2019 year-end tax planning considerations for developers
Electing real property trade or business?
Last year at this time we were all scrambling to fully understand the impact of the Tax Cuts and Jobs Act on low-income housing tax credit (LIHTC) deals. The most important decision to be made with respect to the 2018 tax return was to make the real property trade or business (RPTOB) election or not. Recall that the RPTOB election allows the property owner to fully deduct interest expense but requires that real property be depreciated using the Alternative Depreciation System (ADS). The election is irrevocable, so if it was made on the 2018 tax return, no further action is necessary on the 2019 return.
This does leave open the question for entities that did not make an election last year. For owners that are placing LIHTC buildings in service in 2019, the decision is easy. The regular depreciation life for residential real property is 27.5 years and the ADS life is 30 years, so the RPTOB election can be made with a very minimal impact on expected tax benefits. Owners with properties placed in service prior to 2018 may want to consider the election this year if the circumstances have changed from last year. In addition, the Internal Revenue Service (IRS) is expected to put out additional guidance related to the interest expense limitation, and we’ll be tracking that guidance closely.
Meeting your 50% test
Tax exempt bond financed deals always need to make sure they are meeting the 50% test in the year that owners expect to start to claim tax credits. The deals that commonly face this challenge are deals that are completing construction near year-end or those that may be using the tax-exempt bonds as only permanent financing. It is critical to draw a sufficient amount of bonds to meet the test before the end of the year. There are only a few weeks left before year-end, so take a moment now to be sure that the 50% test is going to be met. If you think you may have an issue, please contact your CohnReznick service team, and we can discuss possible solutions. Bonds drawn in January or February next year don’t help you meet the test for 2019.
Understand your tax credit equity adjusters
There are many varieties of tax credit adjusters. The most common are based on the total amount of tax credits delivered and the amount of tax credit delivered in the first year. The actions that owners take now, as well as those that have been taken since buildings were completed and rented up, can have a tremendous impact on these adjusters. Know how many credits have been promised to the investor by looking at your partnership or operating agreement. In many cases, your investors have been in contact with you, requesting information on building completion and qualified occupancy. They use this information to provide an estimate of expected tax credits to the fund investors. Even with updated information, estimates can go astray.
The first-year credit is founded on the eligible basis of the building at the end of the year and the qualified occupancy for each full month in the year that the building is in service. In most cases, an owner will not want to start taking credits on a building unless the construction is substantially complete. That’s because the eligible basis is locked in at the end of the first year of the credit period. The owner may decide to start credits on a building if it has more eligible basis than is necessary to support the tax credit allocation.
The planning tip is to complete construction on buildings, especially in a multi-building project. You don’t want to be 85% complete on 10 buildings – it would be better to be 100% complete on eight buildings and 50% complete on the other two.
The second part of the first-year credit calculation is the qualified occupancy for each full month that the building is in service. The placed-in-service date for a newly constructed building for purposes of IRC Section 42 is the date that the first unit in the building is suitable for occupancy. The definition of placed-in-service for a building that is occupied at acquisition, and through rehabilitation, is based on the date of acquisition. To determine the occupancy to be used for the first-year credit calculation, look at the number of full months that the building is in service as well as the qualified occupancy at the end of each of those months. For new construction buildings placed in service after Dec. 1 of this year, no credits can be claimed in 2019. For a building that is occupied during its rehabilitation, you need to look at the number of full months in the year from the date of acquisition.
Finally, the goal is to get buildings fully rented at their target occupancy level by the end of the year. If the plan is to start credits in 2019, and the building is to be 100% low-income, it is crucial to get the building fully rented to avoid a 2/3 credit on the units that are unrented as of Dec. 31. The 2/3 credits are available over the remaining compliance period. Therefore, you will never get the full amount of the credit on those unrented units, and this could result in an equity credit adjuster.
Once all these pieces have been pulled together, credits have to be calculated for the draft tax return that is usually due to the investor sometime between late January and early March. If the cost certification is not final, the eligible basis needs to be estimated.
