The low-income housing tax credit

Though still alive, it has an uncertain future. Here's how the tax credit works.

The Low-Income Housing Tax Credit (the credit), enacted in 1986, represents a significant evolution in federal low-income rental housing policy. Made permanent by Congress in 1993, seven years after its inception, the credit represents a shift from rental subsidy and loan guarantee programs that required annual budget appropriations toward tax expenditures. In this respect, it resembles the form of federal subsidy used to promote production of owner-occupied housing, and it has had a significant impact on the real estate investment industry.

While the 1980s real estate boom was fueled by an abundant supply of debt, the 1990 Section 42 tax credit marketplace is fueled by an abundance of equity. In the past three years, corporate America has invested nearly $4 billion in the production of affordable housing. Typically, 30 to 40 percent of the financing for a development comes from the tax credit equity. And although the supply of equity outweighs the demand, most large syndicators and corporations are very thorough in their underwriting process and look for the blue chip developments in the industry.

Many investors require significant guarantees from developers but will commit to and fund a project before a property is fully leased and seasoned. This enables the developer to raise up-front capital outside of the traditional development loan market. Even large commercial development companies like the Shaw Company of Chicago-with the development of Homan Square, a large-scale, mixed-income community in one of Chicago's most troubled neighborhoods-have gotten involved in the tax credit marketplace. (See "Homan Square: Rebuilding the Inner City, September 1996 Urban Land.)

Although the tax credit program can be cumbersome and baffling for developers, it has many advantages. Because most investors invest for credits, oftentimes the developer as the general partner can benefit from the residual cash flow. The increased competition for tax credits has pushed the cost per credit upward three to five cents in the last year, enabling developers to build high-quality housing similar to market-rate properties, compared with cost-controlled HUD-subsidized housing of the 1960s and 1970s. If the units are rented to working families with modest incomes, the units must be comparable within the general marketplace, so quality is critical. Since most tax credit development has occurred out of central city urban areas and in high-growth suburban areas, developers have been able to compete within the growing marketplace. Tax credits allow developers to obtain significant equity, reducing the size of the mortgage, which can translate into rents as much as 10 to 20 percent below market. Generally, the tax credit properties rent quicker and stay filled longer than comparable market-rate properties.

A major question remains: Will the tax credit program become as institutionalized a part of the tax code as the single-family deduction? In fall 1995, the program was slated for elimination during the budget debate. With Congress's inability to act on the budget, the program is still alive as of this writing, but its survival over the long term remains uncertain. It now appears that the tax credit program is safe for the present. It has survived the first round of federal budget cuts and a nationwide audit by the General Accounting Office (GAO) completed earlier this year. The program has received broad support from both political parties, and recent improvements in the economy and a lower budget deficit have likely secured the program's short-term future.

Birth of the Credit

The 1986 federal income tax reform eliminated most passive loss benefits for investors in real estate, but it retained in the form of a ten-year tax credit similar benefits for investors in affordable rental housing. The 1986 reform created Section 42 of the Internal Revenue Service (IRS) Code. Congressional advocates of a federal production program adopted a strategy of making federal subsidies a tax expenditure rather than a revenue appropriation. Although Congress has scrutinized the subsidy almost annually and until 1993 required annual renewals, its character as a tax appropriation has made the subsidy less publicly visible.

In the past few years, the program has been used in approximately 35 percent of newly constructed rental units nationally. It is used in urban neighborhoods and in suburban as well as rural communities, and it is meeting congressional expectations of providing high-quality housing for low- and moderate-income renter households.

The credit essentially is an equity incentive vehicle and, in one small respect, a debt-enhancement vehicle as well. The credit is large and secure enough to leverage private investor equity-as much as 50 percent of total development costs for newly constructed properties. In short, a developer applies to an allocating agency for a share of the state's credits. Developers raise equity by selling, either directly or through a middle agent or syndicator, ownership interests in properties. Currently, equity interests are being sold at 60 to 70 cents per credit dollar. (Investors price their equity close to the present value of the ten-year stream of credits.) Typically, the developer retains an ownership interest in the property as a general partner and guarantees investment performance, including the flow of credits. The tax credit and passive losses provide the highest yield to corporate taxpayers. Some investors are paying equity for cash flow, but few if any value residual benefits.

