Investors in low-income housing tax credit (LIHTC) partnerships might find that a new limit on the business interest expense deduction leads to unexpected tax results.
LIHTC partnerships can avoid the limit by electing to be treated as an electing real property trade or business, but that election has implications for investors’ effective yield and tax benefits. Some investors might think they are protected from such effects due to the “small-business” exception to the deduction limit, but the exception generally does not apply to these types of partnerships.
The interest deduction limit in a nutshell
Many financial services organizations have paid little attention to the business interest expense limit created by the Tax Cuts and Jobs Act (TCJA) because they generally do not incur net interest expense. Those that invest in LIHTC partnerships need to familiarize themselves with it, though.
IRC Section 163(j) generally limits the business interest deduction to the sum of 1) the taxpayer’s business interest income for the taxable year, 2) 30 percent of the taxpayer’s adjusted taxable income (ATI), and 3) the taxpayer’s floor plan financing interest expense for the taxable year. ATI is calculated as federal taxable income before business interest expense and income, the net operating loss deduction, the qualified business income deduction, depreciation, amortization, and depletion. After 2021, ATI will not be adjusted for depreciation, amortization, and depletion.
The partnership business interest expense limitation is calculated at the partnership level, and any limitation is carried forward at the partner level. Any disallowed interest expense can be carried forward indefinitely by the partner.
The small-business exception – and why it generally doesn’t apply
The business interest expense deduction limit does not apply to most taxpayers with average annual gross receipts of $25 million or less. It might seem at first glance that many LIHTC partnerships would be excluded from the limit based on their average annual gross receipts, but the small-business exception is not available to entities that are prohibited from using the cash receipts method of accounting under IRC Section 448(a)(3). Partnerships in which more than 35 percent of its losses are allocable to limited partners generally are prohibited from the cash receipts method of accounting and therefore most LIHTC partnerships will not meet the small-business exception.
An LIHTC partnership can, however, avoid the Section 163(j) limit by making an irrevocable election to be an electing real property trade or business. However, this decision likely will affect investors’ returns.
Businesses that make the election must use the alternative depreciation system (ADS) for real property used in the business, regardless of when the property was placed in service. This will change the depreciation period and therefore the timing of depreciation deductions that are allocated to investors. Revenue Procedure 2019-08 clarifies that real property held by the electing company, including property placed in service prior to the election, shall be depreciated using ADS, and the change will be prospective in the year of the election.
The current modified accelerated cost recovery system (MACRS) cost recovery period for residential real property is 27.5 years straight-line. Under the ADS, the recovery period is 30 years for buildings placed in service in 2018 and later. That difference is not significant, but the pre-TCJA recovery period under the ADS was 40 years, and buildings placed in service before 2018 still will be subject to the longer 40-year recovery period if the electing real property trade or business election is made.
Property that must be depreciated under ADS is not eligible for bonus depreciation, but 100 percent bonus depreciation remains available on personal property and land improvements.
Time to reach out
Financial services organizations that invest in LIHTC partnerships should contact the partnerships to inquire if they have made or are considering the electing real property trade or business election. Where partnerships have done so, investors must determine how that will affect tax deductions on Schedule K-1 forms in 2018 and in future years. Organizations considering future LIHTC partnership investments should take the election into account as part of due diligence.