Investors require the best possible calculations by the deadlines prescribed in the partnership agreement, so it is important to try to finalize the cost certification. If this is not possible due to construction completion that is close to year-end or due to other issues, work with your CohnReznick advisor to get as close as possible to the final expected eligible basis. This process can start now. It is much easier to handle these estimates now rather than in the height of tax season.
Tax losses including depreciation are also an important component of the expected investor benefits. In cases where the depreciation is being estimated for the draft tax return, a sound estimate of personal property and depreciable land improvements is necessary. Step one may be to understand what the investor is expecting by looking at the financial projections that are often attached to the partnership or operating agreement. Also, the projection may show if bonus depreciation is expected. Sometimes a cost segregation study is planned to maximize the amount of depreciable property that is classified as a 5- or 15-year asset. Alternatively using the construction cost line item breakdown from the final construction draw accompanied by an appropriate allocation of soft costs is a common approach to determine the depreciable basis. In every case the syndicator or investor is expecting that estimated losses on a draft tax return will be close to the results on the return that is ultimately filed.
Is there a loss reallocation in your deal’s future?
A loss reallocation during the tax credit period could initiate a reallocation of tax credits that results in a tax credit equity adjuster. Situations that can lead to allocation issues include:
- Construction overruns that were paid for with related party debt
- Development fees that are being paid more slowly than projected
- General partners or other partners with substantial capital accounts
- Deals that have operating deficits
The reallocation usually occurs when the limited partner’s tax capital account gets to zero.
Discussing potential issues like this should be part of your year-end tax planning meeting with your CohnReznick service team. There are several possible remedies, and it is best to start working on them now.
One solution is having the limited partner execute a deficit restoration obligation (DRO). In simple terms the DRO allows a partner’s capital account to go negative as long as that partner agrees to put capital into the deal upon liquidation of the partnership if the capital account is still negative. Often a limited partner is not interested in contributing additional capital so the DRO is not the most common solution to a loss and credit reallocation situation. New IRS regulations finalized in October have made some changes to what is required to have the DRO respected.
The basic requirements for an acceptable DRO are as follows:
- There are commercially reasonable provisions to enforce the DRO if it comes due
- The partner must provide commercially reasonable documentation to the partnership indicating its ability to perform on the DRO
- The obligation does not end or can’t be terminated prior to the liquidation of the partner’s interest in the partnership or while the partner’s capital is negative, and
- The terms of the DRO are provided to all partners in a timely manner
If you have partnerships or LLCs with existing DROs, you will want to review those documents now to be sure they comply with these new requirements. You will also want to identify situations where a DRO is needed for the 2019 return. A DRO is usually part of the partnership agreement and must be in place not later than the original due date of the partnership return (March 15 for a calendar year-end entity).
8609s and Amended Returns
Form 8609 is the Low-income Housing Credit Allocation and Certification obtained from the state tax credit agency indicating the final amount of the LIHTC available for each building in a project. The state provides the form after reviewing the final cost certification and other documents that the owner is required to provide in accordance the Qualified Allocation Plan. Having the Form 8609s from the state is a requirement to claim the LIHTC as indicated on the instructions to Form 8609-A Annual Statement for Low-Income Housing Credit. If an owner plans to claim the LIHTC on the 2019 tax return, it must have the 8609s by the extended due date of the return (Sept. 15 for a calendar year-end entity). The owner will usually estimate the amount of the credits on the draft return provided to the fund or investor in the spring, and if the 8609s have not been received by the extended due date, the LIHTCs will not be included on the return filed. For partnership returns prior to 2018, the partnership return would be amended to add the LIHTCs when the 8609s were received. The rules for amending partnership tax returns have changed beginning in 2018.
The Bipartisan Budget Act (BBA) of 2015 changed the centralized audit regime for partnerships including the process for amending returns beginning with the 2018 tax year. The process requires filing an Administrative Adjustment Request (AAR) in addition to providing various statements to the IRS and the partners of the partnership. The form of the statements has not yet been finalized, though draft Form 8985 Pass-Through Statement – Transmittal/Partnership Adjustment Tracking Report and Form 8986 Partner’s Share of Adjustment(s) to Partnership-Related Items(s) are available. The new process appears to be complicated, so owners should do everything in their power to get the Form 8609s from the state agency by the extended due date of the partnership return.
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
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