Tax Reform Presents Both Challenges and Opportunities for Retail Developers
The definition of taxable income isn’t always clear—and it changed for many retail developments. The December 2017 federal tax reform bill has proved to be a “mixed bag” for the retail sector during its first six months, according to panelists discussing federal policy changes at the 2018 International Council of Shopping Centers (ICSC) ReCon. The bill’s changes to what is considered taxable income, particularly as it relates to government tax incentives, is profoundly affecting which investments make sense for investors, developers and their sources of capital.
I participated on the panel along with members of the ICSC Tax Advisory Group, the ICSC Infrastructure Task Force, the Mayor of Baltimore, the Honorable Catherine Pugh, and others from the public and private finance sectors. The ICSC Task Force represents members’ interests in federal policy discussions, advocating for legislative, regulatory and political outcomes that benefit retail owners, investors and developers.
Understanding the Tax Code Changes
Prior to the Tax Cuts and Jobs Act, passed in December 2017, corporate taxpayers could exclude contributions from non-shareholders, such as governments, from their income with tax structuring made possible by the wording of the previous Internal Revenue Code (IRC) section 118. The strategy allowed owners to defer certain tax liabilities to a later time when the asset was sold and the liability could be anticipated and managed. Under the new wording of the IRC section 118, a corporation receiving an upfront cash incentive – including land donation, grants, and tax incentives— in some cases now, can no longer exclude these contributions unless the government makes the contribution as a shareholder. These contributions are being treated as income with no offsetting expenses. (There are, however, structuring options available for various tax incentive payments, including TIF.)
The bill has also jeopardized tax credits for restoring historic properties. The federal historic preservation tax credit was retained, but weakened. The reform bill eliminates the 10 percent non-historic credit for buildings built before 1936 and requires that the 20 percent historic tax credit be taken over five years instead of being reaped in full when the restored building opens. This change may affect some investors’ willingness to fund projects, since the payoff is delayed, impacting developers’ ability to finance rehabs.
The Opportunity in Opportunity Zones
On the more positive side, the reform act also created Opportunity Zones. An Opportunity Zone is an economically distressed area where new investments may be eligible for preferential tax treatment if they meet certain conditions. Localities qualify as Opportunity Zones if they have been nominated for that designation by their state, and that nomination has been certified by the Secretary of the U.S. Treasury. At this time, many questions surround how Opportunity Zones will be enacted. The Treasury Department and Internal Revenue Service will be providing additional legal guidance on this incentive later this fall.
As Mayor Pugh described it, “One of the best things that has come out of tax policy changes are the Opportunity Zones. But, it’s like one hand giveth, and one hand taketh away.” For older urban environments, such as Baltimore and many other American communities, realizing the opportunity in rehabilitating distressed areas will take long-term investment from the private sector, which may also be dissuaded by tax policy changes.
What this Means for Developers and Investors
In Tax Increment Financing (TIF) deals around the country, many developers are facing a shared challenge making their pro formas work, now that some government contributions may be considered taxable income.
However, some projects are falling under a transition rule, which states that any contribution made pursuant to a “master development plan” approved by a government entity before December 22, 2017, would not be considered taxable income. Unfortunately, the transition rule doesn’t explicitly outline what is considered a master development plan. And, while many current projects could be grandfathered under this rule, future projects will not be able to benefit from it.
Another workaround is to use some tax revenues on expenses that are public, for example, parking garages or other infrastructure that would be able to be purchased back by the TIF bond issuer or a public authority that would own it with the developer maintaining it.
Local and state governments are also trying to make economic development deals work through alternatives to upfront tax incentives, such as:
- Forming public-private partnerships (P3s) where the governmental entity is considered a shareholder.
- Providing tax abatements or tax credits rather than contributions.
- Structuring contributions throughout the development process rather than at the outset.
Private and Public Working Together
The new tax code and the uncertainty around how elements such as the Opportunity Zones or transition rule will work in practice has both the private and public sector seeking clarity and compromise. Both the public and private sector could greatly benefit from an extension of the transition rule about master development plans into a permanent rule. They reason that developers and private corporations that enter into a thoughtful plan with a government entity to benefit the community should not be subject to tax treatment.
With relationships among more than 500 state and local public-sector clients across the country, the KeyBanc Capital Markets Public Finance practice excels at understanding the sensitivities and needs of local constituencies and public officials. We can advise clients about how federal tax policy changes will impact their deals and help structure financing that betters communities. To discuss the items in this overview article, contact me at 216-689-0885 or email@example.com.