Federal Tax Overhaul a Mixed Bag for Cities

Posted on December 1, 2017

Tax reform has consumed most of the oxygen on Capitol Hill lately, and Republican leadership in both the House and Senate still intend to send President Trump a plan before the end of the year. In fact, the House of Representatives will likely vote on Monday to form a conference committee with the Senate to iron out differences in their approaches. The proposals are rather fluid, but below are the key issues relative to Kentucky cities:

State and Local Tax (SALT) Deduction

Currently, income tax filers may deduct the cost of their real estate taxes as well as either income taxes or sales taxes paid to state and local governments. However, most SALT deductions are for income and property taxes. According to a report from the Government Finance Officers Association, about 26 percent of Kentuckians claim the SALT deduction for an average totaling $9,955. City property taxes in Kentucky are lower than in many high-tax states; however, the total property tax burden is relatively high due to the layering of taxes of multiple jurisdictions – city, county, schools, state, special districts, special assessments, etc. Proponents of the SALT deduction argue that local governments would face increasing pressure from residents to lower their tax rates if the deduction is eliminated or reduced.

Go here to see an interactive state and county map of SALT deductions.

Go here to read about the impact of eliminating SALT deductions.

Municipal Bonds Income Tax Exemption

Municipal bonds are the primary way state and local governments finance public infrastructure projects. The interest gained by these bondholders is exempt from the federal income tax, as it has been since the tax was created in 1913. The tax exemption incentivizes the purchase of municipal bonds at lower interest rates, which saves local governments – and their rate or taxpayers – money. Kentucky cities hold $5.4 billion in long-term debt, the majority of which is funded by municipal bonds. Despite initially floating the idea of changing or eliminating the tax exempt status, neither chamber included that provision.

Advance Refunding

Under current law, the interest income exclusion municipal bonds applies to refunding bonds but with limits on advance refunding bonds. A refunding bond is any bond used to pay principal, interest or redemption price on a prior bond issue (the refunded bond). A current refunding occurs when the refunded bond is redeemed within 90 days of issuance of the refunding bonds. An advance refunding occurs when the refunding bonds are issued more than 90 days before the redemption of the refunded bond. Advance refundings permit issuers to lock in lower interest rates or get out from burdensome covenants while still honoring the call protection on the outstanding bonds. Advance refunding bonds are a significant part of the Kentucky municipal market and are widely used by cities across the state.

Go here to learn more about advance and current refunding.

Private Activity Bonds

Under current law, interest on both governmental bonds and private activity bonds (PABs) is excluded from the federal income tax. Governmental bonds typically are issued to finance projects that constitute public goods (e.g., roads, schools, parks). By contrast, the proceeds of PABs finance the activities of, or loans to, private parties, with indirect benefits accruing to the state or locality that issues the bond. PABs represent only 1 percent of all municipal long-term debt in Kentucky; however, PABs include bonds issued on behalf of a 501(c)(3) including healthcare institutions and housing bonds. The Bond Buyer estimates that PABs make up 15-20 percent of the municipal bond market.

Historic Rehabilitation Tax Credit

Under current law, a taxpayer may claim a credit for expenses incurred to rehabilitate old and/or historic buildings. A 20 percent credit is allowed for qualified rehabilitation expenditures with respect to a certified historic structure, while a 10 percent credit is allowed for qualified rehabilitation expenditures with respect to a qualified rehabilitated building. To qualify for the 10 percent credit, the rehabilitation expenditures during the 24-month period selected by the taxpayer and ending within the tax year must exceed the greater of the adjusted basis of the building (and its structural components) or $5,000.