Do you live in Elmira, NY? What about Rochester? Or Buffalo? The Tax Cuts & Jobs Act’s (TCJA) change to IRC Sec. 118 is likely to have a significant impact on the prevalence of urban revitalization efforts in your communities.
Are you familiar with the concept that the moment you drive a new car off the lot, that its value is immediately below the price you paid? In the case of urban development projects, this effect is much the same. Real estate developers who choose to rehabilitate properties in depressed areas end up spending more on the rehab work than the ultimate marketable value of the building. As you could image, this creates significant barriers to entering a revitalization market. The solution in the past has been state and local grants for urban development.
Let’s say that a building will cost $12 million to construct in an area which has experienced economic decline. Let’s assume that the amount a willing buyer would pay to purchase the completed building is more in the neighborhood of $6 million because of the economic forces in its location. A bank is strongly disincentivised from financing above that $6 million because it needs to be able to recover its investment in the event of a foreclosure. Let’s also assume that the developer is able to obtain another $2 million of capital investment from people who want to own a stake in the company. The developer is left with a gap in funding for the project of $4 million. In sweeps New York’s Empire State Development Corporation (ESD) with a $4 million grant.
Pursuant to the old IRC Sec. 118, as long as the developer was organized as a corporation, this $4 million grant would not be taxable. Instead, it would simply reduce the depreciable basis of the building by the amount of the grant. That would mean that the developer would be able to revitalize a location in an economically depressed area. The theory here is that if you build one, two, three, of these rehabbed buildings, it will improve the economic standing of the community. Eventually, the theory is that the grants will no longer be needed because the community will have been revitalized.
Under the TCJA, these grants become taxable.
In the same example above, the cost of that $12 million construction project becomes roughly $13.1 million after paying the investors’ tax burden on that $4 million of income. How is the developer going to fund the construction now? Where is the $1.1 million of taxes owed on receipt of the grant going to be found?
That is a question that is hard to answer. One could ask the investors to benevolently just pay the tax personally. That may be a hard ask when the investor would get paid out upon liquidation after the secured creditor. ESD could gross-up the grant for the extra taxes. For that to work, they would have to shell out $5.7 million to make that math work so that, after tax, the project ends up with $4 million. That would mean $1.7 million less in the way of funds that could be deployed to other projects.
 This figure assumes both that the development company is an S-corporation, and that the owner qualifies for the full qualified business income deduction under the TCJA.