Tax planning is an important factor that investors look at when evaluating projects for potential investments. LIHTCs are designed to reduce an investor’s tax liability, so investors must be able to project their taxable income over the term of the investment in order to evaluate to what extent they can use LIHTCs to reduce their overall tax liability.
It is important to understand the difference between a tax credit and a tax deduction. A tax deduction enables a taxpayer to reduce their taxable income. For example, if a taxpayer earned $500,000 and gave $100,000 to charity, the taxpayer would generally be eligible to take a $100,000 deduction on their taxes. So the taxable income is now $400,000. Assuming a flat tax rate of 36% (simplified for illustrative purposes), the taxpayer would owe $144,000 vs $180,000 without the deduction. Therefore the taxpayer saved $36,000 by taking the deduction.
A tax credit is much more valuable than a deduction. Rather than reducing one’s taxable income as with a deduction, a tax credit enables an individual or corporation to reduce its tax liability dollar-for-dollar. Now, instead of a $100,000 donation to charity the taxpayer made an investment that allocated annual tax credits of $100,000. The resulting tax savings would be as follows:
Widely held C corporations are ideal investors in LIHTC projects because they are exempt from passive loss restrictions which serve to limit the use of tax credits and depreciation deductions. In addition to the development of corporate goodwill, corporations invest in tax credits to: 1) use excess cash to produce investment returns in excess of their internal hurdle rates; and/or 2) reduce the corporation’s effective tax rate and in turn increase after-tax earnings.
Individuals, Partnerships, LLCs and S corps
Affordable housing investment was not always dominated by large corporate entities. In fact, individual taxpayers played a prominent role in financing affordable housing development during the early 1980s. That role changed with the passage of the Tax Reform Act of 1986.
Prior to this legislation, individuals could deduct construction period interest and taxes, accelerated depreciation, and amortization of building costs. Taken together, these tax benefits were significant enough to attract many wealthy individuals to the market. By 1986, however, Congress had become wary of overly generous tax benefits, loopholes and deductions. The result was the passage of new passive loss, passive credit and at-risk rules. Among other changes, the new rules established a financial disincentive for individual taxpayers to claim credits in excess of their marginal tax rate multiplied by $25,000. These rules have not been updated since 1986 and continue to suppress individual demand for tax credit investments.
Rental real estate properties owned by individuals and pass- through entities (partnerships, LLCs, and S corps) fall under these unfavorable passive activity loss rules. These rules say you can generally deduct passive losses only to the extent you have passive income from other sources. Losses from passive activities in excess of passive income are disallowed in the current year and then are carried forward to future years. The carried forward losses can be used against future passive income or taken in the year the activity is terminated.
Even an investor without passive income can use the investment for ten to twelve years to reduce federal income taxes. The Omnibus Budget Reconciliation Act of 1989 eliminated the income and active participation restrictions specifically for LIHTC transactions and permitted individual LIHTC investors of any income and participation level to offset up to $25,000 of their income with low income housing tax credits. For example, assuming the highest tax bracket of 39.6% in 2014, this would entitle an individual investor to utilize approximately $9,900 ($25,000 x 39.6%) of tax credits per year. Individual investors can only utilize the tax credit as the exclusion does not permit the use of tax losses.
If you have a lot of passive income or are considered a real estate professional (as such, rental real estate activities are no longer automatically considered to be passive), you may be able to take advantage of any losses as well as the tax credits.
Alternative Minimum Tax (AMT)
The LIHTC is a non-refundable credit included within the section 38 general business credit and may be claimed against either the individual or corporate income tax. Historically, however, section 38(c) has prevented the credit from being used to offset individual or corporate alternative minimum tax. The Housing and Economic Recovery Act of 2008(HERA) amended section 38(c)(4)(B)(ii) to provide that LIHTCs claimed regarding buildings placed in service after December 31, 2007 may be used to offset individual and corporate AMT. Therefore LIHTC may be appealing to investors that may be subject to the AMT.
Carry Back, Carry Forward and Additional Rules
The Tax Reform Act of 1997 amended the carryback provisions to only permit investors to carryback credits for one year but allows them to carry forward for 20 years. In simple terms, if an investor were unable to use the credits allocated to it in 2014 but would have been able to use them in 2013 due to excess income, that investor could “carryback” the credits to offset its income, as long as it does not exceed its credit allocation. Likewise, if the investor has income in any of the years from 2015 through 2034 (2014 + 20 years) it can “carry forward” the unused credits to those years.
Consult With Your Tax Attorney and Accountant!
Everyone’s tax situation is unique. You should consult with a tax planner to determine how a LIHTC investment could affect you.