Impact of Tax Reform on Affordable Housing Deals

7 min read

The accountant’s perspective  

In the weeks since the passage of HR 1, also known as Tax Cuts and Jobs Act (Act) on December 22, 2017, we have been assessing the potential impact of this law on the affordable housing industry. The good news is that the bad results we feared from the possible elimination of the private activity bonds, Historic Tax Credits and reduction of the 30 percent basis boost to 25 percent did not happen. This was a result of significant ground roots advocacy.

This does not mean that the new law will not impact affordable housing deals. The change that is likely to have (and to some extent already has had) the biggest impact is the corporate tax rate reduction from 35 percent to 21 percent. In 2017, most investors assumed that there would be a tax rate reduction to 25 percent and they adjusted their pricing accordingly. The expectation is that pricing in the short-term will drop four cents or so from pricing seen in the fall of 2017.

Interest Limitation
The changes that are most likely to impact affordable housing deals relate to the ability to fully deduct interest known as the 30 percent interest limitation. The Act generally limits the annual interest expense deduction to 30 percent of adjusted taxable income plus business interest income plus floor plan financing interest. Adjusted taxable income is the taxable income of the taxpayer computed without regard to:

  • Income gain, deduction or loss not allocable to the trade or business;
  • Business interest and business interest income;
  • Net operating loss deductions;
  • The new 20 percent deduction for pass-through income; and
  • Before 2022 depreciation, amortization and depletion.

The key to the calculation for most affordable housing partnerships is that depreciation is only added back through 2021. If depreciation is not added back then the partnership is likely to have a taxable loss and no business interest expense in excess of business interest income would be allowed. The good news is that a real property trade or business can elect out of these provisions.

In order to fully deduct all business related interest expense, the owner (usually a partnership or LLC) will have to make an election to be treated as real property trade or business. This election will require that the owner switch to the alternative depreciation system (ADS) for all residential, nonresidential real property and qualified improvement property. The election once made is irrevocable. The election does not impact personal property (five-year property) or depreciable land improvements (15-year property). The new ADS life for residential real property is 30 years. The details of the revised depreciation calculation are not specified, but future IRS guidance may follow the regulations for depreciation when there is a change in use of the property.

An example may help to clarify the analysis: Assume a $10M building was placed in service in January 2012 using 27.5 year depreciation. After six years, on December 31, 2017, the adjusted basis of the building (original basis less depreciation) is $7,832,000. There is a question about which ADS life should be used for buildings placed in service prior to 2018. The life may be the new 30-year ADS or it may be the 40 years, which was in effect at the time the building was originally placed in service. If the life to use is 30 years, the remaining years of depreciation based on the new life less years previously taken would be 24. The depreciation for 2018 would be $7,832,000/24 = $326,333 vs. the $364,000 being claimed using the original 27.5 year life. If the life is 40 years however,  then the 2018 depreciation would be $7,832,000/34 = $230,353. Owners will need to do an analysis of when to elect to fully expense the interest and it seems that in most cases it will be more beneficial to expense 100 percent of the business interest.

The election to be a real property trade or business also applies to deals that have not yet been placed in service. If the election is made, the real property will be depreciated over the 30-year ADS life from day one. The personal property and depreciable land improvements are eligible for 100 percent expensing in the year placed in service. The expensing phases out starting in 2023 through 2026. The 100 percent expensing applies to property acquired after and placed in service after September 27, 2017. The property may not be considered “acquired” after this date if it was subject to a binding written contract prior to that date and construction has commenced. We await some clarification from the IRS on this matter.

The 100 percent expensing is very much like the current bonus depreciation and an owner can elect out of expensing annually by asset class. One situation where the owner may want to do 100 percent expensing on five-year property, but elect out of expensing on 15-year assets, relates to the preservation of tax capital accounts during the LIHTC credit period. The change of real property ADS life from 40 years to 30 years makes the possibility of a capital account issue during the credit period more likely. Substantial expenses in Year One while beneficial to the investor’s rate of return could cause the investor’s tax capital account to go negative too quickly resulting in a tax credit reallocation in later years.

Owners with tax exempt partners may no longer want to make an election to have the partner be a taxable entity – known as a 168(h) election. Without the election, the partnership would have to depreciate the assets over the ADS life to the extent that the property is tax exempt use property. If the partnership is an electing real property trade or business, the real property is already going to be depreciated using the ADS. In this situation, the personal property and land improvements would also use the ADS and would not be eligible for 100 percent expensing.

Historic Credits
The Historic Tax Credit (HTC) is often claimed in conjunction with deals using the Low Income Housing Tax Credit. The Act changed the HTC so that it is now 20 percent claimed ratably over five years. Ratably may mean four percent per year or the four percent in Year One may be prorated for the number of months that the building is in service for the year. Another question relates to the timing of the basis adjustment: Is the basis adjustment all at the time that the building is placed in service, or is it each year as the credit is claimed? The answer to this question could impact the determination of the eligible basis. We await IRS guidance on these questions. That guidance could take many months.

Syndicated Funds
There are a few items of interest related to syndicated funds aside from the impact on pricing related to the tax rate change. One is that the technical termination rule has been eliminated. Under prior law, a technical termination of a partnership occurred when there was a sale or exchange of 50 percent of the capital and profits interest in the partnership. Syndicators and investors had to be creative to avoid a termination if that was the goal. Alternatively, at times terminations were a useful planning tool, but that is not an option now.

There are several questions related to the deductibility of fund level interest expense. The first question is, is the interest expense considered to be business interest which is properly allocable to a trade or business? The second question is, is this interest tied closely enough to be considered part of a real property trade or business? We know that the IRS has spent considerable time defining real property trade or business in the context of the passive activity rules as real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business (IRC 469(c)(7)(C)). But it is not clear how these rules would be applied in the context of a syndicated fund. We look forward to guidance in this area.

The provisions of the new law are complex and you should contact your tax advisor to determine how the Act impacts your deals. We look forward to guidance from the IRS and potentially technical correction legislation in 2019.

Beth Mullen, CPA, is the National Director of the Firm’s Affordable Housing Industry Practice and a member of the Firm’s Tax Practice Executive Committee. She has more than 30 years of experience providing consulting, tax, and accounting services to real estate owners and developers. A significant portion of Beth’s time is devoted to helping clients to facilitate transactions by structuring public/private partnerships that are financed in part by Low-Income Housing Tax Credit, the federal and state historic tax credit programs, the New Markets Tax Credit Program, and energy tax credits. Beth teaches internal and external courses on these tax credits and has published articles in affordable housing and not-for-profit trade magazines. Her extensive knowledge of partnership tax law has been invaluable in resolving allocation, at-risk, exit tax, residual value, and other common partnership problems. Beth is an industry spokesperson and is a frequently invited speaker at national and local industry trade conferences. She teaches internal and external courses on low-income, New Markets, and historic tax credits and has published articles in several trade magazines.