Low-income Housing Tax Credits: A guide that (hopefully) won’t make your eyes glaze over

For months, every time I read the term Low Income Housing Tax Credits (LIHTC) , usually in an article or report about affordable housing policy, my eyes glazed over and my attention darted to the next sentence. I could tell these credits were important but I did not know what they entailed (nor did I entirely understand what a tax credit was) and context clues were slim. I convinced myself I was more interested in the result of the policies than in their bureaucratic mechanisms. And so I lived in happy, uninformed bliss. Eventually, however, after seeing LIHTC referenced in almost every discussion of affordable housing financing and realizing that it is a major driver of new affordable developments, I decided to begin the process of disambiguation.

The listing for the LIHTC program on the Department of Housing and Urban Development’s (HUD) website disputes the claim that LIHTC are complicated to understand. Their proof: the more than 39,000 projects comprising approximately 2,548,000 units financed, in part, by LIHTC between the program’s initiation in 1987 and 2012. If thousands of developers throughout the country can figure out the program, it cannot be as difficult as it sounds.

Still, I contend that understanding the program takes time, especially because of the scattered way the HUD chooses to organize information. To arrive at a point of relative proficiency, I had to go through resources published on at least four different HUD pages, the IRS, the Illinois Housing Development Authority (IHDA), and other non-government sites. My explanation is by no means complete -if any readers of this page find inaccuracies, misconstructions, or deficient data please let me know. I strive to be as accurate as possible.

The LIHTC program was initiated by the Tax Reform Act of 1986 as a way to entice developers to invest in affordable rental housing and to increase private involvement in what had been a traditionally public market. It is administered by the IRS, and HUD plays a supporting role by managing LIHTC data and assisting in the enforcement of Fair Housing laws within LIHTC buildings. Under the program regulations, the IRS distributes approximately $8 billion in tax credits each year to state or local housing agencies.  Each agency receives an equivalent of $2.30 per state resident (in 2014), which it allocates to developers of qualified projects that result in the acquisition, rehabilitation or construction of new affordable housing. The developers bundle the credits and sell all ten years’ worth to private investors, who usually take the form of a syndicate group using pooled capital to invest in projects. Investors receive credit for their federal income taxes as well as equity, making the investment profitable even when the tax credit period ends.

Tax credits are not real cash; they are, in essence, a discount on federal taxes owed. When an investor purchases a tax credit, it means they receive a dollar for dollar decrease in their federal tax liability, the amount of income and assets that are taxed by the federal government. Because tax credits exist in the realm of imagined or theoretical money, when the IRS gives budget authority to state and local LIHTC distributing agencies it allocates an equivalent, not a tangible, sum. This money can only be used for tax purposes.

An example:

IRS => $8 billion tax credits => state agencies (@rate of $1.75/resident) => qualified developers => investors <= equity

A qualified developer receives $1,000,000 total credit (I will go into how this credit is determined later), which is then sold to an investor. The investor       has a taxable income of $500,000, which is then reduced (using the LIHTC) to $400,000 per year for ten years ($1,000,000 total credit/10 years =             $100,000 credit per year). For a breakdown of equity returns, read this paper by the Office of the Comptroller of the Currency; it explains the investment terms, tax credits and distributions in terms more succinct than I can manage.

Developers trade equity and tax credits in return for up-front working capital as well as shared liability. If, for example, the above developer  sells their $1,000,000 in LIHTC for $750,000 (75 cents per dollar) they then have $750,000 in a one-time cash infusion to offset early development costs such as architecture and engineering, site improvements and utility hook-ups. In addition, the investors carry the burden of $750,000 worth of potential losses.

Because LIHTC benefit both developers and investors, they have become the most popular method for financing affordable buildings.

Each state LIHTC distribution agency has a Qualified Allocation Plan (QAP) that sets forth specific regulations and timelines. Developers must outline such things as their projected budget, project and site characteristics, market demand, and adherence to a local revitalization plan. The Federal government mandates that state agencies give priority to projects that serve lowest income families or are designed to remain affordable for the longest period of time. In addition, each state must give ten percent of its annual housing credits to projects owned by non-profit organizations.