Local Control of the Credit

Many federal housing programs are viewed as administratively burdensome and lacking in local direction; therefore, the credit program was designed to allow for local control. In each state, the program requires one or more allocating agents to be designated by the executive (usually the governor). These allocators are usually the state housing finance authorities (HFAs), although some larger cities are suballocators within their states.

Each state receives an annual allocation of tax credits that represents $1.25 per capita. States can also receive additional credits through a reallocation of a national pool of unused credits at the end of the year. Credits for properties financed with federally tax-exempt mortgage revenue bonds come from a separate pool. Until 1989, many states were not able to allocate all their credit. In recent years, almost all states fully allocated their credits, and many states have extremely competitive conditions, receiving applications for three to five times the credit available.

All credits must be allocated in accordance with states' qualified allocation plans (QAP). The QAP is a publicly reviewed and state-executive-approved document that defines the priorities and competitive criteria for allocating the credits. Most tax credits give preference to properties serving the lowest-income residents and having the longest period of rent and income controls. The QAP must also reflect selection criteria for location, housing needs characteristics, development characteristics, participation of local nonprofit organizations, resident populations with special needs (e.g., persons with developmental or physical disabilities), and length of public housing waiting lists.

The QAP may reflect additional, state-based affordable rental housing policy preferences, and each state can assign points to the federal selection criteria and its own preferences in its point scoring system. The scoring system typically is used to rank applicants requesting an allocation. Most allocators have two to three application cycles annually. Winning applicants receive a reservation of credit and move to the next stage of the allocating process.

Participation by Nonprofit Organizations

The IRS requires that each state set aside a minimum of 10 percent of its allocation to developments involving nonprofit organizations. The nonprofit must be an equity owner (typically a 1 percent general partner) that materially participates-that is, conducts more of the management of the asset and the ownership entity than any other owner participant-in the development and operation of the property. The nonprofit's ownership percentage is small since it cannot claim income tax liability and credits. The requirement for material participation is effective for at least 15 years, and if the nonprofit should fail and be replaced, it would have to be replaced by another nonprofit. For these and other reasons related to the technical and financial capacity of nonprofit housing providers, as well as the stringent definition of "materially participate," use of the 10 percent nonprofit set-aside pool has seen mixed success. Many developers do team up and work with nonprofits or municipalities but apply for the general set aside for tax credits, bypassing the material participation restrictions.

Mechanics of the Credit

The amount of credit allocated to each property is determined by a formula laid out in Section 42 of the IRS Code and simplified below:

[eligible development cost basis] x
[applicable fraction (percent of units meeting Section 42 rules)] x
[credit rate (either 4 percent or 9 percent)] =
annual tax credit

Developers selling equity ownership of a property use a variety of formulas to compute the amount of equity that can be raised, but one simplified calculation follows below:

[annual tax credit amount] x
[ten-year stream of credit] x
[present value pricing factor] =
equity investment

Costs allowed in establishing the eligible credit basis include costs of construction or rehabilitation and may include soft costs, such as architectural, engineering, and development fees. Soft costs related to permanent debt (origination fees, closing costs) and equity financing are not eligible. Since land costs are not depreciable, they are excluded from the eligible basis. The inclusion of landscaping costs, impact fees, and off-site improvement costs is determined by the particular facts, often after consulting with a tax attorney or accountant.

Credit Percentages by Type of Development

New construction or substantial rehabilitation expenses not financed by a federal source receive a 9 percent annual credit. For rehabilitation properties involving acquisition, a 4 percent annual credit is given on the eligible costs of acquisition. The actual credit percentages vary monthly and are indexed to ten-year U.S. Treasury bond yields. For example, the actual credit rate for the 9 percent credit in September was 8.50 percent and the 4 percent credit rate for the same period was 3.64 percent.

