Tax Reform Wolf is at the Door: What Should You Do?

Published by Michael Novogradac on Tuesday, October 3, 2017 - 12:00am

The tax reform wolf is at the door.

For nearly seven years I have blogged about tax reform. Much like the shepherd boy from the Aesop fable, I repeatedly cried out that the tax reform wolf is coming. During these years I wondered, if the tax reform wolf comes, will people listen? I can’t say tax reform will get here, but the tax reform wolf is as close to arriving as at any time since I started blogging.

With the Republican unified framework for tax reform now on the table and being considered by the tax-writing committees in both houses of Congress, what should we consider?

  • For starters, it is worth remembering what we learned regarding transition rules from 1986 and 2014, because it’s likely that many changes won’t take effect immediately.
  • When assessing the possible impact of tax reform, it’s logical to divide effects into direct and indirect. For direct effects, we should focus on the effective dates of various changes, both for provisions created and ended. Furthermore, we need to factor in whether such provisions end (or start) abruptly, versus phasing in or phasing out.
  • For indirect effects, we assess how various tax changes may alter the investor base and project financing, both immediately and over time. Bear in mind, by phasing in or phasing out certain provisions, the revenue cost (or benefit) is impacted.

A reminder: As tax reform goes through the process, we will continue to blog regarding tax planning. As always, reach out to your Novogradac tax professionals for specific advice concerning tax credit transactions.

Transition Rules: Lessons from 1986, 2014
The Tax Reform Act of 1986 (TRA ’86)–the last comprehensive tax reform–was a game-changer, with steep declines in both the individual and corporate tax rates. The top marginal corporate rate declined from 46 percent to 34 percent, while the top individual rate dropped from 50 percent to an effective rate of 28 percent. The rates, however, didn’t drop immediately. For calendar-year corporations, the corporate rate dropped to 40 percent in 1987 and then to 34 percent in 1988.

TRA ’86 had other significant effects: Passive activity rules were enacted, severely curtailing tax shelter investing, particularly in rental real estate. It featured the introduction of the low-income housing tax credit (LIHTC), which is responsible for nearly all affordable rental housing built in America. The historic tax credit (HTC) dropped from a three-tiered credit of 25, 20 and 15 percent to the current two-tiered credit of 20 percent and 10 percent.

As with the tax rate, the passive activity loss provisions were phased in, with 35 percent of passive activity loss disallowed in 1987, 60 percent in 1988, 80 percent in 1989, 90 percent in 1990 and 100 percent in 1991.

The change in HTC percentage was handled differently, with the 10 percent and 20 percent credit applying to buildings placed in service after Jan. 1, 1987, the 25 percent rate applying to those placed in service before that. Even that had significant exceptions: for instance, the HTC had a binding contract exception for properties started before 1987, stating that modifications to the HTC would not apply to property placed in service before Jan. 1, 1994, if the property was placed in service as part of a rehabilitation completed pursuant to a written contract that was binding as of March 1, 1986.

The HTC wasn’t unique: there were more than 1,000 requests in 1986 for transition rules from members of Congress. One of the largest set aside $500 million in relief for investors in low-income housing, who were obligated to put money into affordable housing but faced new tax shelter restrictions. The transition rules allowed them to continue to claim the losses in a gradually decreasing amount until 1991, enabling affordable housing to survive while the LIHTC program launched. Another $400 million was set aside to allow steel companies to get refunds of unused investment tax credits.

The 1986 legislation contained an estimated 650 “rifle-shot,” or “ad-hoc” rules, provisions that benefited very few taxpayers (sometimes just one), but were worth more than $10 billion. The “rifle-shot” approach is unlikely this year due to procedural rules and the political price that make it difficult.

In 2014, Rep. Dave Camp, chairman of the House Ways and Means Committee, introduced the Tax Reform Act of 2014. Camp’s legislation never advanced, but it paved the way for last year’s Republican House blueprint for tax reform, called “A Better Way: Our Vision for a Confident America,” and this year’s tax reform framework.

Chairman Camp’s draft gives us additional insight into transition rules. Camp proposed to reduce individual and corporate rates, decreasing the corporate rate from 35 percent to 25 percent over five years from 2015 to 2019. Camp also proposed a gradual phase-out of the standard deduction for taxpayers earning more than $513,600 (married) or $356,000 (all others), the earned income tax credit and other provisions. His legislation included a phase-in of the limitation on investment interest, the ceiling for loan limits to receive the mortgage interest deduction, the amortization of certain advertising expenses and more.

