Sponsor Considerations for Investor Requests for Tax Elections, Amendments

In the past few years, Congress passed two major pieces of tax legislation that impact all partnerships and limited liability companies, the Bipartisan Budget Act of 2015 and the Tax Cuts and Jobs Act of 2017 (TCJA).

The 2015 Budget Act changed the rules for how the Internal Revenue Service (IRS) audits partnerships and imposes liability from such audits on partnerships. While the TCJA made sweeping changes to individual, partnership, corporate, and estate taxation, this article focuses primarily on changes to depreciation schedules and tax elections that impact owners of affordable housing.

Since the passage of this legislation, many sponsors of affordable housing developments have received requests from their investors to amend partnership agreements or sign letter agreements addressing these changes and have encountered new language in tax credit commitment letters relating to these changes. This article outlines the changes to the tax code resulting from these laws and offer suggestions as to how sponsors—in particular, tax-exempt entities such as nonprofits and housing authorities—should think through these issues. For simplicity, terms for partnerships (e.g., partners, limited partnership agreements, etc.) are used to cover both partnerships and limited liability companies and will not address limited liability companies that have elected to be taxed as corporations.

Partnership Audit Rules

The 2015 Budget Act directed the IRS to change the way that it conducts partnership tax audits for partnership tax years beginning after Dec. 31, 2017. Under the new rules for partnership audits, the IRS requires each partnership to appoint an individual person to serve as the designated representative to the IRS. Affordable housing sponsors should expect that, for all partnerships that they control or manage, they will need to designate an individual, such as the executive director or CFO, to serve as the partnership representative going forward.

The new partnership audit rules also change the manner in which the IRS collects adjustments or assessments after an audit. Under the old audit regime, if the IRS found issues that impacted specific partners in a partnership, it would impose liability on those particular partners and not the rest of the partnership. Under the new rules, designed to increase the ease of auditing and enforcement for the IRS, the IRS can place liability that results from an audit on the partnership itself rather than the individual partners. This means that an affordable housing sponsor could be held liable by the IRS for the tax issues of one of its investor limited partners.

The IRS does allow partnerships to make an election, under Sec. 6226 of the Internal Revenue Code, to make a “push-out” election that permits the partnership to push the liability onto the applicable individual partners. Owners of affordable housing should push to ensure that all partnership agreements include a provision that, in the event of an IRS audit that imposes liability on the partnership, will allow the general partner to make a push-out election that will be binding on all partners (including former partners if the audit takes places after a partner has left the partnership).

This is particularly important for tax-exempt owners such as nonprofits and housing authorities that cannot directly benefit from credits and losses but may be left with cleanup duty in the event of an audit if the partnership’s liability is not pushed out to the tax-paying partners and former partners. (Tax credit partnership agreements will contain provisions requiring “adjuster” payments from the general partner to the investor limited partner in many circumstances, but it is better for the partners to deal with these issues directly between themselves per the terms of the partnership agreement and avoid a scenario where an investor limited partner exits the partnership and the general partner remains effectively the sole party on the hook for an audit of tax benefits that went overwhelmingly to the former limited partner.)

Real Property Trade or Business Election: General Overview

TCJA also imposed a limitation on the amount of business interest expenses that a corporation or a partner of a partnership can deduct against its federal taxable income. Generally speaking, the amount of deductible interest expense in a taxable year is now limited to 30% of the taxpayer’s adjusted taxable income for that tax year. Beginning in 2022, the limit on deductible interest will be reduced further to approximately 30% of adjusted taxable income less depreciation and amortization. This would reduce the business interest deduction that affordable housing developers and investors have previously relied on.

In order to account for the importance of this deduction to the real estate industry, TCJA does allow partnerships that meet certain standards to make an irrevocable election to be treated as a Real Property Trade or Business (RPTOB) under Sec. 467(c)(7)(C). Partnerships that make this election would then be exempt from the business interest limitation. Entities that do not immediately elect to be treated as a RPTOB can elect to be treated as a RPTOB in any subsequent tax year. An entity that makes the RPTOB election may also need to change the depreciation schedule for property as set forth below.