To include acquisition expenses in the eligible basis, the acquired property must have been under continuous ownership for at least ten years or otherwise have been "placed in service." This is an IRS rule to prevent churning of the depreciable basis for tax purposes. Furthermore, for acquisition/rehabilitation-type developments, eligible rehabilitation expenses must be the greater of $3,000 per unit or 10 percent of the acquisition basis.

For properties that use federally tax-exempt debt (such as mortgage revenue bonds) to finance 50 percent or more of their total cost, only the 4 percent credit is given. The tax code presumes this lower credit percentage will be offset by lower-than- conventional interest cost on the debt. For tax-exempt properties, the allocation rules are different. These properties must still meet the state's QAP rules, but their credit is not allocated from the state population component credit pool.

If the tax-exempt bonds financing the property are subject to the state's bond volume cap (the maximum amount of federally tax-exempt debt the state can issue each year), the credit can be allocated without a reduction in the population pool. Financing with tax-exempt debt thus can be advantageous because it sidesteps the competition for population pool credit. A recent survey showed that in 1995, 19 states allocated over $13 million in credit outside of their population pools to tax-exempt debt financed properties.

Grants or below-market-rate federal loans used to pay for development costs generally are subtracted from the eligible basis, thus lowering the credit amount. Loans funded through local or state awards of community development block grants do not reduce the eligible basis. Other low-interest loan programs, such as the federal Home Investment Partnership Program (HOME) or the Federal Home Loan Bank Board's Affordable Housing Program, have particular rules for classification when used with the credit.

Amount of Credit Based on Need

The IRS requires that the amount of credit allocated not exceed the amount sufficient to make the property financially feasible. The method that most allocators have implemented to meet this section of the code is to calculate what is known as an "equity gap," or the amount of equity the property needs to raise to complete its capital sources. Figure 1 is an example of the equity gap calculation of a tax credit property with commercial space, 20 percent market-rate units, and federal grant funds.

The calculation of an equity gap considers only the equity required for qualified units and does not allow for the capital cost of commercial space ($750,000) or the 20 percent of the market-rate or nonqualified residential units. The next step in the calculation of maximum sufficient credits is illustrated in Figure 2.

Purpose of Equity Gap Calculation

The IRS requirement is designed to prevent properties from capitalizing excess development fees by leveraging more debt and equity than needed. In the previous example, the property would generate annual credits-based on its qualified basis-of 428,400, well in excess of the $266,666 justified by the gap method (see Figure 3).

If the developer in this case was able to sell the equity for 60 cents per credit dollar, equity of $2,570,400 ($428,400 x 10 x $.60) would be raised, which, when combined with the other sources of funds ($5,750,000), realizes $570,400 above what is needed (net of commercial costs).

Rent and Income Controls

To receive an allocation of credits, owners agree to make units affordable or credit qualified for a "compliance period" of at least 15 years. Two "minimum set aside" formulas determine the minimum percentage of units made affordable: 20 percent of the units at 50 percent of the area median gross income (AMGI) or 40 percent at 60 percent of the AMGI. Some tax credit allocators, such as New York City and Chicago, have special set asides. (In practice, many owners make 100 percent of their units affordable to maximize the credit, but a minimum set aside must be elected in any event. If the owner falls below the minimum set aside after claiming tax credits, past and future credits may can be recaptured.)

The income of a household renting a tax credit unit initially cannot exceed 50 percent or 60 percent (depending on the minimum set-aside election made) of the AMGI, as adjusted for household size. The maximum gross monthly rent (rent plus resident-paid utilities) that can be charged for a tax credit unit is 30 percent of the monthly income of a household with income equal to 50 or 60 percent of the AMGI. The maximum rents for different size units are calculated based on 1.5 occupants per bedroom: for example, 1.5 occupants for a one-bedroom unit, three occupants for a two-bedroom unit, and so on. Several software programs have been created to monitor residents' income and rent and the complicated regulations surrounding developments with fractions less than 100 percent.

