tax refunds, and everybody ought to consider it if they’re eligible.”

Furthermore, there may be issues with federal changes outpacing those at the state level, and those who think they can make a claim will need to verify compliance. In any event, LIHTC investors ought to explore a switch to the 30-year schedule, and take advantage of the new deduction options if they find it beneficial. It could offset the impact of TCJA’s changes on the affordable housing market.