How Would Tax Reform Affect LIHTC Investors’ GAAP Financials?

Published by Bentley D. Stanton, Michael Novogradac, Paul Charron on Friday, December 9, 2016 - 12:00am

Given all the talk of tax reform in Washington, D.C., current low-income housing tax credit (LIHTC) investors want to know how tax reform, if passed, would affect their financial statements.  Obviously, the ultimate impact of tax reform isn’t fully knowable or measurable until final details become available. How much will tax rates decrease? To what extent and how will Congress pay for tax rate reductions? What tax deductions, exemptions and/or credits will be added, modified or eliminated? The answers to these questions will eventually determine the actual effect for investors. In the meantime, here are some points to consider from a generally accepted accounting principles (GAAP) perspective.

Impairment is a key area of concern for LIHTC investors under tax reform. Changes in tax rates will immediately impair the carrying value of many LIHTC investments. Impairment is generally measured by comparing the aggregate remaining value of tax benefits against the current carrying value of the investment. The impact on a particular LIHTC investment will be governed by the accounting method used by the investor.

Proportional Method

Under proportional amortization accounting method, the investment is generally amortized over the tax credit compliance period based on future expected tax benefits. Therefore, if tax rates decrease, then the annual investment amortization would be recalculated based on the remaining recalculated anticipated tax benefits. To the extent the remaining anticipated tax benefits are less than the carrying value of the investment, the investor would record impairment based on the shortfall. This impairment charge has different geography on the income statement than the periodic amortization expense.  Periodic amortization expense for the investment under the proportional amortization method is recorded through the tax provision, whereas impairment is recorded as a pre-tax expense or loss.

Equity Method

Investors under the equity method will likely find that impairment charges arise more quickly if tax rates are reduced. Under the equity method, initially, LIHTC investors generally only reduce their investment balance by annual pass-through GAAP losses.  Because the annual pass-through losses from operating properties are generally considerably less than the annual tax benefits, the equity method investor will record notably less annual expense than the investor using the proportional amortization method. As such, investors using the equity method, anticipate, at some point, incurring an impairment charge.  If tax rates decline, then investors will generally find that the impairment charge occurs earlier than initially anticipated.  The impact on each investor will vary based on the impairment approach used.  There are alternate impairment approaches used within the investor community.  Additionally, in the year that tax rates reductions are enacted, many investments that have already been impaired, will see an additional accelerated impairment charge reflecting the reduction in future anticipated tax benefits because of the rate change.

Guaranteed Funds

Investors in guaranteed funds may also experience impairment in the year of rate reductions.   This is due to the combination of the reduction in anticipated future tax benefits and the general exclusion of changes in enacted tax rates within yield guarantees.

What Investors Should Consider Now

Now may be an opportunity for investors to reevaluate how impairment is currently being calculated. This could lessen the impact of future impairment. Additionally, an anticipated decrease in tax rates also affords opportunities in tax planning as investors consider when to dispose of their LIHTC investments. Investors may be able to continue to recognize greater tax benefits on pass-through losses from LIHTC partnerships prior to a decrease in the tax rate. Begin planning now and maximize potential returns, while minimizing the possible impairment.

With tax reform, investors may or may not have as much tax liability as under current law.  It is unclear if corporate tax reform, if enacted, will be revenue neutral, or reflect an overall tax cut.  Even if an overall tax cut is enacted, some industries and companies might still see tax increases.  If the effect on a company from corporate tax reform is a tax cut, then the company may not be able to fully use existing deferred tax benefits. If such benefits are unrealizable, an investor would be required to record a valuation allowance.  Operating loss carryforwards are generally used first in calculating taxable income, in a lower tax rate environment, operating loss carryforwards are likely to still be realizable, albeit at a lower marginal tax rate.   The portion of deferred tax assets attributable to tax credits are the portion at greatest risk of a valuation allowance, e.g., foreign tax credits. 

More to Come

As noted above, the specifics that are eventually implemented as part of future tax reform are what will impact the amounts investors may record in asset impairment and valuation allowances on deferred tax assets in the end. When more information is available, those considerations will be discussed in this space. Novogradac & Company’s professional services teams are available now to assist you in assessing the possible effects of tax reform. 

Investor in Other Tax Credits?

If you are an investor in new markets tax credits, historic tax credits or renewable energy tax credits,  stay tuned.  Novogradac & Company will address some of the unique GAAP accounting issues affecting your existing investments in a future blog post.