January 05, 2018
Tax Credit Alert
Author(s): Forrest David Milder
The alert provides a summary of things that we are noticing about the recently adopted tax legislation generally referred to as the Tax Cuts and Jobs Act of 2017. This alert covers all of the tax credits; see our separate alert for a review focused more on renewable energy tax credits.
Of the credits that we work in, the Act most affected the rehabilitation (or historic) tax credit (HTC). So, let’s start there. The “old” credit was 10 percent for pre-1936 buildings, and 20 percent for certified rehabilitations, all taken when the QREs are placed in service. The “new” credit is only for certified buildings, and it is 20 percent taken ratably over five years.
There’s a transition rule making the old credit still available for a building that is “owned or leased” by “the taxpayer” at all times after December 31, 2017. Based on this rule, the tax credit community is anticipating that a building will qualify for grandfathering, and the old rules, by virtue of having the building owned by a partnership at the end of 2017 and thereafter. This should be the result even if the partners of that partnership change with the admission of an investor, or the lease-pass-through method is used and the credit is passed to a master tenant entity that didn’t even exist at the end of 2017.
In support of the entity-ownership view is:
Accordingly, it makes sense that a lessor partnership could be the “taxpayer” that qualifies for grandfathering, and if it owns the building being rehabilitated at all times after 2017, then the project should be eligible for the pre-2018 HTC rules, even if the partnership then changes its partners sometime after 2017, or passes the credit to a master tenant.
Of course, qualification under the transition rules is a “cliff issue,” and there are arguments contrary to the favorable view described above.
The bottom line is that for those transactions that didn’t actually close with an investor before the end of 2017, it is best if, before the end of 2017, the building was owned by an entity that is considered a partnership for tax purposes (i.e., a partnership or LLC that has two or more partners). In some cases, “ownership” may have been accomplished by a long-term lease of the building (generally 75 years or longer) before the end of 2017 to the partnership or LLC that will serve as the “owner” for tax purposes.
In fact, even a building owned by just a single individual or corporation has the potential to qualify for grandfathering and a third-party investor. Of course, on those facts, the lease pass-through method would have to be used (because adding an investor at the owner level would create a new partnership entity). For the same reason, prepaid rent would have to be used (and not admission of the master tenant as a partner to the landlord) to get the investor’s money to the landlord.
Even if an HTC transaction doesn’t qualify for grandfathering, the new rule still provides a ratable 20 percent credit for certified rehabilitations, with a few things to remember:
It’s not clear how “ratability” will work; Is the credit available annually (i.e., 4 percent each year, regardless of when the QREs are placed in service)? Or monthly (i.e., .33 percent each month)? Or some other method, e.g., daily? The monthly computation is similar to how the LIHTC is computed, while a daily method, perhaps with a mid-month convention, is also a possibility. Although some have expressed concern that perhaps the credit attributable to months in the sixth year after placed in service might be lost, that seems incorrect; the HTC recapture period has always run for five years from the actual date the project was placed in service, even if that runs into a sixth year. A hard cut-off would also be inconsistent with how the 10-year credit period for LIHTC transactions is handled. There, credits deferred from the first year are simply taken in the eleventh. If the HTC is computed on a daily or monthly basis, rather than a simple 4 percent each year for five years, this will result in pricing adjustments depending on which day is the actual placed-in-service date, because every day that goes by may result in a smaller first year credit (accompanied by a larger one in the less valuable sixth year).
The new rules present at least two new tax issues that may be resolved by technical corrections. First, should the basis adjustment be for the full amount of the credit in the first year, or just the ratable portion, as claimed adjusted each year? In the near term, the industry will have to coalesce around some treatment in the event there is no clarification. The basis adjustment rules of Section 50(c) refer to a basis reduction “by the amount of the credit so determined,” indicating that the proper treatment should be to reduce basis each year by the amount of the credit taken that year. We will also have to figure out how this adjustment should work with the LIHTC in those projects that involve both credits. Second, should the recapture rules be different for a credit that is claimed ratably? The existing recapture rules (also in Section 50) are not clear. Given all of the changes made to the HTC, the industry may even seek congressional support for simplification that would eliminate the basis reduction and Section 50(d) rules that currently underpin the HTC.
With the new depreciable lives for certain property (30 years for electing residential rental property and probably 15 years for qualified improvement property or “QIP,” which is essentially non-structural improvements to commercial property; QIP is discussed in greater detail below), a question is also raised as to whether there should be a change in the proper lease term required for HTC master leases. Typically, long-term leases are for 80 percent or more of a property’s life. While 22 years (for 27.5 year residential property) and 32 years (for 39 year commercial property) have long been used, these new depreciable lives may call for a change.