Because the maximum gross rents are computed based on a percentage of area median income and not on actual residents' income, in many cases residents pay more than 30 percent of their income in gross rent. For example, if the annual income ceiling for a household of three persons was $24,000 and the maximum gross monthly rent for a two-bedroom unit was $600 ($24,000 ^ [12 x .30]) but a qualifying resident's actual income was only $20,000, that resident would be paying 36 percent ($600 ^ [$20,000 ^ 2]) of his or her income in rent. This example provides another instance in which the tax credit program differs from the public housing and Section 8 federal programs, which generally have adhered to the standard that residents pay no more than 30 percent of their income in rent, regardless of their actual income. Many property managers follow a minimum income policy whereby residents can pay no more than 33 to 35 percent of their gross income in rent-or variations on this-but others undoubtedly qualify residents at higher percentages of income.

In this respect, tax credit developments do not fully address the problem of affordability, which many housing economists have identified as the most acute problem with rental housing. They have observed that over the past decade growing percentages of low-income households are paying larger shares of income for rent and that affordability- not necessarily supply-is the most serious problem. Tax credits do permit residents' incomes to increase, a big difference from other public housing programs in which residents must choose between affordable housing and livable wages. In addition, the tax credit program meets the needs of a growing sector of the workforce-lower-paid service and manufacturing employees-and may indirectly address affordability by reducing demand on the existing housing stock through new supply.

Estimates of Area Median Gross Income

The IRS relies on the U.S. Department of Housing and Urban Development (HUD) to publish the AMGIs annually. Increases in the estimated AMGIs have averaged 2 to 3 percent annually since the program began, although year-to-year increases for some areas have been uneven. The definition of AMGI is based on family income, as opposed to household income, which tends to skew the income estimate upward. This is because HUD's definition of family includes only those households with two or more individuals related by blood or marriage and excludes all single-person and nonrelated group households. In many large metropolitan areas, the estimated median income for a family of three persons is at least $50,000 or higher. For example, the 1995 AMGI for Stamford/Norwalk, Connecticut, was over $78,000.

This skewing of qualifying program incomes also elevates allowable gross rents, in many cases resulting in maximum credit rents actually exceeding market rents. This is usually the case in nonmetropolitan and rural areas. By contrast, in larger metropolitan markets, credit rents typically are $50 to $200 per month below market rents.

Below-Market Rents

One mistake that can be made in credit development financing is to overestimate rental income. This can take the form of:

Using conventional market rents instead of more affordable, below-market rents; Misusing assumptions involving Section 8 rents;
Making unrealistic assumptions involving conversion of a property to market rents after the compliance period expires; and
Attributing too much income to the nonresidential components of a development.

Ideally, tax credit units should offer rents that are below the market rate for a given neighborhood; however, in some instances, the maximum allowable rents may be equal to or higher than market levels. Lenders and investors evaluate the market area for comparables, and rents customarily are established at 90 percent of the market rate and no more than 95 percent of allowable credit rents.

There should be at least a 10 percent differential before it is assumed that tax credit units will rent faster than other units in the same market. (This differential applies unless the unit is in a depressed area where decent housing of any kind is scarce; the assumption is that tax credit units would not be built in these neighborhoods and that residents face a gross undersupply of decent housing.)What should be avoided is using market rents to inflate investment values or to artificially enhance projected debt coverage. The only way to determine market rents precisely is to analyze rental comparables.

Some underwriters may try to get around the cash flow problem by using assumptions involving higher Section 8 rents. Though probably justified if the development has secured a Housing Assistance Payment contract, this practice otherwise is usually unfounded. As a rule, vouchers and certificates do not ensure rents any higher than market levels, nor are they necessarily available for tax credit units.

Rent and income controls are enforced through a deed restriction called an Extended Use Agreement that runs with the land and remains in place for the period specified by the allocating agency at the time the allocation is made (often 30 years). It is further defined in Section 42(h)(6)(D)(E) of the code. A publicly recorded agreement between the owner and the credit allocator is entered into at the time the development is placed in service that details the minimum set-aside percentage, the qualified number of units, rent and income guidelines, and any special criteria (such as targeting of units to special needs populations) that the owner may have elected in order to gain points in the application process. As a deed restriction, the agreement survives transfers of ownership and can be enforced by third parties, including residents or local public authorities.

