The Year of Big Tax Changes

11 min read

Industry Looks to IRS for Guidance on 2021 Tax Issue

Tax issues are going to be a mixed bag this year, with some positive changes, like the four percent Low Income Housing Tax Credit floor, and others that are not so positive. But there’s one thing that a lot of industry observers agree on—the need for guidance from the Internal Revenue Service.

The new floor is going to bring in more equity to four percent LIHTC deals, according to Beth Mullen, partner at CohnReznick.

“It’s going forward full speed ahead for new deals that did not have bonds issued, that were not started until 2021.And that certainly is great. Folks are structuring their deals,they’re getting more equity, obviously. The four percent rate brings in a lot more equity than the 3.07 percent or 3.08 percent they were getting many times last year.”

The four percent rate is making deals more viable, she says, and there’s a ripple effect as well. “In some cases, it allows the owners to reduce the soft financing they are getting from either federal or state programs. And those dollars are being repurposed into other deals. So, it is truly expanding the amount of housing that is being created.”

But, she says, there is a snag. “That leaves somewhat of a question about deals that started construction in 2020 but are not going to be placed in service until 2021.”

Congress, Mullen says, wanted the change to be fully prospective, only applying to 2021 projects. “They did leave some ambiguity related to a question of any bonds being issued in 2021. If, for example, you had a COVID-related cost overrun, construction was delayed, your costs went up and you’re not going to be complete until 2021. But you have to get an additional issue of tax-exempt bonds because you need it so you can meet your 50 percent test. In that situation, would you qualify for the four percent rate?

“The answer is, we really don’t know. We’re going to need some guidance from the IRS.”

But for deals that are just getting started now, the change looks “very positive. The thing that makes it tricky” are the projects underway at the time the law was enacted, she says.

A Win-Win
Dudley Benoit, executive vice president at Alliant Capital, agrees, calling the floor a “win-win. It will help increase units produced. It’s going to put more equity into projects.”

He also agrees it will free up soft second money for other projects. “It will allow government entities to use more subsidy dollars. Subsidies will spread further and do more,” he says.

Sam Green, vice president of strategy and investor relations at Alliant Capital, notes investors are liking the floor.

“From the investor side, if you have more equity dollars coming in and it’s less risky because you’re having to leverage a little less, some deals on the margin where debt service might be too onerous under the old regime are going to be able to make it now,” he observes.

Benoit adds, “Investors are worried about leverage. The rate was at 3.06 percent towards the end of the year. Now, you’re almost getting a 25 percent boost. That will reduce a lot of leverage, so properties will be able to service their debt a lot better.”

William “Bill” F. Machen, a tax and housing attorney at Holland & Knight, thinks the floor is the most important change for the tax credit industry in 2021. He has some concerns, though, about the effective date provision.

“The bond part has generated the most questions,” he says. “The way it is worded is quite broad. The new floor will apply in the case of any building placed in service after December 31, 2020, any portion of which is financed with volume cap tax-exempt bonds, if any such tax-exempt obligation is issued after Dec. 31, 2020,” Machen explains. “This raises the question of when are tax-exempt bonds issued and when will an additional 2021 bond issuance qualify?”

There may be some flexibility, he feels.

It May Be New Issuance
“If you have drawdown bonds issued in 2020 and you’re making drawdowns in 2021, there are bond lawyers who will tell you that those drawdowns in 2021 constitute a new issuance,” Machen says.

That’s what the bond lawyers say. What about tax credit lawyers?

“Tax credit lawyers are more concerned about this lack of guidance. There’s a general concern that Congress didn’t really want this to be retroactive, that it enacted it to be prospective,” he says. And, there may be problems with “excess equity.”

“There’s concern about over-subsidizing projects that already were determined to be feasible in 2020 with a lower equity amount. Now you’re saying because of a small bond issuance in 2021 you can up your credit amount significantly, given how low interest rates are, up to the four percent floor.

This can provide a ‘windfall’ of excess equity,” he says.

“What do you do with that? Pay down a deferred developer fee? Do you reduce some of your soft debt? Whose permission do you even need to do that? These and other issues will have to be addressed on a case-by-case basis,” Machen says.

Upward Caps Are a Wrinkle
Another potential wrinkle is that multi-investor funds have upward caps on adjusters. “Typically, you can only go up five percent. A change going from 3.1 percent to the four percent floor could be in excess of that.”

Machen concludes, “The floor itself is great, but unless we get more guidance from Treasury and the IRS on some of these effective date issues, I think it is going to be difficult for many tax credit firms to issue should-level opinions that you’re okay in some of the fact situations that are coming up.”

Another potential wrinkle is the acquisition of used facilities in 2020 with 2021 bonds. Forrest David Milder, tax partner at Nixon Peabody LLP, writes in Nixon Peabody’s Community Development Finance Alert, “Suppose a used building is acquired by a LIHTC partnership in 2020, and it is already occupied. It gets ‘official action’ at the time of acquisition so the acquisition can be bond-financed.”