The lesson from 1986 and 2014? Expect gradual phase-outs and phase-ins for many changes.

Direct Effects
While considering direct effects of tax reform on tax credit transactions, the following potential changes are being considered (there are no news flashes here):

  • Lower corporate, pass-through and individual tax rates.
  • Limits on interest expense deductibility.
  • Creation of a dividends paid deduction.
  • Asset expensing.
  • Limits on deductibility of state income taxes.
  • Repeal of the alternative minimum tax.       

In the LIHTC, NMTC, HTC and RETC areas, much change is possible. Also possible: No change. We continue to monitor these areas. The framework specifically mentions retaining the LIHTC and calls for the elimination of most business tax credits, albeit with the proviso that they can be retained if they fit within the budgetary constraints necessary for tax reform under budget reconciliation. That means supporters of the NMTC, HTC and RETCs can argue for their continuation.

Transition Rules for 2017
If tax reform is enacted, it most certainly will include a notable reduction in the corporate tax rate, (the framework calls for a drop to 20 percent) and such a reduction would almost assuredly be instituted over several years. It wouldn’t be surprising to see something like 3 percent a year for five years, lowering the rate to 20 percent and softening the effect of lower tax rates.

Of the other provisions mentioned above, how might they be transitioned to or phased in? Here are some reasonable guesses:

  • Lower tax rates, perhaps dropping by the aforementioned 2 or 3 percent per year.
  • The limits to business interest expense deductions, widely considered a negative provision for many taxpayers, would likely be a gradual phase-in of the limits or gradual phase-down of deductibility.
  • Enactment of a dividends-paid deduction, similarly, could be phased in.
  • A change in depreciation or expensing allowances could see a fairly quick phase-in rule, with a phase-out after five years.
  • Any limit on the deduction of state income taxes could see a phase-out over multiple years.
  • Repeal of the alternative minimum tax could be immediate, or phased out.

Other considerations
There are numerous positive possibilities, too many to enumerate here (though we are tracking them), including:

  • Passage of up to a 50 percent increase in LIHTC allocations (if the Affordable Housing Credit Improvement Act is part of tax reform). As written, the legislation calls for a 10 percent annual increase until the 50 percent mark is reached.
  • Enacted of a 4 percent minimum for LIHTCs, which likely occurs for properties placed in service after a certain date (maybe Jan. 1, 2017, or Jan. 1, 2018?).
  • Allowing the NMTC to offset corporate AMT, a provision that is part of the New Markets Tax Credit Extension Act of 2017 (which of course is possible only if the corporate AMT remains in the code).
  • A potential lowering of the expenditure threshold to qualify for the federal HTC to 50 percent of the adjusted basis, a reduction from the current 100 percent. That is one of the provisions in the Historic Tax Credit Improvement Act of 2017, parts of which could be rolled into a HTC-retaining tax reform package.

Unfortunately, there are numerous negative possibilities. These painful, worst-case scenarios include:

  • Tax reform could claim the 20 percent and 10 percent HTCs, but would likely have an effective date and binding contract exception.
  • Private activity tax-exempt bonds could have a wind down, though that is not expected.

Again, the phase-out provisions are worst-case scenarios, but they also show that even in that dire situation, the affected industries would likely enter a wind-down, not a sudden stop.

Indirect Effects
Indirect effects on the tax credit community include the ways in which individual taxpayer behavior changes based on the direct effect.

Corporations are projected to pay nearly $4 trillion in federal taxes over the next 10 years. Irrespective of how large a tax cut they might receive (in a static scoring sense) they still will owe consider tax liability. However, within industries and among individual taxpayers, the effect can be diverse. This has the potential to dramatically alter the investor base for tax credit communities. Stay tuned here, as we learn and assess, more.

Various tax changes obviously have an effect on book income and book balance sheets. The net effect of book reporting changes has the potential to alter public company investor demand.

Some changes may alter the relative attractiveness of corporate versus individual investment. For instance, if state income taxes are no longer deductible for federal purposes, more individual investors may invest in state tax credits.

Similarly, if the alternative minimum tax is repealed, many individual investors may begin looking at investing in NMTCs.

Stay tuned, and email us your thoughts
We at Novogradac are continuing to assess and analyze the various ramifications–good and bad–of tax reform on tax credit communities. Please email us your observations and questions ([email protected]) and look to future blogs and more as we continue to keep tax credit communities informed on the possible effects of tax reform.