The agreement also describes the duration of the rent and income controls. A property may phase out the controls after 15 years. This process is begun in the 14th year with the owner's request that the allocator find a qualified buyer of the development who will maintain the controls. If, after one year, a buyer is not found, the owner may begin phasing out the controls.

Many states have lengthened the minimum duration of controls imposed by the code, either through blanket requirements that properties maintain controls for 30 years or more or through their competitive application scoring systems. On the 9 percent tax credit program, California requires controls to remain in force for 55 years. In most states, applicants simply cannot score high enough to gain a reservation of credit unless they elect to lengthen the controls beyond the required restriction period.

Reservation and Allocation Process

Upon successful application, the allocator gives the applicant a reservation of credit by written letter or agreement. To preserve the reservation until the tax return is filed, the developer must either build and place the property in service by the end of the year in which the reservation is received or meet a test demonstrating such progress, at which time the developer receives what is referred to as a carryover allocation that commits the developer to placing the property in service within two years. In the first scenario, the property is completed, given a certificate of occupancy, and placed in service. The housing finance agency issues the allocation on IRS Form 8609, which the owner includes with his or her federal tax return to claim the credit.

Under the second, more likely scenario, the IRS 10 percent test requires the applicant by year-end to have incurred 10 percent of the reasonably anticipated total development costs. If, for example, the total development cost was $3.5 million, the applicant must have incurred costs of $350,000 by year-end. For purposes of this test, the cost of land can be included. Most allocators require some evidence of costs having been incurred, such as a letter and description of costs from an accountant or attorney hired by the developer.

In establishing the carryover method, the IRS recognized that most developers would not be able to apply for credit, win a reservation, construct a project, and place it in service all in one calendar year; the development process more often spans 18 to 24 months. A carryover allocation typically is issued before the end of the year following a reservation and is valid for two years from the last date of the year that it was issued; that is, the property must be placed in service within two years.

For example, if a reservation was issued on June 1 of this year and a carryover allocation was issued December 10 of this year, the property must be placed in service by December 31, 1999; if it is not placed in service by this date, the allocation is invalid, causing recapture of any credits taken by the owner entity.

The allocators conduct their own review of 10 percent tests to varying degrees, but equity and debt financiers in the tax credit marketplace subject the developer's 10 percent test to greater scrutiny. This is because the 10 percent test is a pass/fail test and an invalid 10 percent test renders the carryover allocation, and any credit claim, invalid.

In recent years, the 10 percent test has become a more difficult threshold for developers because of scrutiny by equity and debt financiers and their legal and accounting tax professionals. The IRS has issued guidance on the types of costs that can be included in or must be excluded from the test, and the tax professionals also have weighed in with their opinions. Qualifying costs as of this writing include:

• Acquisition costs: the purchase price for land and/or an existing structure, title insurance premiums, real estate commissions, survey costs, appraisal fees, recording fees incurred in connection with a land or building acquisition;
• Physical construction or rehabilitation work: amount paid or payable for services actually performed on or before December 31 in connection with the physical construction or rehabilitation of a development;
• Construction materials costs: costs for materials used in the ordinary course of construction;
• Attorney and accountant fees: the portion of the legal and accounting budget that is properly allocated to services actually rendered by lawyers and accountants in connection with the acquisition of land or existing structure;
• Architect's fees: the amount paid or payable to the development architect for design services; and
• Construction period interest and points: interest accrued on any loan outstanding after construction begins and before year-end, as well as construction loan points accrued before year-end.

The result is that meeting the 10 percent test without incurring construction costs, especially for new construction, is a difficult hurdle. Short of having equity and permanent and construction financing committed, developers must have sufficient financial capacity to start construction and incur hard costs in order to meet the 10 percent test. Some equity financiers have begun to assist developers with whom they have longstanding relationships to meet the 10 percent test by providing interim loans for land acquisition or construction.

