How Would Tax Reform Affect HTC Investors’ GAAP Financials?

Published by Michael Novogradac, Michael Kressig on Monday, January 9, 2017 - 12:00am

A previous post discussed the likely effects of corporate tax reform on the generally accepted accounting principles (GAAP) financial statements of corporate investors in low-income housing tax credit (LIHTC) properties. This post addresses the likely GAAP effects of lower corporate tax rates on historic tax credit (HTC) investments. Look for future posts regarding the likely GAAP effects of lower corporate tax rates on New Markets Tax Credit and Renewable Energy Tax Credit investments. As a word of caution, the actual effects of any tax reform will of course depend on the specific provisions of such legislation, including any modifications to existing tax rates, deductions, exemptions and credits, as well as the accompanying transitional rules and effective dates.

Economic Overview
Before diving into the GAAP effect of lower corporate tax rates on HTC investments, it is useful to review the economic impact of lower rates. The net economic result may be surprising, particularly compared to the conclusions in our blog post that observed that lower tax rates adversely affect LIHTC investment yields.

If all other factors remain constant, in a lower tax rate environment HTC investments would be more profitable on a cumulative basis. To be more precise, HTC investments would be more profitable on both an after-tax cash basis and on an after-tax GAAP net income basis. This result differs from LIHTC investments because the HTC is a taxable credit; that is, there is a basis reduction or income inclusion associated with claiming the tax credit. At a lower tax rate, the cost of this basis adjustment or income inclusion is less, so after-tax cash and net income is higher.

Because after-tax cash would be higher, internal rates of return (IRR) or net present values (NPV) of HTC investments would also generally be higher. One exception would be in high tax loss situations, where lower tax rates adversely affect IRR and NPV calculations.

The timing of recognizing the larger GAAP after-tax net income will depend on the GAAP accounting policies adopted by the investor. Many investors recognize all, or substantially all, of the GAAP income in the year HTC property is placed in service.

With the above in mind, the following discussion examines two major GAAP considerations with respect to HTC investments if the United States moves to a lower tax rate environment:

  1. current impairment of existing investments, and
  2. the effect of lower corporate tax rates on deferred tax assets or liabilities.

Impairment Considerations
GAAP generally requires investors to assess whether an investment is impaired. Equity investments not quoted in an active market are impaired, and a loss is recognized in the income statement, when the amount of expected future cash flows are less than the carrying value of the asset and the decline isn’t temporary.

If corporate tax rates decline, HTC investors would need to consider whether their equity investments require impairment, but impairment isn’t expected to be a common occurrence. This is because for investments in HTC property not yet to be placed in service, future cash flows should still exceed carrying value. For investments in HTC property already placed in service, the carrying value of the asset has likely already been written down such that the carrying value equals the remaining cash expected to be generated over the life of the investment. Lowering corporate tax rates would not be expected to affect anticipated future cash flows.

Deferred Tax Considerations
The principal effect of a corporate tax rate reduction on the GAAP financial statements of HTC investors would relate to deferred taxes. Deferred tax liabilities (DTLs) and deferred tax assets (DTAs) are measured using the enacted tax rate expected to apply to the taxable income in the periods in which the DTL or DTA is expected to be settled or realized. A deferred tax asset arises when an item is expensed for book purposes before it is expensed for tax. The DTA created equals the expected tax savings when the tax deduction is expected to be claimed. Accordingly, the GAAP financial statements of taxpayers with net deferred tax assets would be adversely affected (resulting in recognition of additional book expense) in the year in which lower tax rates are enacted. Conversely, the GAAP financial statements of taxpayers with net deferred tax liabilities would benefit from the enacted lower tax rate changes (resulting in recognition of an income tax benefit as a result of the remeasurement).

The question investors would face is whether their HTC investments created a net DTL or DTA position. A number of factors influence the answer for any specific HTC investment as well as the relative magnitude of the DTL or DTA. These factors include the investment structure, the investor’s method of accounting for the investment, whether the property level debt is recourse or nonrecourse, where the investment is in the investment life cycle (typically six to seven years) and the weighted average recovery period of the project’s depreciable property. Given all the variables, it is useful to separately examine the likely deferred tax status of investments based on their investment structure.

Common Structures
HTC investments are typically organized using either:

  1. a single-tier (direct) structure where the investment is made directly into the partnership generating the credit, or
  2. a lease pass-through structure where the investment is made into the lessee of the credit property and passed from the property owner to the lessee via a tax election (also known as the “lease pass-through” structure).

