Understanding the proportional amortization method

In March 2023, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) aimed at improving the accounting and disclosures for investments in tax credit structures. The news made headlines as it expanded the use of the proportional amortization method for certain tax credit equity investments.

For public business entities, the amendments are effective for fiscal years beginning after Dec. 15, 2023, including interim periods within those fiscal years. All other entities will have an extra year to adopt the changes, which will be effective for fiscal years beginning after Dec. 15, 2024, including interim periods within those fiscal years.

Are your business clients ready? Strengthen your role as a trusted advisor by helping clients navigate the changes and better understand the potential implications.

Under the proportional amortization method, entities are able to amortize the cost of an equity investment in relation to the overall proportion of tax credits it garnered during that period vs. the total tax credit it expects to obtain over the life of the investment. The investment amortization and tax benefits are presented on a net basis in the income tax line item of the income statement.

Prior to the FASB-issued Standards Update, only low-income housing tax credit (LIHTC) investments could apply the proportional method. Those investments that earned income tax credits and other income tax benefits through other tax programs had to instead use the equity method. Accountants, however, argued that the equity method proved too difficult and did not fairly represent the profitability or the economic characteristics of the investments.

As a result of the changes, this has now been expanded to include more federal and state tax credit investment programs. The new ASU enables other tax credit programs beyond LIHTC investments to qualify for the proportional amortization method.

To further explain, consider the following proportional amortization method example, which illustrates how a client may apply the method:

At the beginning of the first year of eligibility for the income tax credit, your client invests $102,000. Under a tax credit program, the partnership will obtain income tax credits.

The straight-line method is used to calculate the depreciation expense over a 10-year lifespan. The client’s tax rate is 40%, and the income tax credits will be received over a four-year period. To keep it simple, let’s assume the residual value of the investment will be zero.

In this scenario, the client will recognize an annual income tax benefit of $3,600 in the first four years of the investment (comprising of gross income tax benefit of $24,000 minus the amortization of the initial investment $20,400). In the remaining years (5 through 10), the client will recognize an annual income tax benefit of $600. Over the 10 years, this totals $18,000. The pre-tax income would include the non-income tax-related benefits.

Given that affordable rental housing projects often lack enough profit to warrant an investment, the LIHTC program was developed to incentivize private developers and investors. LIHTC is an indirect federal subsidy that is used to finance the construction and rehabilitation of low-income affordable rental housing.

How does it work? By providing financing to develop affordable rental housing, investors, in turn, receive a dollar-for-dollar reduction in their federal tax liability. Their equity contribution subsidizes low-income housing development, which enables some rental units to rent at below-market rates. Investors then receive tax credits paid in annual allotments, which is typically over a 10-year period.