From a small northwestern observatory…

Finance and economics generally focused on real estate

Posts Tagged ‘Low Income Housing Tax Credits

Trump’s Tax “Reform”

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Mark Twain is usually — and incorrectly — quoted with the phrase “No man and his money are safe while Congress is in session.  (The actually quote goes to 19th century NY politico Gideon Tucker, but I digress.)  There’s little to be said, in general, about TheDonald’s proposals yesterday, simply because there’s little substance to analyze.  However, I’m old enough to remember the last tax overhaul, in the early stages of the Reagan administration, and perhaps I can offer a few observations.  I’ll limit my mental meanderings to real estate for now.

First, the Reagan tax re-hab (the 1986 Tax Act) was a disaster for real estate investing, particularly at the individual, atomistic investor level.  One of the “loopholes” to be cured was the elimination of deductibility of passive losses on real estate investments.  The real estate community reluctantly supported the tax act, in trade for increases in the deductibility of home mortgage interest and a guarantee that passive losses on then-existing real estate deals would be grandfathered.  Indeed, in the run-up to passage, there was a flurry of investing (by Main Street USA folks — the kind of folks who still, amazingly, support Trump) in just such “grandfathered” investments.  At the last minute, the grandfathering was removed, costing Main Street USA investors tons of alternative minimum tax payments on now-sour investments.  Some pundits suggest that this grandfathering-revocation, alone, led to the downfall of the Savings and Loan industry, but that excuse is a bit to simplistic.  It did, however, shut down the time share industry for a while.

Today, according to news reports, single family residences are enjoying record demand (which may or may not be good news).  The hottest market is among first-time buyers, and the demand is greatest among starter homes.  The Trump proposals would double the standard deduction for a married couple filing jointly.  While, on the surface this seems like a good idea, it will drastically shrink the number of tax payers who itemize mortgage interest and property taxes.  In short, for the biggest tranche of homebuyers, the biggest differentiation between ownership and renting would be effectively removed.  As a guy who invests in rental property, that’s nice, but the home building industry won’t react well.

Otherwise, I don’t see lowering the marginal tax rate on corporations as having much of an effect on real estate investing.  For one, most of those projects are either done thru tax-advantaged REITs or thru other pass-thru entities, like partnerships and LLCs.  Even if it did, the demand / supply of investment grade real estate depends on other factors, and slight changes in the tax rate may have an impact on the debt/equity mix, but not on the aggregate output of new commercial construction.  The ONE area most affected will be low income housing, which is funding in no small part by tax credits.  The value of those credits will be slashed, requiring a complete re-thinking in the finance side of low income housing.  The last time such a tax cut went into effect, it was a real mess for low income housing.

If I was the government, and I wanted to create good paying construction jobs, I’d embark on a long-term infrastructure redevelopment plan.  That would probably require actually raising tax rates a bit, but would have marvelous returns on investment for middle America.  But that’s just me….

Low Income Housing Threatened

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OK, folks, this gets complicated, so follow along with me.  The Reagan era tax cuts, and specifically the U.S. Tax Reform Act of 1986, adversely affected many of the incentives for investing in low income rental housing.  To provide some balance, the Low Income Housing Tax Credit (LIHTC) program was added to the Act.  This program provides a tax credit which can either be used or sold by the developer.

Usually, the tax credits are sold or syndicated, and corporations that anticipate that they’ll have taxable income over the next 15 years will buy the credits, which can be used to offset future tax bills.  The developer uses the proceeds from the tax credit sales as the equity for the low income housing development.  Coupled with the program is a substantial emphasis on fiscal discipline (audited financial statements, regular reporting, etc.) and as such, these low income multi-family developments have had a foreclosure rate of less than 0.1%, which is far better than comparable market-rate properties.

Typically, a developer will cobble together several programs, such as FNMA debt financing, Section 8 vouchers, and state and local incentives.  The LIHTC program is administered by State Housing Authorities, and of course has oversight from the IRS.

Here’s where it gets both interesting and complicated.  The selling price for the credits is a function of two things — the discount rate (which is very low now-a-days) and a company’s forward-looking tax burden.  Let’s say, just as an example, I believe my company will have $1 million per year in net income in the coming fifteen years.  My tax rate is 40%, so I’ll end up paying $400,000 in annual federal income taxes, and I’d be willing to pay for credits which would erase that tax burden.  In short, I’m agnostic as to whether I send the money to the IRS or to a developer who wants to use the money to build an apartment complex.  (Actually, it’s w-a-a-a-a-y more complicated than this, but bear with me.)  Now, my tax burden over the coming 15 years will be $6 million ($400,000 per year times 15), but the present value of that cash flow is what I’d pay today instead of the $6 million.  If my cost of capital is 5%, the present value of that 15 year tax bill is actually closer to $4.15 million.  So, I’d be willing to pay $4.15 million to avoid paying $6 million in taxes in the next 15 years.   A given developer is awarded a certain level of tax credits based on the overall value of the project being proposed.

So, what’s the problem?  Ahhh…. “problem” depends a bit on your perspective.  As it happens, the new administration, and Congress for that matter, are bent on cutting corporate tax rates.  Good for them.  I own a couple of corporations.  I’d like to save some money.  However, if a corporation envisions that their tax bills over the next 15 years will be much lower than previously anticipated, then the amount they’re willing to pay TODAY to avoid those tax bills is much lower.  How much, you say?  Well, let’s assume our company had it’s effective tax rate lowered from 40% to 15%.  The tax bill over the next 15 years would only be $2.25 million, and the present value of THAT is only $1.56 million.  Ahem…..

I’m not knocking tax cuts, but everything has a cost, and building low income housing employs a lot of people, provides a much-needed private sector solution to a public problem, and creates investment.  We’re already seeing this market dry up.  An article in today’s Pittsburgh Post-Gazette, by Kate Giammarise, outlines the problems that developers are already facing.  One solution may be for Congress to increase the level of available tax credits, so that developers can be left whole even with the tax cuts.  This will, by its nature, be a nationwide problem.

Written by johnkilpatrick

February 6, 2017 at 12:56 pm