The low-income housing tax 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.