Tax Reform - The Details
In my last post I outlined the major changes to the affordable housing industry that the tax reform bill, now approved by the House, would bring by eliminating the tax-exempt bond and 4% LIHTC. This post deals with the detailed changes to other tax provisions that will impact the market for LIHTCs.
I am measuring these changes by manipulating the financial projections for a single new construction development to gauge their impact. This is in no way financial advice for all LIHTC developments, but a broad measure of the potential changes to the LIHTC market next year.
The development in question is new construction, financed with 4% LIHTCs and tax-exempt bonds, and benefits from a DDA basis-boost (an allowed 30% increase in eligible basis due to the location within a HUD-designated DDA). There is accrued interest on two subordinate mortgages, which causes the investor's capital account to go negative and the model assumes a reallocation of net losses to the GP, which is tax-exempt. The gross IRR to the LIHTC investor was 7.3% on a price/credit of $0.95 in today's tax code, generating approximately $4.83 million of LIHTC equity. Now, to the changes:
1. Corporate Tax Rate
The most impactful change is reducing the corporate tax rate from 35% to 20% as in both the House and the Senate bill. LIHTC investors are nearly all C-corporations and the value of the investment is heavily impacted by the corporate tax rate, because the LIHTC investor can deduct net losses from real estate from their overall tax liability. Nearly all affordable housing developments generate net losses, due to the permitted depreciation deduction. The LIHTC investor's IRR drops by 320 basis points to 4.7%. Assuming the investor needed to hold its IRR steady, that translates to a $0.10 or $480,000 (10%) reduction in LIHTC equity.
2. Depreciation Period / Interest Expensing
The Senate bill includes a complicated provision that would change the period for depreciation of residential real estate from 27.5 years to 30 years, unless the taxpayer elected to cap its interest expense deductions at 30% of net income, at which point the taxpayer could depreciate residential real estate over a 25 year schedule. In our case (and in most affordable housing) the interest deduction is well above 30% of net income, so the effect would be to push the depreciation schedule out to 30 years. In our example the impact is a $0.01 or $50,000 (<1%) reduction in LIHTC equity. Note that the cap on interest deductability is in the House bill but does not apply to residential real estate.
3. Immediate Expensing
Both the House and Senate bills include provisions allowing site improvements and personal property to be deducted 100% in the first year (currently site improvements are deducted in 15 years and personal property in 5 years). In our example the model assumed 5% of depreciable assets were personal property, which is relatively conservative. The impact is a $0.01 or $50,000 (<1%) increase in LIHTC equity. Some more aggressive models utilizing a cost segregation study to maximize site improvement and personal property depreciation might see a $0.02 or $0.03 ($100,000-$150,000) increase from baseline due to this change.
This exercise shows that the 20% corporate tax rate is by far the most impactful on the affordable housing industry and led to a 10% reduction in LIHTC equity in this example. The other tax changes are either a wash or perhaps beneficial, but it will vary by project. The accounting firm Novogradac estimates a roughly 6% reduction in affordable housing production over 10 years from the corporate tax rate reduction. There are various proposals to offset the corporate tax rate, such as some of the changes proposed by Senators Maria Cantwell and Orrin Hatch in their bill to expand the LIHTC, but these have gone nowhere and are not included in either the House or the Senate versions of the tax reform bill.