As adopted, the Act kept both the 24- and 60-month rehabilitation periods, so if a building passes the transition rule for grandfathering, it may qualify for a very long period of qualified rehabilitation expenditures, remembering several subsidiary rules:
Example: imagine an investment that closed in 2015, with QREs placed in service in 2016 and 2017. Suppose further that the building’s basis at the end of 2017 is $1.5 million, and that the taxpayer plans another $70,000 per month of expenditures in each of 2018, 2019 and 2020. Finally, assume that ownership of the building will not change, so that it qualifies for the transition rule. If the taxpayer selects a 24-month period starting February 1, 2018, it will run up 24 months times $70,000, or $1,680,000 of QREs in the 24-month period ending January 31, 2020, which exceeds its basis on January 31, 2018 (i.e., $1,500,000 plus $70,000 incurred in January 2018). Accordingly, it can claim QREs using the old 20 percent, all-in-one-year HTC for all of its expenditures, including those incurred through the end of 2020.
QIP is the sole survivor of a collection of “qualified” properties under prior law (qualified leasehold, restaurant, retail and improvement properties were all defined in Section 168 of the Code), and it is intended to be eligible for three different depreciation methods. I say “intended,” because previous versions of the legislation, and the accompanying reports, provide what I say here, but the actual Act does not have any rules for depreciating QIP. If and when fixed by technical corrections, the depreciation choices should be 15-year straight-line depreciation; 20-year straight-line if the alternative depreciation method is selected; and bonus depreciation with a 100% write off. See below for a discussion of the new real property trade or business election that is paired with an election to use the ADS lives. Only the straight-line methods can be used with the HTC. Note also that QIP is non-residential, so that it does not apply to LIHTC property.
For the other credits, the changes are far less obvious. Most of the changes are due to the incidental effects of changed depreciation rules, or new rules regarding the deduction of interest. Here’s what didn’t happen:
For renewable energy (RETC), none of the proposed negative changes happened—the begun construction test for many technologies continues to benefit from the IRS’s four-year safe harbor on whether the project has been in continuous construction (but remember: the IRS still hasn’t published a safe harbor for solar), and the inflation adjuster that elevated the 1.5 cent production tax credit to 2.4 cents in 2017 remains as well. While the so-called “orphan energy credits” were not addressed in this Act, a bill has already been filed to grant them extended periods to begin construction and qualify for credits.
The new markets tax credit (NMTC) was not repealed. There continues to be $3.5 billion available for allocation for 2017, 2018 and 2019.
The LIHTC was not directly affected by any of the changes. Private activity bonds were not repealed.
But here’s one thing that did happen: repeal of the corporate alternative minimum tax will benefit wind PTC transactions, which had been subject to the tax in years 5 through 10, and NMTC transactions, which had also been subject to the AMT.
One of the new provisions that has the tax equity community searching for guidance is the new rule that caps a business’s interest expense at 30 percent of its adjusted taxable income. Of course, many tax equity deals are dependent on borrowing, and this threshold is often exceeded.
The limitation is computed annually at the partnership level, but once computed, all record keeping is then done at the partner level. In particular, any deduction allowed after applying the limitation becomes part of each partner’s non-separately stated taxable income or loss from the partnership. And any interest that is not allowed on account of the limitation is allocated to each partner as “excess business interest.” The partner then keeps track of this excess business interest, and it may deduct its share against its “excess taxable income” (essentially income in those years to the extent that the 30% interest limitation is not used up) from future partnership years of the same partnership. Excess business interest reduces the partner’s basis in its partnership interest (even if it cannot currently use the deduction), with the basis reduction being restored if the partner disposes of its partnership interest, effectively reducing its gain (or increasing its loss) on disposition.
There are three prominent exceptions from the cap. First, the limitation does not apply to taxpayers whose average annual gross receipts for the three-tax-year period ending with the prior tax period do not exceed $25 million. However, this exception does not apply to “tax shelters,” which would include typical tax credit equity transactions. A second exception applies to real property trades or businesses; more on that below. A third exception applies to certain electrical energy, water, sewage, gas and steam transactions. See our renewable energy alert for more details on that one.
As mentioned above, there is a savings feature for “real property trades or businesses” (or RPTOBs until we come up with an easier abbreviation or acronym). If such an entity makes an election, which then requires it to use the “alternative depreciation system” (or ADS) for its nonresidential real property, residential rental property and QIP, then it is not subject to this cap. Note a few things about the RPTOB election:
The IRS is directed to provide the rules for the RPTOB election; of course, the rules and/or forms do not yet exist.
The RPTOB election onlyapplies to the three kinds of real property described above. It does not apply to personal property or site improvements, which should be eligible for usual MACRS depreciation or even 100% bonus depreciation. There is some confusion on this issue because the House bill would have required RPTOBs to use the ADS method for all of their property. But this harsher House provision was notadopted in the final Act, so personal property and site improvements should be eligible, even if an RPTOB election is made.
The ADS write off for nonresidential real property continues to be 40 years and for QIP, it is probably 20 years if fixed by technical corrections. With the enormous debts normally associated with LIHTC projects, it should be expected that virtually all LIHTC projects will make the election to be treated as RPTOB taking slightly longer depreciation in exchange for being able to deduct all of their interest expense.
If the taxpayer doesn’t need to make the RPTOB election to use ADS (because its interest expense doesn’t exceed the 30 percent cap), then its QIP is probably eligible for the one-year 100% write off. Again, we probably need technical corrections to assure that treatment.
