Year-End Tax Planning Considerations for Developers
Electing real property trade or business?
As we move into the last quarter of the year, there is at least one matter related to the Tax Cuts and Jobs Act of 2017 that needs to be addressed by every building owner. The question is will the building owner elect to be a real property trade or business to fully deduct the net business interest expense of the entity? We have detailed this issue in the April edition of Affordable Housing News and Views. Syndicators and investors are in the process of preparing year-end projections of 2018 tax losses, so they are likely to reach out to you to discuss this matter.
Several syndicators and investors have asked us if there is a rule of thumb for if it is better from an internal rate of return perspective to make the election. The options are to make the election in 2018, to make the election effective starting in 2022, or not to make the election. The election would allow for full deduction of interest expense and necessitate the switch to the Alternative Depreciation System (ADS) for real property and Qualified Improvement Property. The ADS life for assets placed in service prior to 2018 is 40 years; 30 years for residential rental property placed in service in 2018. For deals with modest interest deductions, you may want to continue to take a 27.5-year depreciation, while highly leveraged deals may find the interest expense deductions more valuable. The value of deferring the election until 2022 will depend on the process the IRS decides to use for elections made after 2018. It is likely to be a change in accounting method, which could be automatic or non-automatic requiring more time and a larger filing fee. We await guidance on this topic.
Owners need to understand that the internal rate of return is not the only thing to consider. Some investors maximize other financial or accounting metrics and may not be as concerned about maximizing tax losses. The change in depreciation or interest expense deductibility also will affect tax capital accounts which can have an impact upon sale or liquidation of the partnership. If these are important planning considerations, you may want to prepare updated financial projections to determine the impact of the options.
Asking questions now will save time during tax season and will allow for better decision making with your Cohn Reznick tax professional. As always, there are a few other items to think about now.
Meeting your 50% test
Tax exempt bond-financed deals always need to make sure they are meeting the 50% in the year that owners expect to start to claim tax credits. The deals that commonly face this challenge are completing construction near year end. It is critical to draw enough bonds to meet the test before the end of the year. Take a moment now while there are a few months before the end of the year to see where you are with respect to the 50% test, because bonds drawn in January or February next year don’t help you meet the test for 2018.
Know 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, investors have been in contact with you requesting information on building completion and qualified occupancy. They are using this information so they can provide an estimate of expected tax credits to the fund investors. Even with updated information, estimates may 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, 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 ten 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 December 1 of this year, no 2018 credits may be claimed in 2018. 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 2018, and the building is to be 100% low-income, it is crucial to get the building fully rented to avoid a two-thirds credit on the units that are unrented as of December 31. The two-thirds 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 must be calculated for the draft tax return that is usually due to the investor in late January through 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 finalize the cost certification. If this is not possible due to construction completion that is close to year end or 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.
Is there a loss reallocation in your deal’s future? A loss reallocation during the tax credit period may 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 and 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.
The examples provided are general suggestions and the facts in your deal may vary. Don’t rely on general advice. Instead, make sure you are getting the advice that is most appropriate for your specific situation.
Subject matter expertise
CPA, Partner, Affordable Housing Industry Leader
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Affordable Housing News & Views October 2018
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 legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. 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 partners, 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.