Selling the Equity Ownership

Most developers sell a substantial portion, typically 99 percent, of the equity ownership of credit developments to equity investors. Because the credit anticipated will be the major share of the investor's return on equity, investors need to have sufficient federal tax liability to claim the credit, both in the current year as well as in the foreseeable ten-year period. Most developers do not have the dollar amount or predictability of it over ten years of tax liability to motivate them to retain a significant share of equity. For these reasons, a sophisticated equity purchase industry has grown around the tax credit market. Credit developers can pursue three distinct equity sale strategies in the market. First, they can sell equity to any one of dozens of regional or national syndication firms that buy the equity on many properties, pool the assets, and resell the equity to investors, either through public or qualified-buyer (corporate) offerings. The sales in this market are tightly priced among competing syndicators and have a fairly standardized set of terms relating to the timing of investors' payments and guarantees made by the developer. These syndicators, in turn, sometimes offer minimum yield and other forms of guarantees to their investors.

Second, developers can sell equity directly to corporate investors. The list of participating corporations includes many Fortune 500 manufacturing and finance companies. Many of these corporations invested in syndicators' offerings in past years but more recently have begun to buy directly from developers. There is a wider range of purchase terms and pricing compared with the syndication market, but generally prices are higher and guarantees are greater. This portion of the equity purchase industry has been increasing its market share as developers seek higher pricing and corporate investors seek higher yields.

Third, and last, developers can sell equity to groups of individual (usually local) investors, either directly or through small investment bankers or other financial consultants. This method accounts for only a small share of the market but is occasionally used, especially for smaller properties. The pricing and terms vary considerably.

Equity purchasers have created a reliable and liquid market for investment in credit developments, and they have met congressional expectations of the credit's ability to leverage private investment in low- and moderate-income rental housing. Competition among investors has held transaction costs in check-buyers' or syndicators' costs range from 5 to 10 percent of investment.

Special Financing

Since tax credit properties may involve several layers of special financing, the appraisal and underwriting analysis cannot end with a capitalized net operating income. Two essential questions remain. First, does cash flow meet debt service for the entire term of the loan? Second, will the future resale of the property cover the remaining debt? These questions must not be overlooked in the excitement over tax credits.

Often public loans provide that debt will be serviced only to the extent of available cash flow or at a percentage of available cash flow, with the balance accruing until the end of the loan term. Even in such cases, the accrued amounts can sometimes be so large, or the total amount of the debt so great, that the resale of the property in the year the debt is due will not yield enough to cover the balloon payment or balance due. Many lenders require a stand-still provision in the junior mortgage agreements. Although an automatic conversion to market rents in the future can correct this problem, that this will happen usually is not a prudent assumption since most properties have 30-year land use restrictions and, in some markets, tax credit rents equal market rents. A better way to account for this situation is to make a lump sum deduction from the total investment value, based on the difference between the selling price and the debt due, discounted to present value.

Using the Credit with Historic Properties

Properties meeting the U.S. Department of the Interior's standards for historic rehabilitation and qualifying for the 20 percent of cost historic credit can also use the Section 42 tax credit. Some allocators even provide incentives for credit applicants to adapt historic structures through their ranking schemes. In most cases, the historic credits leverage additional investor equity, which is used to cover the extraordinary rehabilitation costs that historic buildings typically require. An investor claims the historic credits for the first tax year that the property is placed in service. The amount of anticipated historic federal credits is deducted from the eligible basis of a credit development in calculating the amount of Section 42 credits.

A Leading Financial Tool

Competition for tax credits has created, at least in some areas, an environment that allows states to serve households with very low incomes, to target difficult-to-reach populations, and to provide new housing in underserved areas. The tax credit is a financing tool that can be used in neighborhood revitalization strategies; however, to reach very low-income households or promote neighborhood revitalization, other sources of capital often are needed. Increasingly, the program is fulfilling congressional expectations as a vehicle to provide affordable housing to a broad spectrum of constituents. Today, tax credits are the leading financial tool for creating multifamily housing in America, responsible for approximately 35 percent of starts in the past two years.