Tax Credit Equity Pricing– What Does the Future Hold?
As President Joe Biden’s Build Back Better plan works its way toward enactment, the likelihood of a significant increase in the supply of federal community development tax credits has stakeholders pondering tax credit equity pricing in 2022 and beyond.
If enacted, the tax credit expansion provisions of the Build Back Better Act (BBBA) would most certainly lead to a greater aggregate supply of tax credit equity, which would lead to more financial support for more community development businesses and projects. That said, as individual transactions are structured and underwritten, the per-tax-credit equity pricing translates into the per-transaction sources of tax credit equity.
All things being equal (as they say in economics), an increase in the aggregate supply of tax credits would create downward pressure on tax credit equity pricing. But, all things are never equal.
To assess the future of tax credit equity pricing, it is useful to analyze how the supply of tax credits may increase (or decrease) in 2022 and beyond, with a focus on low-income housing tax credits (LIHTCs), renewable energy investment tax credits (ITCs) and production tax credits (PTCs), historic tax credits (HTCs) and new markets tax credits (NMTCs). It is also important to assess how the demand by investors for tax credit equity may rise or fall.
Let’s start with potential changes in the supply of community development tax credits.
Direct Legislative Increases in the Supply of Community Development Tax Credits
As this column went to press, the House of Representatives had approved the BBBA, which includes provisions to increase many federal community development tax credits–particularly for housing and renewable energy–beginning in 2022. Should the Senate approve the measure and the BBBA become law, 2022 would see a major increase in the supply of credits.
Renewable Energy Tax Credits
The BBBA includes a proposed extension to 2032 of the phasedown period for the ITC and PTC along with an increase in the credit rates. That would increase the annual supply of these tax credits, although the direct-pay option (discussed later) would reduce the amount of these tax credits seeking equity investors.
The BBBA also contains new renewable energy tax credits, which would further add to the supply. They include tax credits for components of solar and wind projects, tax credits for hydrogen production, tax credits for electric transmission facilities and more.
Low-Income Housing Tax Credits
Provisions in the BBBA would increase the supply of both 9% and 4% LIHTCs.
9% Allocated Credits
A four-year, 12.5% annual increase in 9% LIHTC allocation is scheduled to end this year, but the BBBA proposes to preserve that increase through 2024 along with an additional annual increase.
4% Private Activity Bond Credits
Another significant provision in the BBBA would temporarily lower the 50% test for private activity bond (PAB)-financed homes to 25%, which would free bond cap. The result would be an increase in the use of PABs and 4% LIHTCs–particularly in states that are cap-constrained. In those locations, the use of PABs and 4% LIHTCs could eventually increase by 100% or more. In addition, the BBBA contains a proposal for a 50% basis boost for extremely low-income properties, which would make such housing eligible for additional credits.
Neighborhood Homes Tax Credits
A new housing tax incentive, the neighborhood homes tax credit (NHTC), is included in the BBBA. The NHTC would be used for the construction or rehabilitation of owner-occupied homes in distressed neighborhoods and would result in slightly more than $1 billion in annual credit allocation for 2022, 2023 and 2024, going up to $2.2 billion in 2025 before expiring.
New Markets Tax Credits
The BBBA includes a $175 million addition to the existing $5 billion annual pool for 2022-2025 in tribal statistical areas, a 3.5% increase in annual allocation authority. An early provision in proposed reconciliation legislation–which fell out of the legislative language, but could conceivably be part of year-end legislation–would make the NMTC permanent, index the annual amount for inflation, add a supplemental allocation for the next two years and add $100 million in allocation for U.S. territories.
Historic Tax Credits
The Historic Tax Credit Growth and Opportunity (HTC-GO) Act was in BBBA draft legislation, including a temporary increase from 20% to 30% of qualified rehabilitation expenditures and a permanent increase of that percentage for small projects. Although those HTC provisions fell out of the BBBA, they still could be attached to year-end legislation, paving the way for more credits in 2022.
Even Greater Potential Increases in Uncapped Tax Credits
For capped tax credits (LIHTC, NHTC, NMTC) initial or additional allocation authority provides a direct increase in the supply of tax credits. For uncapped community development tax credits–such as the HTC, ITC and PTC, as well as 4% LIHTCs–additional money for related government funding programs encourages additional use of these tax incentives, which indirectly leads to an increase in the supply of tax credits.
Among the renewable energy direct-funding provisions included in the BBBA are billions of dollars in grants and other funding that would be made available to various green energy properties. The use of those grants would make more properties financially feasible and more likely to use ITCs, PTCs or other renewable tax credits, thus increasing the supply.
The BBBA also included $156 billion in additional funding for housing and community development spending–topped by $65 billion for public housing. The bill also included $15 billion for the national Housing Trust Fund and $10 billion for the U.S. Department of Housing and Urban Development (HUD) HOME program. Both are huge jumps and provide gap funding to allow more affordable housing properties to be financed by tax credits.
Another gap funding source is the Community Development Financial Institution (CDFI) Fund’s Capital Magnet Fund (CMF), which will soon announce the allocation of $386 million in grants to CDFIs and nonprofit organizations for affordable housing and related economic development and community services. The BBBA would provide an additional $750 million to the CMF for 2022, which would be paired with an expected $300 million-plus in allocation from Fannie Mae and Freddie Mac.
Factors that Will or Could Reduce the Supply of Tax Credits
While most signs indicate an increase in community development tax credits in 2022, there are factors that will or could result in decreases.
More than $2 billion in disaster LIHTCs ($1 billion to fire-ravaged California) were authorized by Congress for 2020, 2021 and 2022–one-time allocations that will create a practical decrease in supply as they are used. The BBBA, if enacted, would extend the 12.5% annual increase in 9% LIHTC allocation beyond 2021. But if the BBBA is not enacted, affordable housing stakeholders face the looming end of that increase in allocation.
Renewable energy stakeholders face a similar situation. The PTC is slated to drop from 60% of the applicable rate in 2021 to zero in 2022, barring the BBBA’s proposed extension at 100% through 2031. Similarly, the solar ITC is slated to remain at 26% through 2022, then drop to 22%. The BBBA proposes an extension of the ITC at 30% through 2031, but without the legislation, solar credits will be reduced.
Renewable energy tax credits are in line for a dramatic jump if the BBBA is enacted, but BBBA also includes an elective payment option for credits, which means a developer could retain tax credits and receive a refund from the IRS. That would likely have a positive effect on the number of properties that make financial sense, but would decrease the amount of credits otherwise available for wider investment.
Factors That Could Increase Investor Demand for Tax Credits
While the market could see more credits available for equity investment–which often results in lower equity prices–there remain factors (both for specific tax credits and overall) that could increase demand, a factor that creates pressure for an increase in equity prices.
Some overarching issues could create incentives to invest in community development tax credits. While the purpose may not be to affect equity pricing, these elements could raise demand.
- Should the Office of the Comptroller of the Currency, Federal Reserve and Federal Deposit Insurance Corporation provide updated Community Reinvestment Act guidelines, banks could be further incentivized to invest across the community development world.
- Changes to the Base Erosion and Anti-Abuse Tax that was part of tax reform legislation in 2017–as envisioned in the BBBA proposal–would make investing in tax credit equity more attractive to some large corporations and increase competition.
- Social impact investing is changing how investors look at opportunities: Certain developments and types of investment become more attractive through the social impact investing lens and create greater tax credit appetite among investors. Social impact investing applies to virtually all renewable energy and community development properties.
Meanwhile, broad factors that were considered in the past appear to be off the table for 2022:
- An increase in the corporate tax rate would create an increased demand for many community development tax credits.
- Provisions to allow investors to carry back tax credits to previous years would create an increase in demand by corporations with a significant tax bill in previous years.
- A change in the general business credit limit, which currently limits the use of many tax credits to 75% of federal income tax, would similarly provide an increased demand by investors.
There are tax-credit-specific issues that could increase demand:
Government-sponsored entities (GSEs) Fannie Mae and Freddie Mac both increased their annual equity investment in the LIHTC arena, jumping from $500 million to $850 million in 2021. That will increase competition for the credits, which generally increases equity prices. Beyond that, it is possible the Federal Housing Finance Agency (FHFA) may further increase the annual GSE LIHTC investment cap.
One of the key proposals in the New Markets Tax Credit Extension Act of 2021 is to allow the NMTC to offset the alternative minimum tax (AMT), which is currently allowed for most other federal tax credits. Allowing the NMTC to offset the AMT–which could be part of year-end legislation, along with other provisions in the NMTC Extension Act–would potentially open the incentive to individual investors, expanding the number of potential investors and demand.
A key provision in the HTC-GO Act–portions of which could be included in year-end legislation–is the elimination of the basis adjustment. That provision–which would mean that the amount of the HTC would no longer be deducted from the building’s basis–would increase the tax benefits of investing, thereby increasing demand for the HTC.
There are also factors that could play a role in decreasing demand across all community development incentives, a force that exerts downward pressure on equity pricing. For example, looming over all the tax credits is the impending phaseout of bonus depreciation, which is currently set to drop from 100% for the year placed in service to 80% in 2023 and decreasing each year thereafter until it hits 0% in 2027. If the phaseout remains in place, demand and equity pricing–particularly for LIHTC and RETC developments–would likely decrease.
Factors that Could Increase or Decrease Demand for Tax Credits
There are myriad situations that could either increase or decrease the demand for tax credits. These factors could affect investors directly and make current equity pricing more or less competitive as compared to other investment opportunities. Here are four examples:
- Corporate profits. The amount of corporate taxable profits has a significant effect on tax credit appetite, since more profits generally means higher tax bills and because corporations are major investors in virtually all community development tax credits. Should profits soar in the next few years, appetite for credits will likely increase, too. A struggling economy pushes down demand for credits.
- Interest rates. We could be nearing the end of an unprecedented period of low interest rates and rising rates usually necessitates a rise in yields from tax credit investments, which translates into lower equity pricing. The October inflation rate was 6.2% over a year prior, the biggest increase since December 1990. If that increase continues, it would likely create downward pressure on pricing.
- Minimum tax on book income. President Joe Biden has proposed a 15% minimum tax on certain large corporations. That could have a mixed effect on tax credit equity, as it would likely increase the tax base for some corporations (increasing appetite for tax credits). But as currently drafted, accelerated tax losses would not generally reduce book income, thus reducing the value of LIHTC and RETC investments to corporations that would be subject to the tax on book income.
- GAAP guidance. NMTC stakeholders–and, to a lesser degree, those in the HTC and RETC communities–have sought similar book accounting treatment to LIHTC investments since the Financial Accounting Standards Board (FASB) ruled in 2014 that LIHTC investors could use the proportional amortization method. Should the FASB expand that option to other credits, it would make investment more attractive to most investors–a result that would increase demand (and pricing), although the magnitude is unclear.
Proposed legislation, government spending, regulation changes, the state of the economy and more affect the supply and demand for community development tax credits.
As we prepare to enter 2022, community development stakeholders are at multiple crossroads: Many legislative proposals would significantly increase the supply of community development tax credits, while regulatory and economic issues could significantly affect the demand.
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