The Low Income Housing Tax Credit (LIHTC), pronounced “lie-tech,” program was created by Congress in 1986 to raise private equity for new construction and rehabilitation of affordable housing by allocating federal tax credits to the development. The private equity subsidizes the development, allowing for either some, or all of the units to be rented at below-market rates to low income tenants.
The LIHTC program has become an integral tool for developing affordable rental housing. The LIHTC program has stimulated the new construction and rehabilitation of nearly 2.8 million affordable homes and supports over 100,000 jobs annually. Today, as much as 30 to 40 percent of all new multifamily construction is subsidized using LIHTC. Up to 90 percent of the cost of a rental complex, with the right mix of low income units, may be returned to the owner in federal tax credits.
The LIHTC program is a proven success, allowing rental housing developers to raise private equity by selling federal tax credits. The annual amount of the federal tax credits is determined by multiplying (i) a building’s qualified basis, by (ii) the applicable tax credit rate (9 or 4 percent). The qualified basis of a building is the product of the qualified cost of the building (known as the eligible basis) multiplied by the percentage of the building that is occupied by low income tenants. The eligible basis may equal the cost of acquiring an existing building (but not the cost of the land), plus for new buildings or rehabilitation expenditures to an existing building, the construction and other construction-related costs to complete the development. After a building is complete and the owner certifies the eligible basis, the building will qualify for federal tax credits upon rental of the units to low income individuals and families.
Generally, LIHTCs are delivered over a 10-year period (the “credit period”), with each year making up 1/10th of the total tax credit award. Generally, the yield of the 10-year credit stream has a present value equal to 70 percent of the qualified basis of any new building not financed by tax exempt bonds, and a present value of 30 percent of the qualified basis of any building that is financed by tax exempt bonds. Rehabilitation expenditures are treated as a new building for this purpose, and an existing building may qualify for the 30 percent present value credit only. The state agency allocates the tax credits using a competitive application process for new and existing buildings not financed by tax exempt bonds, while for buildings financed by tax exempt bonds the qualification for tax credits depends generally on 50 percent or more of the aggregate cost of the land and building being financed by tax exempt bonds that receive a volume cap allocation from the issuer.
LIHTC are typically allocated by the owner to either a third party investor or investors in return for equity contributions. The affordable housing development is commonly owned in a partnership or limited liability company for tax purposes. Tax credits are more attractive than tax deductions as they provide a dollar-for-dollar reduction in a taxpayer’s federal income tax, whereas a tax deduction only provides a reduction in taxable income equal to the highest marginal tax rate of the taxpayer. The owners of interests in a project owner claim LIHTC and tax losses generated by the project buildings. Today, almost all interest owners in a project owner generating LIHTC are widely-held corporations, because of the “passive loss limitations.”
Traditionally, one of the interest owners in a project owner is also the developer, but there are instances where a landowner will hire a developer (known as a mercenary builder) to build the housing for the project owner. A developer looking to receive LIHTC for new construction or acquisition/rehabilitation of a housing project that is not financed by tax exempt bonds typically submits an application with the state housing agency where the property is located. If the developer application receives an allocation of LIHTC, then in order to claim the tax credits the developer must (i) complete construction or rehabilitation of the project, (ii) certify the construction costs, and (iii) meet the minimum lease-up percentage of low income tenants, as stipulated in the application.
Prior to starting construction, the developer will have secured an investor to buy the LIHTC. Similar to the NMTC and HTC, the price for the LIHTC is driven by the investor’s desired yield. The developer’s objective, however, is to maximize the tax credit price while the investor seeks to buy the tax credit for the lowest possible price. The investor will pay in its equity by making “capital contributions” for an ownership interest in the project owner’s entity, which will be either a partnership, or limited liability company. The investor is also able to increase its yields by delaying the delivery of the capital contributions. The developer’s objective on the other hand seeks to accelerate the delivery of the capital contributions, because it eases concerns whether the funds are available and it also allows the developer to defer paying accrued interest on advancements under the construction loan. Typically, the investor remains in the deal for the duration of the compliance period, which is 15-years starting with the first (1/10th) year of the credit period. Once all the credits are received by the investor and the compliance period is over, the investor typically sells its interest ownership back to the developer, affiliate, or third party.
Failure to comply with the applicable rules, or a sale of the project or an ownership interest before the end of the 15-year period, could lead to partial recapture of the credits previously taken and the inability to take future credits. The IRS requires the property maintain the designated number of units rent restricted for at least 30 years after construction; however, some state agencies may require that housing maintain its rental restricted status for more than 30 years. However, due to tax law changes in 2008, recapture is inapplicable if the project continues as a low income housing project for the 15 year compliance period after the sale of an interest in the project owner or the project itself. Thus, an investor may sell its interest in the project owner after the end of the 10 year credit period and not incur partial recapture of the credits previously taken provided the project remains a low income housing project throughout the compliance period.
To encumber the property for the 30 or more years, the owner records a Land Use Restriction Agreement (LURA). The LURA is recorded after or before the development is completed, but before the tax credits are ultimately determined by the state agency. Under the LURA, the project is required to meet the particular development’s low income requirements for a 15-year period, known as the “compliance period,” and after the initial 15-year period, the property is subject to the “extended use period,” which can either be for another 15-years or longer.
Location, location, location very much applies to LIHTC projects. For successful LIHTC projects the golden rule of real estate applies…locate the project in an area that lacks affordable housing, but has a constant pool of qualifying tenants. While the federal tax credits will not make a bad deal good, it will certainly make a good deal better. However, it is possible that a bad project is able to further reduce the debt burden by seeking additional federal, state, and/or local subsidies. Moreover, if located in a designated area, the eligible basis will be increased by 30 percent and the additional LIHTC will reduce the debt burden further. The key is utilizing the federal tax credits to help create and carry the project in an up-and-coming market such that when the affordability period expires, the owner is left with a very low leveraged piece of real estate in a prime location. Typically, developers look for apartment sites with high visibility, good traffic, and with infrastructure necessary for the development. The objective is that the housing promotes growth within the surrounding area. The LIHTC program allows great opportunities for the owner and investor to earn profit and develop quality housing to benefit low-income residents.