What happens if the bond issuance is in 2021? “These seem to be two ‘separate buildings’ for tax credit purposes,” he says.

“One building, the acquisition, falls in the first part of the transition rule, on account of being placed in service in 2020 and therefore gets the floating rate.

“On the other hand, the rehabilitation, treated as a separate new building under Section 42, seems to pass both parts of the rule and should get a fixed rate.”

This is a new deal structure “that we have already seen, and there undoubtedly will be more,” he concludes.

An Income Averaging Glitch
Not so positive for the industry is a “glitch” in the regulations the IRS has put out to implement the income averaging test (IAT) that passed in 2018 legislation. According to tax professionals, one misstep here could take a whole tax credit project out of compliance.

“The average income set aside proposed regulations have rocked the whole industry,” says Mullen.

“I think the IRS thought they were being helpful with what they were doing. But it has made the situation more uncertain for investors and state agencies and most importantly, has made it less desirable for the tenant.”

Machen agrees. “The IRS has created some technical glitches,” he feels.

“One of the things they did in applying the IAT, the proposed regulation says the average of imputed income limitations of all the low-income units in the project can’t exceed the 60 percent level of adjusted median gross income. The statutory language requires the average of the imputed income limitations designated shall not exceed the 60 percent level.”

The reason that’s important? “If the IRS interpretation is correct, you could have a situation where the project loses all of its credit because of the failure of a single unit in the project to qualify as a low-income unit.

“That can’t have been Congress’s intent,” he concludes.

Another difficulty may come from investors wanting to create a “buffer” to be safe.

“The deal right now is 40 percent of your units have to be rent restricted and occupied by individuals whose incomes don’t exceed the imputed income limitations designated by the taxpayer and the average of the imputed income limitations that are designated can’t exceed the 60 percent levels. The designated imputed income limitations have to be between 20 and 80 percent in ten percent increments,” Machen says.

“Because of the draconian possibility that a project could lose all of its credits because of a problem with a single unit, some investors are requiring buffers where there’s more room for error. That will result in rents being reduced overall for the project because of the unit mix investors are requiring to produce this kind of a buffer,” he explains. “In turn, that will decrease the amount of debt a project can support, making it less feasible.”

Guidance on Depreciation
Another issue the industry could use some guidance on this year is depreciation, Mullen says.

“The depreciation change relates to residential rental property that made a real property trade or business election. It allowed the property to use a 30-year alternative depreciable life, rather than 40.

“It makes it more attractive to make the real property trade or business election because there isn’t much difference between using the usual depreciation life of 27.5 years and the 30-year life, which has been in force since 2018. Prior to 2018, they were switching from the 27.5 year life to 40. That led some owners to decide not to make a switch.”

Bottom line, “This is good for the investors for deals in service prior to 2018, preserving the losses they originally bargained for.”

There is a but, though. “We have no guidance from IRS how to put this change on a tax return. We’re flying blind right now.”

Mullen thinks guidance will come by September 15, which is the due date on extended tax returns.

Machen feels this change is an issue “that has flown under the radar a little bit.”

On another issue, the IRS last year issued final regulations and made some correcting amendments for Opportunity Zones. Alliant Capital’s Benoit feels they won’t “supercharge” the sector, while Green says that while that sector has been slow getting off the mark, it still has potential.

“There are a couple of strategic issues with Opportunity Zones,” Green says.

Opportunity Zone Strategies
“The first one is you have a mismatch of investors and projects. You have to have capital gains. That automatically takes out pension funds and endowments and some larger institutional investors.”

That means, “You have to go predominantly to individuals. It takes a long time to educate individuals on new tax structures and get them comfortable with something unfamiliar,” he says.

“Another issue is matching investors to the project. Opportunity Zones require you to hold your deals for ten years. But that fails to bifurcate two investing strategies.

“There are some investors who aren’t looking for yield, who are only looking for capital appreciation, so they’ll invest if they’ll build it, stabilize and sell it. The expectation is they’ll build it and sell it.”

There’s another kind of investor, though. “Different investors buy and hold, but for yield,” he says. “They collect checks until they sell it several years later. In the Opportunity Zone sector, both of those investors have to be the same person. And it can be hard to find that sometimes.”

Still, Green is fairly sanguine about the prospects for Opportunity Zones.

“There was still $15 billion last year. It’s not anywhere near as big as projected when it started. But the LIHTC took ten years to take off,” he says.

“I imagine Opportunity Zones to be similar.”

Story Contacts:
Beth Mullen, Partner, CohnReznick

William F. Machen, Tax and Business Planning Attorney, Holland & Knight

Dudley Benoit, Executive Vice President, Alliant Capital

Sam Green, Vice President of Strategy and Investor Relations, Alliant Capital 

Forrest David Milder, Tax Partner, Nixon Peabody LLP

Mark Fogarty has covered housing and mortgages for more than 30 years. A former editor at National Mortgage News, he has written extensively about tax credits.