How Recent Tax Law Changes May Affect State LIHTCs
As previously discussed in this space, Novogradac estimates that the tax bill enacted in December would have reduced the future supply of affordable rental housing by about 235,000 rental homes nationwide over the next 10 years. Thanks to the recently enacted temporary 12.5 percent increase in 9 percent allocated low-income housing tax credits (LIHTCs), more than 10 percent of that loss should now be avoided.
The reduction in the federal corporate income tax rate from 35 percent to 21 percent is by far the most significant factor in the estimated unit loss, accounting for approximately 90 percent of the reduction in production because of a sharp drop in equity pricing for federal LIHTCs. The estimated reduction in future production does not account for further reductions stemming from other effects of the 2017 tax reform bill that are difficult to quantify, such as reduced investor demand as a result of the new base erosion and anti-abuse tax, and an increase in after tax rates of return from taxable investments.
Reduced corporate tax rates also have an effect on the equity raised from state LIHTCs. Fifteen states (and counting) have state LIHTC programs. Certain states, including California, have enacted “certificated” LIHTC programs designed to enhance efficiency and facilitate increased funding opportunities for affordable housing. States may have opportunities to help offset at least some of the negative impacts of tax reform by refining their own respective tax laws. This discussion focuses on some examples of such opportunities in California, which will lose more affordable rental homes than any other state by a significant margin as a result of the new tax law. The following discussion considers allocated state LIHTCs as well as certificated LIHTCs, and closes with some steps that can be taken to increase the value of state LIHTCs.
Allocated State LIHTCs (Non-certificated)
The composition of state LIHTC equity investors varies from state to state. In California, the state LIHTC equity market is typically comprised of corporate investors. In general, state LIHTC equity pricing for allocated credits is strongly inversely correlated with the investor’s federal income tax rate. There is an inverse correlation because the state credit reduces the investor’s federal deduction for state income taxes, such that the higher the federal tax rate, the less valuable the state credit. When the corporate federal rate was 35 percent, state LIHTC equity prices were generally in the range of, but slightly greater than, 65 cents. Now that the federal rate has been reduced to 21 percent, equity pricing for allocated state credits is expected to increase, possibly in the range of 20 percent. The mechanics behind this relationship are tax based. When an investor receives an allocation of state LIHTCs, the investor benefits from a reduction of their state income tax liability. The reduction of the investor’s state income tax liability also reduces the investor’s federal deduction for state income taxes. This increases their federal taxes by the amount of the lost deduction multiplied by the federal tax rate. So, if an investor has federal and state income tax liabilities of $1,000 and $100, respectively, prior to claiming state LIHTCs, a state LIHTC allocation of $25 will reduce the state income tax liability to $75. However, the investor’s federal income tax liability will increase by $5.25 ($25 x 21 percent, assuming a 21 percent federal income tax rate), because the investor’s state tax deduction decreases by $25. State tax credit equity pricing is generally slightly greater than the inverse of the federal rate because the investor will typically recognize a tax benefit upon the disposition of the investment. To illustrate, based on the facts in the previous example and assuming an equity price of 80 cents, the investor is entitled to allocations of state credits by contributing equity of $20 ($25 of credits x 80 cents) to the partnership. (The 80 cents equity pricing reflects a presumed 20 percent increase over pre-tax reform equity pricing.) Assuming the investor disposes of the investment after the end of the credit period for a nominal amount, the investor will generally recognize a federal tax benefit of $4.20 from the $20 loss recognized upon disposition ($20*21 percent), plus a corresponding state tax benefit based on the state income tax rate.
California’s tax law allows bifurcation of state LIHTCs, allowing different parties to invest in the state and federal credits. Because California state LIHTCs are generally recognized over a shorter, four-year period, when the state LIHTC is bifurcated, state LIHTC equity investors generally would not be expected to remain in the partnership for the full 15-year federal tax credit compliance period. As such, the disposition benefits may be realized much sooner. This results in two tiers of observed pricing for state LIHTCs, those where the state LIHTC is bifurcated, yielding a higher price, and those where the state credit is not bifurcated, resulting in a lower price.
Certificated State LIHTCs
California’s certificated LIHTC gives the developers an option to receive certificates for state LIHTCs, which can then be sold outright to an unrelated state investor rather than requiring the investor to be a partner. There are some interesting differences between certificated credits and allocated credits that are important to understand.
When an investor acquires certificated credits, the investor recognizes a reduction of their state income tax liability equal to the amount stated on the certificate. The investor does not lose the benefit of the corresponding federal deduction for state income taxes, but the investor recognizes incremental increase in taxable income equal to the difference between the price paid for the credit and the amount of the credit claimed. Also, because of the readily transferable nature of certificated credits, developers may have opportunities to time the sale of the credits such that less time passes between sale and the buyer’s use of the certificate. As a result, certificated credit prices are not as negatively correlated with the investor’s federal income tax rate, so higher pricing is generally expected from corporate investors for certificated credits compared to allocated credits.
While certificated credit investors do not lose the federal tax benefit of the corresponding federal deduction for state income taxes, they do not receive the benefit of the disposition of the investment at the end of the credit period. To illustrate, based on the facts in the previous example, the certificated credit investor will not recognize an increase in the federal tax liability of $5.25 from the lost state income tax deduction, nor will they recognize the decrease in the federal tax liability of $4.20 from the loss recognized upon disposition. Also, assuming a credit price of 87 cents, and $25 in state tax credits, the investor will recognize additional income of $3.25, equal to the difference between the credit price, less the amount of the credit. The investor will owe additional federal tax equal to 3.25 multiplied by 21 percent, or 68.25 cents, plus a corresponding additional state income tax based on the state income tax rate.
