The low-income housing tax credit

• 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.