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Tax Reform Could Significantly Affect LIHTC Equity Market

Published by Dirk Wallace and Michael J. Novogradac on Thursday, December 29, 2016 - 12:00AM

As noted previously in this space, the election has increased the likelihood of substantial tax reform being enacted in the coming years. This has renewed concerns about the potential effects—intended and unintended—of that reform on the low-income housing tax credit (LIHTC).

Simply put, if current efforts to enact corporate tax reform are successful, the resulting changes to the tax code will affect the amount of LIHTC equity that can be raised and in turn the number of affordable rental apartments that can be built or preserved. It’s important to note that the overall effects of tax reform could be net positive or net negative, depending on the totality of the impact of the various changes.  

One of the basic tenets of tax reform is to broaden the base and lower the marginal tax rate. In their tax reform “blueprint,” House Republicans have targeted a lower top corporate tax rate of 20 percent. President-elect Donald Trump campaigned on a top tax rate of 15 percent for corporations. Additionally, accelerating depreciation periods is one of many measures reported to be under consideration.

As investors and others in the affordable housing community consider what tax reform could mean for the future of the LIHTC, Novogradac is analyzing the possible ripple effects of these two tax reform outcomes on LIHTC investor yields, investor equity pricing and the amount of equity raised. This analysis is a partial update to the report Novogradac & Company published in 2013 on how tax reform could affect affordable rental housing.

To gauge the effect of lower corporate tax rates and accelerated depreciation periods on LIHTC yields and possible investor equity pricing, Novogradac & Company ran a series of calculations using an internal rate of return (IRR) model, at a range of investor equity prices from $0.95 to $1.10, for 9 percent investments and 4 percent tax-exempt bond investments, both with and without basis boosts (allowing the project to increase its eligible basis by 30 percent).  

The calculations estimated the IRR effect of the corporate tax rate dropping from the current level of 35 percent to 28 percent, 25 percent, 20 percent and 15 percent. We also ran calculations to consider the effect of tangible and intangible assets being expensed when the asset is placed in service and interest on the debt only being deducted to the extent there is interest income for tax purposes. (Under the House tax reform blueprint, land would not be deductible.) The investor equity price per credit at each tax rate represents the investor equity price per credit required to achieve an assumed investor level yield of 4.5 percent to 5 percent.

These calculations didn’t vary for factors that commonly affect investor demand and investor equity pricing, such as property type, transaction terms or Community Reinvestment Act considerations. These calculations do not assume any transition rules, where changed tax rates and/or changed policies on depreciation or interest deductibility are phased in over time.  Also, the investor equity pricing estimates, as explained above, are based on an IRR model and, as such, do not incorporate adjustments that might be needed if corporate investment models based on earnings per share, return on equity and other assessments were included. Novogradac plans to update this report as such additional assessments are made and are publicly available.

9 Percent Property Not Receiving a Basis Boost at Various Top Tax Rates
To begin, Novogradac & Company considered implications for LIHTC properties not receiving a basis boost. This calculation shows estimated credit pricing at 35 percent tax rate down to a 15 percent tax rate, but with all other aspects of current tax law in force. The base scenario of the analysis assumes the current 35 percent tax rate. As tax rates decrease, the tax credit investor equity price is adjusted to achieve the same yield as the base scenario of 4.5 percent to 5 percent. All other assumptions in the analysis remained constant. For 9 percent properties not receiving a basis boost, there is a higher debt to equity ratio when compared to a 9 percent property receiving a basis boost because the property isn’t receiving the additional equity generated from the 30 percent basis bonus. As a result, any fluctuations in tax rates for this type of property generally impact the yield and investor equity price per credit to a greater degree when compared to the same property receiving a basis boost. Assuming the property received equity contributions equal to $1.00 per tax credit, the results show that if the top corporate rate is lowered to 25 percent, the investor equity price per credit necessary to achieve the same yield as current tax law drops from $1.00 to $0.89. If the top corporate rate is lowered to 15 percent, the investor equity price per credit necessary to achieve the same yield as current tax law drops from $1.00 to $0.83.

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9 Percent Property Not receiving a Basis Boost at Various Top Tax Rates with Expensing Depreciable Assets and Limited Interest Deductibility
Next, Novogradac considered the effect of two of the tax reform proposals in the Tax Reform Task Force Blueprint on that same LIHTC property with a 9 percent tax credit allocation not receiving a basis boost. In this analysis, tangible and intangible assets, except for land, are expensed when the asset is placed in service and interest on the debt is only deducted to the extent there is interest income for tax purposes. Again, the investor equity price per credit at each tax rate represents the investor equity price per credit required to achieve the investor level yield of 4.5 percent to 5.0 percent. Because of the substantial benefit created by the immediate expensing of tangible and intangible assets, except for land, the investor equity price per credit is higher in this scenario than in the base scenario that reflects current tax law. And as tax rates decrease, the benefit from expensing the fixed assets has less of an impact on the yield and investor equity price per credit decreases.

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4 Percent Tax-Exempt Bond Property Not Receiving a Basis Boost at Various Top Tax Rates
These figures assume a property is financed with tax-exempt bonds, is not receiving a basis boost, and tax law is unchanged with the exception of the top corporate tax rate. As illustrated, if the top corporate rate is lowered to 25 percent, the investor equity price per credit necessary to achieve the same yield as current tax law drops from $1.00 to $0.88. If the top corporate rate is lowered to 15 percent, the investor equity price per credit necessary to achieve the same yield as current tax law drops from $1.00 to $0.81.