Real Property Trade or Business Election: Impacts on Depreciation Schedules

Prior to the 2017 TCJA, owners of affordable housing depreciated real property either under a 27.5-year schedule—the standard timeline under the Modified Accelerated Cost Recovery System (MACRS)—or a 40-year schedule under the Alternative Depreciation System (ADS). Typically, owners of real property prefer a shorter depreciation schedule so they can accelerate tax losses. Tax-exempt owners, however, may actually prefer a longer depreciation schedule in low-income housing tax credit (LIHTC) transactions for the reasons set forth below.

When a tax-exempt entity develops or rehabilitates a property using LIHTCs, it partners with a tax-driven investor or a syndicator (i.e.., an intermediary that purchases tax credits and sells them to institutional investors) in a partnership. The tax-exempt developer will have a statutory right under the portion of the Internal Revenue Code that governs LIHTC transactions, Sec. 42, to purchase the entire property after the expiration of the 15-year initial LIHTC compliance period. The terms of this right of first refusal are negotiated with the tax credit investor, but the formula for the purchase price is always based on the amount of debt on the property plus the taxes the investor will need to pay to leave the partnership. The more losses an investor takes during the initial 15 years, the higher these taxes will be.

A LIHTC investor will typically want to increase the amount of tax losses it can generate during the initial compliance period and thus will typically prefer a shorter depreciation schedule. By contrast, because a tax-exempt sponsor typically reimburses the investor for the taxes it pays as part of its exit from the deal, a tax-exempt sponsor will typically prefer a longer depreciation schedule to keep an investor’s losses limited and the exit price under the right of first refusal lower.

The 2017 TCJA made a few important changes to the depreciation schedule for residential real property. First, the depreciation schedule under the ADS has been reduced from 40 years to 30 years for properties placed in service on or after Jan. 1, 2018. Second, if a partnership makes the RPTOB election previously discussed, it must use this 30-year ADS depreciation for properties placed in service on or after that date. If the RPTOB election is not made, the depreciation schedule can now be either 27.5 or 30 years.

The table below highlights the effect on the depreciation rate based on the RPTOB election choice.

With respect to LIHTC partnerships, many of the changes in the 2017 TCJA were inadvertently favorable to tax-exempt sponsors. The decrease in corporate tax rates from 35% to 21% will typically result in a corresponding decrease in the amount of projected exit taxes that a tax-exempt sponsor would otherwise pay to an investor under the statutory right of first refusal to purchase the property at the end of the LIHTC compliance period. The business interest expense limitation will typically reduce the losses an investor partner can take, and the RPTOB election simply allows the partnership to revert to the former treatment of those expenses.

Making the RPTOB election will also, in all cases, either result in no change in the depreciation schedule of residential property or will cause that timeline to increase, which will slow down the investor’s losses and thus in most cases reduce exit taxes.

If an owner receives a request from an investor to make the RPTOB election for an existing property in its portfolio, it should engage a qualified CPA firm to perform an analysis to determine the effect of making the election. In the case of a tax-exempt owner, the CPA firm should focus its analysis in particular on the effect of the election on the investor’s capital account and potential impact to exit taxes when the property is transferred.

While it is important to analyze each property on a case-by-case basis, sponsors should generally expect that, with respect to LIHTC partnerships, making the RPTOB will serve to allow the investor to once again claim losses that the parties originally expected the investor to claim when the deal was originally structured. Most LIHTC partnership agreements contain a provision stating that a sponsor will make tax elections requested by an investor unless those elections will have materially negative consequences on the sponsor. Thus, unless making a RPTOB election would have a dramatic impact on exit taxes for a particular property, it would be reasonable for an investor to expect that the sponsor would make the election if requested. If the request relates to a property that is almost at the end of the LIHTC compliance period and for which significant exit taxes are expected, it would be reasonable for a tax-exempt sponsor to push the investor limited partner to address the potential LIHTC exit and plan for dealing with exit taxes as part of the amendment request.

For those that are not LIHTC partnerships, each party typically pays its own taxes, and exit taxes are not a concern. In those situations, making the RPTOB election should have little to no impact on a tax-exempt organization while providing a significant benefit to any for-profit partners in the partnership.