A Q&A on Tax Reform
Since the passage of the Tax Cuts and Jobs Act (Act) on December 22, 2017, there are many changes that could potentially impact the affordable housing industry. Generally, the changes made apply to tax years beginning after December 31, 2017. The notable exception, which could impact calendar year 2017 tax returns, is for expensing of personal property placed in service after September 27, 2017.
The change that is likely to have (and to some extent, already has had) the biggest impact is the corporate rate reduction from 35 percent to 21 percent. We have been fielding calls from developers, syndicators, and investors wondering what this new law means for both existing and future investments. Here a few of the more common questions that we think are important to you:
How does the new tax law impact my existing low-income housing tax credit (LIHTC) deal?
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 a real property trade or business. This election will require that the owner switch to the alternative depreciation system (ADS) for all residential and nonresidential real property and qualified improvement 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 $10 million building was placed in service in January 2012 using 27.5-year depreciation. After six years, at December 31, 2017, the adjusted basis of the building (original basis less depreciation) is $7,832,000. 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 versus the $364,000 being claimed using the original life. This seems to be a small price to pay to be able to expense 100% of the business interest.
What is the impact on deals not yet in service?
Properties that have not been placed in service are likely to make the election to be a real property trade or business so the real property will be depreciated over the 30-year ADS life from day one. Personal property (generally five-year property) and depreciable land improvements (generally 15-year property) are eligible for 100% expensing in the year placed in service. The expensing phases out starting in 2023 through 2026. An owner can elect out of expensing by asset class. One situation where the owner may want to do 100% 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. 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.
Is the expensing of personal property an all or nothing thing?
Expensing of personal property is an all or nothing proposition with respect to an asset class for assets placed in service in a year. This means that the owner cannot decide to expense all the refrigerators and depreciate all the stoves over five years if they are placed in service in the same year. The owner can, however, vary the election on a year-by-year basis. One situation where this could be useful is if an investor will be admitted to the partnership in 2018, but some buildings and their personal property will be placed in service in late 2017. If the goal is to maximize deductions to the investor, the owner can elect out of bonus depreciation on the 2017 assets and claim the 100% expensing on the 2018 assets.
If the real property is already being depreciated using ADS over 40 years, must the owner switch to the new 30-year ADS?
This question does not yet have a definitive answer, but Reg 1.168(i)-4(d)(3)(ii) gives the owner the option to disregard the change in use when it results in a shorter recovery period. While this regulation does not specifically apply at this time, when the IRS comes out with further guidance, it may look to these regulations which apply to depreciation of property when there is a change in use. Note that an owner may want to continue to use the 40-year depreciation if they are using the longer life to avoid depleting an investor’s tax capital account during the credit period.
Are there impacts to syndicated funds?
Aside from the very important deal pricing and market demand questions, there are a few items of interest related to syndicated funds. First 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; that is no longer an option.
There are several questions related to the deductibility of fund level interest expense. The first question is whether the interest expense is considered to be business interest, which is properly allocable to a trade or business? The second question is whether such interest is tied closely enough to be considered part of a real property trade or business? We know that the IRS has spent considerable time defining a 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)). It is not clear how these rules would be applied in the context of a syndicated fund, so we look forward to guidance in this area.
How does the 30% interest expense limitation work, and should I elect out?
The Act generally limits the annual interest expense deduction to 30% of adjusted taxable income as defined, 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% deduction for pass-through income
- 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 logical choice would seem to be to elect to be treated as a real property trade or business.
Does the deduction for qualified business income apply?
The new pass-through deduction is for taxpayers other than corporations, so most of the investors in affordable housing deals will not be able to use this deduction. This deduction provides a significant planning opportunity for individual owners of operating businesses, such as development companies, management companies, and contractors. A complete discussion of the nuances of this new provision is beyond the scope of this Q&A, and will be covered by subsequent CohnReznick Tax Alerts.
What Does CohnReznick Think?
The provisions of the new law are complex. It is recommended you contact your industry tax advisor to the extent that you have specific questions and for clarification around terms used in the above that are defined in the Act or the Internal Revenue Code. We will continue to keep you posted as new guidance or technical corrections become available.
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.