In the single-tier structure, the investor typically has a 98 percent to 99 percent interest in the property partnership. In the lease pass-through structure, the investor typically has a 99 percent interest in the tenant partnership.

Single-Tier (Direct) Investments
Direct HTC investments have typically priced at less than $1 in equity contributions per dollar of tax credits and direct equity investors are required to reduce the basis of their investment by the amount of the credit. This causes the investor’s tax basis capital account to go negative. The negative tax basis capital account generally means that taxable income will need to be recognized in the future. In this situation the investor’s book capital account would not be negative, resulting in a DTL.

The DTLs of single-tier investments would be higher in circumstances where the investor is allocated tax losses during the investment holding period. The classification of project debt as recourse or nonrecourse is significant in this determination: in general, if all debt is recourse to the developer, losses would be allocated away from the investor to the developer; if all debt is nonrecourse, the investor would typically get its 98 to 99 percent share. In this case, since losses principally result from depreciation expense, the average recovery period of the project’s depreciable property would significantly influence the amount of losses generated during the typical investment holding period. For example, hotel properties typically have a significant amount of short-term life property eligible for bonus depreciation. An HTC investment in a single-tier hotel project with nonrecourse debt that has been placed in service is likely to have a relatively large DTL. The same project, financed with debt recourse to the developer, is likely to have a small DTL or be in a position where the DTL and DTA roughly offset one another (deferred tax neutral).

Lease Pass-Through Investments
Unlike their single-tier counterparts, lease pass-through investments don’t have a basis reduction requirement for the investor. In lieu of the basis reduction allocated to the investor in a single-tier structure, Internal Revenue Code Section 50(d) provides for an income inclusion amount equal to the credit amount, to be recognized ratably over the recovery period of the credit property (typically 15 years in the case of certain leasehold improvements, 27.5 years in the case of residential property or 39 years in the case of nonresidential property). Temporary and proposed regulations issued in July 2016 and effective for property placed in service after Sept. 18, 2016, altered the way most investors historically reported and accounted for these transactions. As a consequence, “legacy” investments, which assumed the 50(d) income was a partnership rather than a partner item, may well fare differently in a reduced-rate scenario than would investments accounted for in accordance with the new regulations. Here’s how they compare:

50(d) Legacy Investments
Because there is no basis reduction allocated to the investor and because the investor’s indirect ownership in the property partnership (assuming it has one) is usually small, the amount of tax losses it would typically expect to receive during the investment holding period is insignificant. As a consequence, the tax basis of investments in this category typically does not diminish significantly during the investment holding period. In contrast, for GAAP purposes most of the HTC investment basis is expensed in the year the credit is taken. This temporary difference creates a DTA. Remeasurement of the DTA as a consequence of lower tax rates would adversely impact the GAAP financial statements of effected investor due to the diminished value attributed to the future deductions.

Investments reported under the new 50(d) regulations
Investors in developments to which the new regulations apply incur a future tax obligation (often referred to as the 50(d) liability) that is recorded on the GAAP financial statements, typically by netting it against the deferred tax asset, in the year credits are earned. The 50(d) liability (or contra asset) is equal to the dollar amount of HTCs associated with the project (such amount representing the 50(d) income it, as the ultimate credit claimant, is obligated to recognize over the recovery period of the property) multiplied by the enacted tax rates expected to apply to the taxable income when it is reported. If the investment cost basis was $1 per HTC generated by the investment, and if the investor fully expensed the investment on its GAAP financial statements in the year the credits were earned, the 50(d) liability would exactly offset the DTA. Alternatively, if, as has generally been the case since the new regulations became effective, the investor’s cost basis was less than $1 per HTC, the investment would be in a net tax liability position and would benefit from enacted lower tax rate changes (resulting in recognition of an income tax benefit as a result of the remeasurement).

Stay Tuned
Again, because the ultimate shape of the tax reform provisions are unknowable, it’s only possible now to consider broadly what the effects of possible tax reform would be for HTC investments. Stay tuned for future discussions about the GAAP implications for new markets tax credit (NMTC) and renewable energy investment tax credit (ITC) and production tax credit (PTC) investments. Novogradac & Company’s professional services teams are available now to assist you in assessing the possible effects of tax reform.