By Michael J. Novogradac, CPA
In his re-election speech on Nov. 6, President-elect Barack Obama said he was looking forward to reaching out and working with leaders of both parties in the coming weeks and months to meet a number of challenges, including reforming the tax code. As the lame duck session of the 112th Congress focuses on a tax extenders package as part of a much larger effort to avoid falling off the so-called fiscal cliff, one of the underlying themes of discussions is likely to be tax reform.
Previously in this space I have considered big-picture implications, such as proposals to eliminate tax credits altogether. Even if tax credits such as the low-income housing tax credit (LIHTC), new markets tax credit (NMTC), historic preservation tax credit (HTC) and renewable energy tax credits are left intact, Congress and the president could consider a number of other changes that would have significant implications for these programs.
For example, if the top marginal corporate income tax rate is lowered, it would likely have different effects on different tax credits; for the NMTC it would likely be a net positive but for the LIHTC it could have a net negative effect. This is because of a key structural difference between tax credits, specifically that LIHTCs don’t reduce basis and NMTCs do.
The difference in basis reduction between the LIHTC and NMTC means that tax reform that results in a decrease in the marginal corporate tax rate would have the opposite effect on NMTC yields than it would for LIHTC yields; after-tax yield for an NMTC investor would actually increase. Based on current pricing for the credits, a drop to a 25 percent marginal rate from the current 35 percent marginal rate would result in an increase to the NMTC investor’s after-tax yield of approximately 50 to 100 basis points. Conversely, lower top corporate tax rates would result in lower LIHTC yields and create upward pressure on LIHTC pricing. Similarly, if accelerated depreciation rates are reduced, there could be a downward impact on yields.
Turning to HTCs, because they have a 100 percent basis reduction similar to NMTCs, if the top tax rate is lowered, yields for HTC equity investments will increase. We estimate that with a top corporate tax rate of 25 percent, HTC yields for direct equity investments could rise 50 to 100 basis points. For HTC investments that involve a pass-through lease structure, however, HTC yields would drop. This means that lower top corporate tax rates would create upward pressure on straight equity HTC pricing, but downward pricing pressure on lease pass-through HTC investments.
In addition to tax credits, tax-exempt bonds will also be under scrutiny during the tax reform process. Several proposals have suggested changes to bonds, including eliminating tax-exempt bonds, capping municipal bond tax exemptions at 28 percent, or replacing tax-exempt bonds with tax credit bonds. But even if none of these changes were implemented, a lower marginal tax rate would also directly impact tax-exempt bonds because the benefit provided by these bonds would be decreased. (Read more about how tax reform could affect tax-exempt bonds on page 32.)
Key to the implementation of any changes imposed by tax reform will be the transition rules that are passed as part of the enacting legislation. This will be especially true for changes that will result in an adverse effect.
For example, before the Tax Reform Act, the HTC was a three-tiered credit: 15 percent for nonresidential buildings at least 30 years old, 20 percent for nonresidential buildings at least 40 years old and 25 percent for certified historic buildings (including residential buildings). The Tax Reform Act of 1986 replaced the three-tier historic rehabilitation tax credit with a lower, two-tier tax credit for qualified rehabilitation expenditures: 20 percent for rehabilitations of a certified historic structures, and 10 percent for rehabilitations of buildings (other than certified historic structures) originally placed in service before 1936.
The effective date for this change was Dec. 31, 1986 and generally applied to property placed in service after that date. However, a general transitional rule provided that the modifications to the HTC would not apply to property placed in service before Jan. 1, 1994, if the property was placed in service (as rehabilitation property) as part of either a rehabilitation completed pursuant to a written contract that was binding (under applicable state law) on March 1, 1986. The rule also applied to rehabilitations with respect to property (including any leasehold interest) that was acquired before March 2, 1986, or was acquired on or after March 1, 1986, if (1) parts 1 (if necessary) and 2 of the Historic Preservation Certification Application were filed with the Department of the Interior (or it’s designee) before March 2, 1986, or (2) the lesser of $1 million or 5 percent of the cost of the rehabilitation (including only qualified rehabilitation expenditures) was incurred before March 2, 1986, or was required to be incurred pursuant to a written contract that was binding on March 1, 1986. In addition, if property that qualified under the transitional rules was placed in service after Dec. 31, 1986, the applicable credit percentages were reduced from 15 to 10 and 20 to 13, respectively. The credit percentage was not reduced for property that qualified for the 25 percent credit.
As you can see, even though the Tax Reform Act reduced the credit percentage rates for the HTC, the transition rules allowed the historic preservation community a chance to phase the reduction, thereby softening the adverse effect on transactions that were underway and in the pipeline. Similar transition rules will be essential to making sure adverse effect on affordable housing and community development at large is minimized should comparable changes be made to the LIHTC or NMTC.
Rifle Shot Transition Rules Unlikely
Conversely, unlike the Tax Reform Act of 1986, the tax reform legislation that emerges in the months and years to come is unlikely to include exemptions that are sometimes referred to as rifle shot transition rules, which were provisions used to grant transitional relief from the repeal of favorable tax provisions that are so narrowly drafted that only one taxpayer (or, in some cases, a very few taxpayers) would qualify. These rules were often cryptically worded to conceal the identity of the intended beneficiaries.
For example, the Tax Reform Act included a rifle shot transition rule for “two new automobile carrier vessels which will cost approximately $47,000,000 and will be constructed by a United States-flag carrier to operate, under the United States-flag and with an American crew, to transport foreign automobiles to the United States, in a case where negotiations for such transportation arrangements commenced in April 1985, and definitive transportation contracts were awarded in May 1986.” Similar examples include exceptions for an unnamed “detergent manufacturing facility, the approximate cost of which is $13,200,000, with respect to which a project agreement was fully executed on March 17, 1986,” and an unnamed “computer and office support center building in Minneapolis, with respect to which the first contract, with an architecture firm, was signed on April 30, 1985, and a construction contract was signed on March 12, 1986.”
These examples, while amusing, are just a few of the estimated 650 such exemptions that were made through the legislative language of the Tax Reform Act of 1986 that were believed to cost more than $10 billion combined. This kind of narrow relief is much less likely to be a part of future tax reform for two reasons. First, since the Tax Reform Act of 1986, Congress has established new procedural rules that make it more difficult to enact legislative provisions that benefit a small number of individuals or entities, including spending provisions and provisions that provide limited tax benefits. And second, with the current laser-focus on spending and the deficit, it’s doubtful that provisions that benefit a narrow subset of taxpayers could gain traction or eventual approval.
Beyond changes to tax credits themselves, a number of factors will come together in the coming months that will shape the outlook for affordable housing, community development, historic preservation and renewable energy in the context of tax reform. And as the LIHTC, NMTC, HTC and renewable energy tax credit communities work to protect the important work that they do, they should keep an eye on the big picture to avoid needless adverse impacts.