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4 Percent Tax-Exempt Bond Property Not receiving a Basis Boost at Various Top Tax Rates with Expensing Depreciable Assets and Limited Interest Deductibility
Next, Novogradac estimated investor equity price ranges for a property financed with tax-exempt bonds, not receiving a basis boost for which the tangible and intangible assets, except for land, are expensed when the asset is placed in service and interest on the debt is only being deducted to the extent there is interest income for tax purposes. Again the investor equity price per credit is higher because of the expensing change. The debt to equity ratio is also higher for a non-boost property and the inability to deduct the additional interest has a greater negative affect on equity investment credit pricing when compared to a property with a basis boost. 

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9 Percent Property Receiving a Basis Boost at Various Top Tax Rates
Of course, it’s essential to also consider implications for LIHTC properties that receive a basis boost (allowing the project to increase its eligible basis by 30 percent). In this scenario, Novogradac calculated investor equity price per credit for a LIHTC property that received a 9 percent tax credit allocation and receiving a basis boost at different top tax rates, but current tax law otherwise in effect. Assuming the property received $1.00 per tax credit, the results show that if the top corporate rate is lowered to 25 percent, the investor equity price per credit necessary to achieve the same yield as current tax law drops from $1.00 to $0.90. If the top corporate rate is lowered to 15 percent, the investor equity price per credit necessary to achieve the same yield as current tax law drops from $1.00 to $0.83. 

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9 Percent Property Receiving a Basis Boost at Various Top Tax Rates with Expensing Depreciable Assets and Limited Interest Deductibility
Next, Novogradac layered into the previous calculation the estimated effect of tangible and intangible assets, except for land, being expensed when the asset is placed in service and interest on the debt being deducted to the extent there is interest income for tax purposes. Again, the investor equity price per credit at each tax rate represents the investor equity price per credit required to achieve the investor level yield of 4.5 percent to 5.0 percent. And again, because of the substantial benefit created by the immediate expensing of tangible and intangible assets, except for land, the investor equity price per credit is higher in this scenario than in the base scenario that reflects current tax law. As tax rates decrease, the benefit from expensing the fixed assets has less of an impact on the yield and investor equity price per credit decreases.

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4 Percent Tax Exempt Bond Property Receiving a Basis Boost at Various Top Tax Rates
The breakdown below assumes a property is financed with tax-exempt bonds and receiving a basis boost at different top tax rates, but current tax law otherwise in effect. As tax rates decrease from the base scenario, the tax credit investor equity price is adjusted in order to achieve the investor level yield of 4.5 percent to 5.0 percent. All other assumptions remained constant. In this scenario, if the top corporate rate is lowered to 25 percent, the investor equity price per credit necessary to achieve the same yield as current tax law drops from $1.00 to $0.90. If the top corporate rate is lowered to 15 percent, the investor equity price per credit necessary to achieve the same yield as current tax law drops from $1.00 to $0.82.

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4 Percent Tax Exempt Bond Property Receiving a Basis Boost at Various Top Tax Rates with Expensing Depreciable Assets and Limited Interest Deductibility
Finally, Novogradac considered the estimated effect of tangible and intangible assets, except for land, being expensed when the asset is placed in service and interest on the debt being deducted to the extent there is interest income for tax purposes, on a property that is financed with tax-exempt bonds and receiving a basis boost. This analysis again found that the investor equity price per credit is higher than in the base scenario under current tax law because of the substantial benefit from the immediate expensing of tangible and intangible assets, except for land. Properties financed with tax-exempt bonds typically have a greater proportion of tax benefits from depreciation compared to 9 percent properties and thus, tax law changes that accelerate cost recovery of assets have a more positive IRR effect on these properties than 9 percent properties. And as with the 9 percent property calculation, as tax rates decrease, the benefit from expensing fixed assets has less of an impact on yield and investor equity price per credit decreases.

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Conclusion
As shown in these calculations, lowering the top corporate tax rate from 35 percent could lower the investor equity price per credit by as much as $0.17, depending on how low lawmakers are able to drop the top tax rate. This would substantially reduce the amount of equity available to build and preserve affordable rental housing. In 2015, the annual LIHTC equity raised was about $13 billion, of which approximately $3 billion was in the 4 percent market. Based on that total, Novogradac estimates that a reduction of as much as $2.2 billion, or more, in annual LIHTC equity would be available under various tax reform proposals. Using historical unit production data from the National Council of State Housing Agencies, this reduction in equity could translate into as many as 16,000, or more, fewer affordable rental homes created or preserved each year.

However, it’s important to also note that in addition to lower rates, proposals to allow immediate expensing of tangible and intangible assets could have some offsetting positive effects as well.

Want More?
Clearly there are a number of additional considerations than those discussed here that will affect the LIHTC equity market. Contact a Novogradac professional to evaluate how those considerations could affect your current and proposed investments.

Additionally, Novogradac & Company has formed a Tax Reform Working Group. Please contact Dirk Wallace, CPA, to learn more. 

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