The final tax reform bill includes several provisions that directly impact the real estate development incentives that many organizations rely on to support their business activities and goals. Here’s what you need to know and how you may be affected.
Low-income housing tax credits (LIHTC)
Changes: The reduction of the top corporate tax rate from 35 to 21 percent will indirectly negatively impact the value of LIHTCs. In addition, some LIHTC developments could be negatively impacted by a provision that reduces the depreciable life of residential rental property under the Alternative Depreciation System (ADS) from 40 to 30 years.
Impact: Lower corporate tax rates will reduce the value of LIHTCs by approximately 15 percent, given the value of the deductions investors currently receive for depreciation and other items associated with their investment. As a result, lower corporate tax rates will reduce the efficiency of the existing tax incentive and likely lead to a decrease in production of affordable rental housing. However, such an impact can be mitigated to the extent that tax reform expands the applicability of bonus depreciation and the Section 179 deduction. The reduction of the ADS life for residential rental property from 40 to 30 years could negatively impact some LIHTC developments since it reduces flexibility to elect a longer depreciable life to prevent the tax credit investor’s capital account from going negative too quickly.
Lower corporate tax rates will reduce the value of LIHTCs by approximately 15 percent.
New markets tax credits (NMTC)
Changes: Despite significant threats to the New Markets Tax Credit (NMTC) Program in earlier drafts, the final tax reform legislation retained the NMTC program and eliminated corporate AMT.
Impact: The reduction in the top corporate tax rate from 35 to 21 percent should positively impact NMTC pricing since the lower tax rate will reduce exit taxes paid by NMTC investors upon the unwind of the NMTC structure after the seven-year compliance period.
Loss or impairment of the NMTC would have killed numerous community development projects. According to the NMTC Coalition, between 2003 and 2015, $16 billion in NMTCs leveraged over $80 billion in total project investments, creating nearly 750,000 jobs.
Planning opportunity: Sponsors of projects with strong community impact that need NMTC subsidy to move forward should attempt to be “shovel-ready” to capitalize on the most recent round of NMTC awards, which was announced on Feb. 13, 2018.
Historic tax credits (HTC)
Changes: The final tax reform bill retains the 20 percent historic tax credit (HTC), but requires the credit for qualified rehabilitation expenditures (QREs) paid or incurred after Dec. 31, 2017, to be claimed annually over five years, beginning with the date the QREs are placed in service. Unfortunately, the 10 percent rehabilitation tax credit will be eliminated for QREs paid or incurred after Dec. 31, 2017.
Impact: The transition rule in the legislation allows a taxpayer to claim rehabilitation tax credits under the existing rules, as long as the taxpayer owns or leases the building continuously after Dec. 31, 2017, and the 24-month substantial rehabilitation period (60-month period for phased projects) begins within 180 days of enactment. The bill clarified that phased projects can use a 60-month measurement period in applying the transition provision. The ownership test in the transition rule appears to apply at the property owner (i.e., partnership) level and not the partner level. However, there is some ambiguity related to the definition of the term “taxpayer” so it is possible that the IRS could apply the ownership test at the partner level.
It is also worth noting that the reduction in the top corporate tax rate from 35 to 21 percent should positively impact HTC pricing for single entity structure transactions since the lower tax rate will reduce exit taxes paid by corporate HTC investors upon the unwind of the HTC structure after the five-year compliance period.
Planning opportunity: Since the final version of the bill eliminated partnership technical terminations, it may be possible for a developer that purchases a building after Dec. 31, 2017, to qualify for the grandfather provision, if they have two separate taxpayers purchase interests in the partnership that owns the building instead of purchasing the building itself. Developers planning a rehabilitation of a historic or old building that they already own can maximize flexibility in qualifying for and/or syndicating rehabilitation tax credits by making sure that such building continues to be owned by the same taxpayer that owned the building on Dec. 31, 2017, to meet the property ownership requirements of the transition language in the bills.
If the ownership test is applied only at the partnership level, the transition language appears to allow changes in the ownership of such partnership after Dec. 31, 2017. In that case, developers should be able to continue to close on historic tax credit syndications through 2019 — potentially into 2020 — as long as a partnership owned or leased the building by Dec. 31, 2017, and is expected to complete the rehabilitation by mid-to-late 2020 (mid-to-late 2023 for phased projects).
State tax credits
Changes: The combination of lower tax rates and new limitations on the deductibility of state and local taxes by individuals will improve the value of state tax credits. As mentioned above, the top corporate tax rate will be reduced from 35 to 21 percent. In addition, individuals will be subject to a new $10,000 limit on the deductibility of the combined total of their state and local income taxes (or sales taxes if higher) and property taxes.
Impact: When state tax credits are assigned or allocated to a partner (versus sold/purchased in certificate form), pricing of such state tax credits is typically adjusted to compensate the investor for the federal tax deduction that they must forgo by contributing capital to a partnership in lieu of paying their state tax obligation in cash. For example, a corporate partner in a 35 percent federal tax bracket would typically not invest more than $650,000 for a $1 million state tax credit since they would receive a $350,000 federal tax benefit if they paid $1 million of state taxes in cash.
With the top corporate tax rate dropping to 21 percent, a corporate partner may be able to invest $790,000 for a $1 million state tax credit since they would only receive a $210,000 federal tax benefit if they paid $1 million of state taxes in cash. Pricing could increase even more dramatically for individuals since they may receive little to no federal tax benefit if they pay state taxes in cash. Individual state tax credit investors may even be able to convert nondeductible state tax payments into deductible losses to the extent they are able to generate a capital loss upon the sale of their investment if they can use such capital loss to offset capital gain income.
Planning opportunity: Projects that expect to generate state tax credits should consider structuring the assignment or allocation of such credits to maximize the value of the credits by taking advantage of the reduction in the top corporate tax rate and the new limitation of the deductibility of state and local taxes by individuals. State tax credits should be more valuable in general as a result of these changes, but they may be particularly more valuable to individuals who pay a significant amount of state income tax since such individuals will no longer be required to forgo a federal tax benefit when using state tax credits to discharge their state tax obligation.
Conversely, individuals who pay a significant amount of state income taxes should consider investing in state tax credits, particularly if they can structure the transaction to generate a capital loss upon the sale of their investment.
Taxpayers should be very careful when structuring assignments/allocations of state tax credits from a partnership to a partner since such structures could be considered a disguised sale of the state tax credits, which could trigger unintended tax consequences.
Section 118 – Grant structuring changes
Changes: The new legislation partially repeals Section 118 effective upon enactment. Now, grant proceeds from governmental entities or civic groups are taxable upon receipt (other than contributions made by a shareholder as such). However, certain grants from governmental entities may qualify for a grandfather provision to the extent that they are made pursuant to a master development plan that was approved by the governmental entity before enactment.
Impact: Section 118 has often been used by real estate developers to defer the tax impact of grant proceeds by structuring the grant to be made to a corporation. The partial repeal of Section 118 will make it very difficult, if not impossible, for a for-profit developer to receive a grant from a governmental entity or civic group to help fund a real estate development project without paying federal and state income taxes on the grant proceeds upon receipt.
Planning opportunity: If the grandfather provision does not apply, and the grant proceeds were not received before enactment of the partial repeal of Section 118, for-profit developers funding projects with grant proceeds should consider the tax impact of the grant proceeds as they create or revise their capital stack.
As always, if you have questions, feel free to give us a call.