Proceeds received from the transfer of certificated credits are also taxed differently to the owner of the credits than the transfer of allocated credits. As a general tax matter, contributions to partnership in exchange for the future allocation of state tax credits and other property benefits is not a taxable event, subject to disguised sale rules, and other federal income issues. On the other hand, the sale of certificated credits generally results in income recognized by the seller equal to the sale price.
Case Study: How These Considerations Affect Pricing in California
The California Tax Credit Allocation Committee compiled statistics on 2017 California state LIHTC awards, both certificated and non-certificated. These statistics show that almost half of the developments that received state credit awards during 2017 elected the certificated credit option (11 out of 23). Certificated credit pricing ranged from 80 cents to 94 cents, and averaged about 87 cents. By comparison, non-certificated equity ranged from 60 cents to 80 cents, and averaged about 74 cents. These statistics demonstrate a significant pricing differential between certificated credit equity and non-certificated credit equity. Tax reform, and the recently enacted 21 percent corporate tax rate will probably decrease this pricing differential some, although the 74 cent average price for non-certificated credit equity during 2017 is indicative that the 2017 pricing was likely based on an estimated corporate rate closer to 25 percent, which was the widely adopted underwriting assumption that was used during 2017 in anticipation of tax reform. It is also possible that uncertainty during 2017 in anticipation of tax reform discouraged use of the certificated credit option. If that is the case, 2018 applications may show an increase in the percentage of state LIHTC applicants electing the certificated credit option.
What Can be Done?
As noted above, 2017’s tax bill will significantly reduce the future supply of affordable rental housing. Some states will be impacted more than others; California will suffer the greatest losses, by a wide margin. Advocates are actively pursuing measures that can mitigate these losses. For example, in February, there was a serious effort given to including provisions of the Senate’s Cantwell-Hatch bill in the two-year federal budget agreement. While not successful then, advocates were successful in getting a four year temporary 12.5 percent increase in volume cap allocated federal LIHTCs. Advocates are continuing to work to ensure that more of the Cantwell-Hatch provisions make their way into any tax legislative vehicle that Congress could consider this year. This bill contains a number of noteworthy provisions that will encourage investment and increase production. Perhaps the most significant provision is the 50 percent phased in increase in the annual per capita credit allocation, which could add an additional 200,000 rental homes over the next 10 years, and the 4 percent floor for tax-exempt bond financed developments.
An increase in state LIHTC allocation amounts could also help mitigate tax reform related losses, especially in states like California, which will probably lose almost 50,000 affordable rental homes over the next 10 years because of tax reform. Some of the groundwork for such efforts has already been paved: In 2015, AB 35, authored by Assembly member David Chiu and then-Speaker Toni Atkins, would have increase the amount of state LIHTCs by $300 million (present allocation amount is around $100 million. The bill passed the state assembly and senate almost unanimously but was one of nine bills that would have would have created a new tax credit or expands an existing tax credit and were vetoed by Governor Jerry Brown on October 10, 2015 because of budget considerations.
California’s state LIHTC program uses “modified conformity” to federal income tax law, whereby the law mirrors the federal statute, with certain exceptions. States that adopt such modified conformity have additional opportunities to modify the manner in which state law conforms to federal law to enhance program efficiency, offset losses resulting from tax reform and further the policy objectives. For example, California’s modified conformity to the federal passive activity loss rules restricts the ability of individual investors to use state LIHTCs. A revision to state tax law exempting state LIHTCs from the passive activity loss rules could significantly increase the state LIHTC equity pricing, even more so since tax reform limits individual taxpayers’ federal deductions for state and local income taxes to $10,000 and subjects individuals to federal tax rates that are significantly higher than corporate rates.
Regarding the state and local income tax deduction limitation, because individuals no longer receive a federal tax benefit for deducting state income taxes in excess of an aggregate of $10,000 in state and local tax deductions, the negative correlation between tax rates and equity pricing that applies to corporations will generally not apply to individuals.
Regarding higher individual tax rates, the new tax law established a maximum federal tax rate for individuals of 37 percent, compared to a corporate rate of 21 percent. This sizeable variance could give individuals a much greater incentive to invest in allocated credits. In California, individuals are also subject to a higher tax rate (up to a 13.3 percent individual rate vs a 8.84 percent corporate rate), further adding to this value differential.
As a result, because of the tax bill, there is potential value that can be created by modifying California’s tax code to allow individual investors to use California LIHTCs. The combination of the tax bill’s reduction of the state and local income tax deduction with the bill’s creation of a significantly broadened gap between individual and corporate income tax rates could result in a significant boost in funding raised per tax credit dollar if such changes are made. As a result of the tax bill, equity pricing for individuals could be notably higher than equity pricing for corporate investors. Initial estimates suggest that individual equity pricing could be 25 to 40 percent, or more, higher than corporate equity pricing. This means a subtle adjustment to California’s tax code could provide an opportunity to better leverage California LIHTCs and significantly increase funding for affordable rental housing.
Allocated, bifurcated credits, if used by individual investors have the potential to create the greatest benefit to the state by a considerable margin.
Given the estimate that California could lose as many as 50,000 affordable rental homes of the next 10 years because of the tax bill, allowing individual investors to use California’s LIHTCs could help combat this decline and maximize efficient deployment of state resources. California currently provides an annual allocation of state LIHTCs of about $100 million. Individual investors could increase the amount of funding raised from these credits by 25 to 40 percent, or more, if California’s tax code is modified to allow more individuals to use California LIHTCs.