The low-income housing tax credit

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: