Overview of the LIHTC Program
Before considering a HOME funding request for a project that has, or is expected to have, LIHTCs, PJ staff should become familiar with what LIHTCs are and how the LIHTC program works.
What is a Low-Income Housing Tax Credit?
The U.S. Congress authorizes each state to allocate a certain number of Federal low-income housing tax credits (LIHTCs) and issue up to a specified amount of tax-exempt bond financing annually. The state’s allocation threshold is based on its population. Internal Revenue Service rules found at Section 42 of the Internal Revenue Code (IRC, or “the Code”) govern the LIHTC program. Each state establishes additional requirements and program priorities for the credits it administers.
The state reserves LIHTCs for approved affordable housing projects that meet certain affordability criteria for up to 30 years. These Federal tax credits are sold to investors as a way to raise cash equity for eligible affordable housing projects. In exchange for cash up-front, the investor receives a tax credit (dollar for dollar reduction in its Federal tax liability) each year for a period of ten years. The IRS enforces compliance with the LIHTC affordability restrictions for 15 years. The LIHTC compliance period is the 15-year period during which a project must continue to comply with the various LIHTC requirements to avoid any tax credit recapture. The compliance period begins with the first taxable year in the credit period. The extended use period is a date specified by either the LIHTC allocating agency or 15 years after the close of the compliance period. During this extended period, the use of the property is restricted to affordable low-income housing.
There are two forms of Federal LIHTCs, known as9 percent and 4 percent tax credits. 9 percent tax credits, also referred to as “70 percent present value LIHTCs,” are available for new construction and rehabilitation. 4 percent tax credits, also referred to as “30 percent present value LIHTCs,” are available for existing housing or federally subsidized housing and are generally used in conjunction with tax-exempt bond financing. In an acquisition and substantial rehabilitation project; the 4 percent credit is applied to the acquisition of the existing buildings and the substantial rehabilitation qualifies for the 9 percent credits.
The LIHTC program has rent and occupancy standards that vary from those of the HOME Program. The requirements for rents and occupancy under both the HOME and LIHTC programs are detailed in Chapter 2.
State’s Role in the LIHTC Program
Each state allocating agency is required to issue a Qualified Allocation Plan (QAP) to document how it plans to make the tax credits and tax-exempt bond financing available to developers. The QAP is published annually. It contains vital information on the LIHTC program requirements and the state’s funding preferences, in terms of the types of projects and locations in which it wishes to invest. Further, it explains the funding process, and identifies application deadlines and when funding decisions (called reservations of credits) are made. Each state’s QAP typically contains separate sections discussing the allocation procedures and requirements for 9 percent LIHTCs and 4 percent LIHTCs.
Each state is required to conduct public hearings in the process of developing the QAP.
One key source of information for the PJ about the state allocating agency’s funding priorities is the state LIHTC Qualified Allocation Plan (QAP). When PJs know and understand the state’s LIHTC priorities, they can better target HOME funds to projects that are the most fundable. Local PJs may also wish to discuss rental housing priorities with state staff, through the formal public hearing process on the QAP, and through other informal opportunities that arise."
Typical LIHTC Ownership Structures
Virtually all LIHTC projects are developed as single-asset entities , meaning that the ownership entity has a single property in which all revenues, expenses, assets, and liabilities are accounted for together.
LIHTC projects are typically owned by one of the following two types of legal entities:
- Limited liability corporations (LLCs). Limited liability corporations are similar to partnerships. Typically one partner (or “member”) is designated as the “managing member” who makes most day-to-day decisions. The tax credit investor member(s) typically is not involved in day-to-day decision-making, but is involved in major decisions such as sales or refinancing.
- Limited partnerships. Limited partnerships are similar to LLCs, except that the manager is called the “general partner” and the investor(s) is called a “limited partner.” Some limited partnerships have more than one general partner, in which case one of the general partners is usually the managing general partner who makes most of the day-to-day decisions.
PJs should be aware of certain special conditions of ownership that apply if HOME CHDO set- aside funds are being used in an LIHTC project. If the CHDO is applying and the ownership structure is a limited partnership, the CHDO must be the managing general partner. If the ownership is an LLC, a HUD waiver is required to allow for this ownership structure and the CHDO must be the managing member of the LLC. Other ownership structures are possible in theory, but are rarely seen in practice.
Role of the LIHTC Investor
The state’s reservation of credits is not money from the state LIHTC allocating agency to the developer. Instead, the allocation gives the owner the right to sell the reservation of LIHTCs to an investor. The investor purchases the LIHTC allocation at a price determined by the market for the credits for which the investor receives a 99 percent plus interest in the LLC or limited partnership that will own the project. In exchange for the infusion of cash equity, the investor receives its 99 percent ownership share plus the annual tax credits (a dollar for dollar reduction against its Federal income tax liability) over the first ten years, followed by an additional five- year affordability requirement, even though no additional tax credits may be claimed in those years.
LIHTC Equity: “Syndicated” versus “Direct Investment”
Direct investment is the simplest form of LIHTC investment: a large corporation purchases the entire investor interest in the project. By contrast, in a syndicated transaction, the investor interest is purchased by a fund or investor pool composed of many investors. Syndicated transactions are organized by LIHTC syndicators, who recruit corporate investors, create investor funds / pools that appeal to a wide array of investors, and represent the investors for purposes of getting the project funded, completed, leased-up, and operated in accordance with all applicable compliance requirements.
The entity that applies for HOME funding is typically the owner, developer, or sponsor of a project. Applicants for LIHTCs are generally referred to as “LIHTC project sponsors.” Under LIHTC, this would typically be either the owner or developer of the project. An LIHTC project sponsor is not the same as a sponsor under the HOME Program. Under HOME, a sponsor is a community housing development organization (CHDO) that works in partnership with another nonprofit to develop and manage a property in certain circumstances. Unless otherwise specified, this publication uses the term “owner” to refer to LIHTC project sponsors as well as developers and sponsors of HOME projects."
9 Percent and 4 Percent LIHTCs
In terms of the requirements and how the credit works, there is little difference between a 9 and 4 percent LIHTC. Simply put, the 9 percent LIHTC leverages more equity for a project than a 4 percent LIHTC, and is therefore usually more desirable. An award of 9 percent LIHTCs typically
generates sufficient investor equity proceeds to cover 50 to 90 percent of the cost to develop the LIHTC units; whereas, an award of 4 percent LIHTCs typically generates investor equity proceeds to cover only 20 to 40 percent of the cost to develop the LIHTC units.
The key differences between the two forms of Federal LIHTCs are summarized in Exhibit 1-1.
Competitive Allocation of 9 Percent LIHTCs
Because of the greater potential financial benefit of the 9 percent tax credit, these are in greater demand, and are therefore allocated competitively, according to the state allocating agency’s annual QAP. Typically, 9 percent LIHTC applications are received only once a year (although some larger states might have more than one funding “round” to allocate credits.) Most state allocating agencies use a point-scoring system to evaluate applications; this system is described in the QAP. Some states create a pool of potential LIHTCs that are reserved for particular types of projects (such as preservation projects in rural areas) or for particular types of sponsors (such as nonprofit sponsors or public housing authorities). Within each pool, the highest-scoring projects that meet all threshold requirements are selected to receive reservations of LIHTCs.
Tax-exempt bond financing cannot be used in conjunction with 9 percent LIHTCs.
Noncompetitive Allocation of 4 Percent LIHTCs
Because 4 percent credits are not in as high demand, most states accept LIHTC applications and issue reservations on a noncompetitive basis year-round. However, 4 percent LIHTC applications must still meet the state’s threshold requirements in order to be eligible to receive a reservation of tax-exempt bond authority. Tax-exempt bond financing must be used in conjunction with 4 percent LIHTCs. The associated tax-exempt bonds can be issued by any state or local agency that has the legal authority to issue bonds (for example, a state housing finance agency, a local public housing authority, or a local redevelopment agency).
For tax-exempt bond projects, there is an LIHTC requirement that at least 50 percent of the total development cost be financed with tax-exempt bonds. Typically, the required amount of tax- exempt bond financing is greater than the supportable first mortgage; in these situations, the required amount of tax-exempt bonds are issued at the start of construction. Then, at the end of the development period, some of the bonds are repaid (“redeemed”) so that the amount of the remaining bonds matches the first mortgage loan amount.
Exhibit 1-1: Summary of Key Differences in 9 and 4 Percent Tax Credits
How LIHTC Equity Is Calculated
The amount of LIHTC equity that can be secured for a project depends on a number of factors:
- Total development cost and how much of that cost is eligible under LIHTC
- Proportion of the project that will be LIHTC-assisted
- Type of LIHTC (9 or 4 percent)
- Price the LIHTC project sponsor is able to get for the credit.
Exhibit 1-2 illustrates the relationship of these variables and how the LIHTC equity is calculated.
Exhibit 1-2: Determining the LIHTC Equity
Total development cost. Total development cost is the total development budget (all costs necessary to produce a finished, occupied project).
Eligible basis. Eligible basis is the amount of the development cost that is LIHTC- eligible (excluding land and certain other costs that are not depreciable). This concept is discussed in more detail in Chapter 2.
Applicable fraction. Applicable fraction represents the share of the property that is LIHTC-assisted. It is based on the lesser of either: (1) the number of tax credit units to the total number of units, or (2) the square footage of the tax credit units to the total square footage of the property. Many tax credit projects have 100 percent tax credit units, and these projects have an applicable fraction that is 100 percent. However, QAPs increasingly favor mixed-income projects that include some market-rate units; mixed-income projects have applicable fractions well below 100 percent.
Qualified basis. Qualified basis is eligible basis multiplied by the applicable fraction. In other words, the portion of eligible basis that is attributable to the LIHTC units.
Basis boost percentage. Basis boost percentage is usually 100 percent. However, projects located in HUD-designated qualified census tracts or difficult development areas can be allocated up to 30 percent additional LIHTCs, at the discretion of the state LIHTC allocating agency. (Note that the Housing and Economic Recovery Act of 2008 gave the states’ housing finance agencies the right to determine which areas in their states could be designated as difficult-to-develop areas.) If the full 30 percent addition is allocated, the basis boost percentage is 130 percent. Basis boost may not be applied to acquisition costs.
LIHTC period. The LIHTC period is the ten-year period over which the investor may claim the LIHTCs. This is also sometimes referred to as the “credit period.” This is not the same as the 15-year compliance period (the period during which the IRS can recapture the tax credits from the investor for noncompliance with the affordability restrictions.)
Total LIHTCs. Total LIHTCs equals the qualified basis multiplied by the LIHTC percentage multiplied by ten years. This is the total dollar amount of LIHTCs that the owner is expected to receive over the ten-year credit period.
Net syndication price. Net syndication price is the amount that the LIHTC investor pays for $1.00 of Federal income tax credit. Historically, the net syndication price typically ranged from 70 cents to 90 cents. (This means that the investor is willing to pay 70 to 90 cents today for every $1.00 of anticipated tax credit that it will receive later.) In the mid-2000s, the typical price rose above 90 cents, only to drop significantly beginning in 2008. At this publication, net syndication prices are volatile and are most often reported toward the low end of the historical range.
Net syndication proceeds. Net syndication proceeds are the total dollar amount that the LIHTC investor pays the LIHTC project sponsor. It is based on the total project credit amount multiplied by the net syndication price. In this example, the net syndication proceeds are sufficient to pay for 51 percent of total development cost.
Market Trends in LIHTC Equity Prices
Historically LIHTC prices have been stable and there has been an adequate market of potential LIHTC investors. As a result, developers had high confidence that an LIHTC reservation could readily be converted into LIHTC equity. However, financial upheaval in 2008 created significant stress in the LIHTC equity market, demonstrating that there can be unpredictability in this market.
In summary, many of the largest LIHTC investors lost confidence that the business environment would be profitable. Without anticipated profits, there would be no Federal income taxes; and without tax liability, there would be no need for credits. The market stopped purchasing LIHTCs. This has had two primary results:
- LIHTC prices became (and continue to be) unstable.
- Some LIHTC projects have been unable to find an investor—particularly those with less- experienced or less financially-sound developers, large projects (over 200 units), projects in rural areas, projects with especially complex financial and compliance structures, and projects in areas of or declining population.
Recent market trends dictate that the PJ understand that the demand for tax credits can change over time; one cannot assume there will always be a supply of investors. PJs should discuss this issue with the state allocating agency when making decisions about funding tax credit projects. In addition, PJ underwriters should consider the following:
- Currently, pre-2008 benchmarks for LIHTC equity prices are not reliable.
- Developers today are under pressure to propose projects that are less complex and that involve fewer risks, as compared to the types of projects that could readily find LIHTC investors prior to 2008.
- There is a greater need for flexibility, creativity, and professionalism by PJs in working with the state and with developers.
There are three primary deadlines in the LIHTC program:
- Allocation and reallocation deadlines
- “Carryover” requirement
- Placed in service requirement.
Allocation and Reallocation
The state has two years to make an initial allocation (reservation) of LIHTCs. If a developer returns its LIHTC reservation, the state has two additional years to reallocate the LIHTCs to another project.
Once the state makes an initial reservation of LIHTCs for a project, the developer must incur 10 percent of the reasonably expected eligible basis within 12 months of when the LIHTC reservation was made. This is called the carryover requirement. Although 10 percent must be spent, the expenditures need not be for basis-eligible items. Once this threshold is achieved, the developer receives a “carryover allocation” from the state; that is, the state allocates the remaining credits to the project. If the developer is unable to spend 10 percent of the reasonably expected eligible basis within 12 months, the project loses the credits and they are reallocated by the state to another project. (Note: the Housing and Economic Recovery Act of 2008 extended this expenditure deadline from six months.)
“Placed In Service” Requirement
The LIHTC program does not have a deadline for full expenditure of funds like the HOME Program, but it has a deadline for project occupancy, called “placed in service.” The state LIHTC allocating agency and the IRS track LIHTC projects at the building level. A new construction LIHTC building is placed in service when construction has been completed and when the first unit in the building is certified as suitable for occupancy under state or local law (see IRS Notice 88-116). Rehabilitated LIHTC buildings are considered to be placed in service at the close of any 24-month period – selected by the taxpayer – over which the rehabilitation expenditures are aggregated. LIHTC buildings must be placed in service no later than December 31 of the second year following the year of the LIHTC reservation. For example, a project that receives 2008 LIHTCs must be placed in service by December 31, 2010.
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