Tax Reform Impact on the LIHTC Industry

Tax Reform Impact on the LIHTC Industry

The real estate industry has undergone significant changes as a result of the new rules and regulations compliments of the Tax Cuts and Jobs Act. The following are some of the provisions signed into law that directly impact those in the low-income housing tax credit (“LIHTC”) industry.

Retention of Private Activity Bonds

The final bill retained tax-exempt private activity bonds (“PABs”) which represent a crucial component of the financing necessary in a typical 4 percent LIHTC property. Without tax-exempt PAB financing, many affordable housing projects likely would not have the financing to perform the substantial rehabilitation necessary to meet the quality of living standards.

Basis Boost

A version of the Senate bill was reducing the 30 percent basis boost to 25 percent. The final bill retained the 30 percent basis boost. A 30 percent basis boost means that every eligible $1 spent on the project creates $1.30 of eligible basis. A project with $10 million of unadjusted eligible basis with a 30 percent boost yields $13 million of eligible basis while a 25 percent boost yields $12.5 million of eligible basis. Assuming a tax credit rate of 3.20 percent, this $500k decrease in eligible basis would decrease the annual credits by $16k per year and $160k in total credits. A reduction to the basis boost percentage likely would have had a downward impact on the pricing of the LIHTC, potentially making it more difficult for deals to be signed.

Interest Expense Limitation

For years beginning after December 31, 2017, net business interest expense is limited to 30 percent of adjusted taxable income which is similar to an EBITDA calculation. Investment interest is not subject to the limitation. There is an exemption for small businesses with annual gross receipts of less than $25 million for the three preceding tax years, however, this exemption is not available to partnerships that allocate greater than 35 percent of losses to limited partners. There is an irrevocable option to elect out of this limitation which virtually all LIHTC properties are expected to do. When electing out, depreciation of the residential real property can no longer be done using MACRS 27.5 years, rather the Alternative Depreciation System (“ADS”) is required. ADS previously required a recovery period of 40 years for residential real property, but under the new tax law, this has been reduced to 30 years.

Below is an actual example of a 300+ unit LIHTC project in Year 1 of its tax credit period and the impact the interest expense limitation would have had on its 2016 tax return.

Taxable loss – Actual $ (2,870,000)
Business interest expense 1,920,000
Depreciation and amortization 4,060,000
Adjusted taxable income 3,110,000
Net interest expense deduction % limitation 30%
Net interest expense deduction $ limitation $ 933,000

As a result of the interest expense limitation, the taxable loss is reduced by $987,000 as follows:

Taxable loss – Actual $ (2,870,000)
Add: Business interest expense 1,920,000
Less: Allowable net interest expense deduction (933,000)
Taxable loss – Interest expense limited $ (1,883,000)

In this circumstance, this project’s $1,920,000 interest expense deduction would be limited to $933,000 reducing the taxable loss available to tax credit investors by $987,000.

Now let’s assume the project makes the irrevocable election out of the interest expense limitation which does not limit the interest expense deduction but requires the ADS method of depreciation for residential real property:

Taxable loss – Actual $ (2,870,000)
Add: MACRS depreciation of residential real property 1,345,000
Less: ADS depreciation of residential real property (1,233,000)
Taxable loss – Elect out of interest expense limitation $ (2,758,000)

There is a significant benefit to this project in electing out of the interest expense limitation and depreciating its residential real property using the ADS cost recovery system. Electing out should help limited partners in LIHTC properties stay on course in terms of maintaining the internal rate of return projected at the onset of the deal.

Bonus Depreciation

Changes to bonus depreciation are as follows:

  • Placed in Service after 9/27/2017; before 1/1/2023 – 100%
  • Placed in Service after 12/31/2022; before 1/1/2024 – 80%
  • Placed in Service after 12/31/2023; before 1/1/2025 – 60%
  • Placed in Service after 12/31/2024; before 1/1/2026 – 40%
  • Placed in Service after 12/31/2025; before 1/1/2027 – 20%

Additionally, property no longer needs to be new and can be used in order to be eligible for bonus depreciation, provided it is the first use of the asset by the taxpayer.

It’s important to note that when electing out of the interest expense limitation, which requires the use of the ADS cost recovery method when depreciating residential real property, that bonus depreciation is no longer available.

Investing in Opportunity Act

The tax reform bill also includes an incentive for investing in low-income communities. The bill enables states to establish “opportunity zones.” When capital gains are re-invested within these “opportunity zones,” the investor may be able to defer the gain. For re-investments held for at least five years, 10 percent of the gain becomes non-taxable and another 5 percent of gain becomes non-taxable if held for at least seven years.

Other Changes Impacting the LIHTC Industry

The reduction of the corporate income tax rate from 35 percent to 21 percent is another significant change which has already put downward pressure on the value of the LIHTC to investors.

The tax reform bill also changed the inflation factor associated with future LIHTC allocations to a ‘chained’ consumer price index. This will reduce future allocations of low-income housing tax credits. With fewer credits, less tax credit equity is anticipated which ultimately will negatively impact low-income housing in terms of new units or substantially rehabilitated units.

Also included in the tax reform bill is the Base Erosion and Anti-Abuse Tax (“BEAT tax”) which is essentially similar to the alternative minimum tax only for large corporations with international operations. Investors subject to the BEAT tax could lose the ability to utilize up to 20 percent of their LIHTCs from 2018-2025 and 100 percent thereafter. If large corporate investors, such as banks, are impacted by the BEAT tax, this could also put downward pressure on demand and pricing.

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