The new interest cap applies to tax years after 2017, which means that even “old” real estate deals may have to elect to use the ADS method for the three real estate items going forward. At this point, tax advisors can’t decide if electing the ADS method for pre-2017 housing transactions means the old 40-year ADS life or the new 30-year life, but the effective dates for the new provisions make 40-year recovery the more likely answer. The shorter period seems to only apply to property placed in service after 2017, which will not be the case for existing projects, but I wouldn’t rule out technical corrections or IRS guidance on this point.
At least in LIHTC deals, there may be far less interest in tax exempt entities making 168(h)(6) elections. That election is often made when an affiliate of a tax-exempt entity is a partner and it has a varying interest in the partnership’s tax items, often referred to as “not having a qualified allocation.” The election enabled LIHTC deals to continue to take 27-1/2 year depreciation. If most LIHTC deals will now be electing to be RPTOBs and using 30-year depreciation, there may not be much reason to make a 168(h)(6) election. On the other hand, the election may still be important in HTC and RETC deals, where the credit itself (and not just depreciation) may hinge on whether the tax-exempt-affiliate has a qualified allocation of tax items, with the election being the traditional solution.
The cap on deducting interest leads to other questions for all the credits. What about interest incurred on borrowing at the fund level, say to bridge the receipt of the investor’s capital contributions? Or borrowing by a managing member to fund its capital contributions to an operating company? What about interest incurred by an operating partnership that makes the RPTOB election and then passes that expense up to an upper-tier fund that is itself a partnership? While there is not yet guidance on these particular rules, there is analogous support for using “any reasonable method” in the IRS’s “interest tracing rules” under Section 163. There’s even an IRS notice that specifically discusses the acquisition of partnership interests and capital contributions to partnerships. In the end, there seems to be pretty decent support for applying these old rules to the new interest cap provisions as well, and, in case of RPTOBs, deducting these items, provided the underlying operating entity uses ADS depreciation as discussed in the preceding paragraph, and possibly subject to construction period capitalization rules, where applicable.
Note that RETC deals are unlikely to constitute a “real property trade or business,” so that election won’t help there. On the other hand, as noted above, certain electrical energy, water, sewage, gas and steam transactions are not subject to the new rules. While lots of RETC deals involve “back leverage,” with no borrowing at the operating level, this can still leave one or more partners in a deal with significant borrowing used to fund their capital contribution to the venture and potentially capped interest expense. NMTC transactions that leverage their investments are borrowing money to make a loan, and have a decent argument that they can use a different provision of the new interest cap rules, allowing a deduction for interest paid on their leverage borrowing against the “business interest income” that they earn from their CDE loan. It certainly makes sense that the interest expense incurred by an investor to fund a portion of its investment in the CDE should have the same character as the interest income it earns. We’re still analyzing this issue.
The jury will be out for a while on the impact of the Base Erosion and Anti-Abuse Tax. The computation and application of the tax are enough to make your hair hurt. Essentially, it’s a minimum tax for certain corporations, with a rate of 5 percent in 2018, then 10 percent for several years, increasing to 12.5 percent for tax years beginning after 2025, and a 1 percent higher rate for banks and securities dealers. It would take a lot of space to describe just how the BEAT works, but here’s a very general overview: the corporations potentially subject to the BEAT are those that average over $500 million of annual revenues for which at least 3 percent (2 percent for banks and securities dealers) of their deductions are intercompany deductions with their foreign affiliates. As I wrote in a prior alert,[1] the BEATas originally proposedwas indifferent to the taxpayer’s tax credits (other than the R&D credit, which was, and still is, fully exempt from its application at least until 2025). If the taxpayer had more tax credits, it might (depending on its particular facts) have a lower regular tax, but a correspondingly higher BEAT, thereby undermining the usefulness of tax credits. In any case, as finally enacted, the BEAT treats the LIHTC and the RETC more favorably than the HTC and NMTC. That’s because, at least for the next few years, up to 80% of the LIHTC and RETC can be used to reduce the BEAT, while none of the HTC and NMTC can be used. Eventually, the favorable treatment for the RETC and LIHTC is scheduled to go away, and for taxable years beginning after 2025, none of the credits will be able to reduce a taxpayer’s BEAT. So even an investment in an LIHTC transaction in 2017, before the BEAT became law, for example, will become subject to the elimination of favorable treatment in the later years of the project’s 10-year credit period. It is important to recognize that application of the BEAT will be very client specific, and many tax credit advisors are suggesting that relatively few potential investors will be affected. Query whether this will cause any investors to move to the more favored credits, or will they still see even a 20 percent reduction in value as too large to justify the investment?
Various items discussed here can have complex effects on the partnership’s capital account computations:
Of course, tax rates for corporations are falling from 35 to 21 percent, and the new rates go into effect for tax years beginning after 2017, as proposed in the House version of the bill. While this reduces interest in losses (because they are now only worth 21 cents per dollar), there are some notable plusses for the tax credit industries:
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