The amount of tax credits given to each qualifying project is calculated by multiplying eligible development costs (which include construction and soil tests but exclude land acquisition) by the lessor of the percentage of affordable units or the percentage of square footage occupied by affordable units. This eligible basis is then multiplied by the the project’s credit rate to determine the amount of money each project can claim. Credit rates are either 9 percent, for new construction or substantial rehabilitation projects that do not utilize federal funding; or 4 percent, for acquisition of existing buildings for substantial rehabilitation, new construction or substantial rehabilitation using other federal funds, or projects financed with tax-exempt bonds. Substantial rehabilitation occurs if the developer spends the greater of an average of $3,000 on each affordable unit or if rehabilitation accounts for 10 per cent of the eligible basis (the amount from which the credits are calculated) during a 24-month period.

The definition of federal subsidies is also specific to the LIHTC. Under the  program, these include loans  and bonds with below market-rate interest. Other forms of federal assistance, such as HOME funds, are allowed with the 9 percent threshold if the amount of tax credits are reduced, if the HOME funds are treated as deferred payment loan with interest, or if the developer pays market-rate interest.

Both the 9 and 4 percent rates are only estimates; actual rates are published each month by the IRS using inflation data. Developers may choose to use the percentage rate either for the month in which they are granted tax credits or the date the building is opened for habitation, referred to as the placed in service date.

Another example:

Here are hypothetical numbers for a development in which 20 percent of units are affordable (the applicable fraction) and the developer is not using federal funds. This is based on an example discussed by HUD.

1,000,000 (land acquisition)
60,000 (architecture and engineering)
3,000,000 (construction)
2,000,000 (additional costs)
Total development costs =6,060,000
Eligible basis= 5,060,000 (development costs minus land costs)
Qualified basis= 1,012,000 (eligible basis x applicable fraction; 5,060,000 x .20)
Annual credit=91,080 (qualified basis x credit rate; 1,012,000 x .09)
Total LIHTC= 910,800 (annual credit x 10 years of credit eligibility; 91,090 x 10)

In this example, the developer receives a total of $910,800 in tax credits. If, as above, the developer sells the credit for $.75 per dollar, they walk away from the deal with $683,100 in working capital and the investor, in addition to the tax credits, has an 8.9 percent equity share ($6,060,000 total costs divided by a $683,100 investment).

Units count toward the applicable fraction (are deemed affordable) if they are rent-restricted for residents making no more than 60 percent of the area median income (AMI) ; . In Chicago, this means a family of four can earn no more than $43,440 and be required to pay no more than $1,086 per month (including utilities). Although not every unit needs to be rented to low-income tenants to secure LIHTC, the program has two possible low-income occupancy thresholds for eligibility: either 20 percent (or more) of units are rent-restricted for and occupied by households with an income at or below 50 percent of AMI; or 40 percent (or more) of units are rent-restricted for and occupied by households at or below 60 percent AMI. Because LIHTC apply only to affordable units, developers have incentive to rent restrict more units, up to 100 percent . In addition, funding priority is given to buildings with higher affordable percentages, and to developers that include units for people who earn less than 50 percent AMI.

When awarding funding, housing authorities look for a variety of included amenities. Using the IHDA as an example, scoring criteria include energy efficiency, proximity to transportation and services, site suitability (with respect to market, area growth, population), community assets (public libraries, post offices, public schools, health care facilities), job-housing mismatch (more points are awarded to buildings that provide housing in an area with a high job but low housing rate), involvement of non-profits and local companies. The IHDA revokes points if the project’s managing partner has engaged in unfavorable practices in regulated affordable housing within the prior three years. All approved projects must also have proven local support and undergo substantial environmental and demographic review.

The housing authority and the IRS continue to monitor the building for affordability, livability, and  compliance with local building and health codes for 30 years after the building is placed in service. After 15 years, owners are no longer at risk for non-compliance penalties from either the IRS or the housing authority and have the option to convert all units to market-rate by claiming financial distress and applying for regulatory relief. A 2009 study conducted by HUD, however, showed that the majority of owners choose to keep their buildings affordable. LIHTC remain a viable option for developers who are not opposed to mixing low- and moderate- to high-income residents in the same building.

Despite the success of LIHTC, Congress has issued items in the FY2015 budget that would eliminate or cripple LIHTC, thus reducing the potential number of new affordable units by thousands. The advocacy group Affordable Rental Housing A.C.T.I.O.N has more information, here, about the risk of losing LIHTC as well as tools to reach out to politicians to preserve this vital funding mechanism. The LIHTC program is not perfect -a 2013 study found that LIHTC promoted segregation in the New York City region because priority is given to development in poor, underserved communities -but the program has provided more than 2 million homes to Americans in the past 26 years. Considering the increasing need for affordable homes, this is a resource our country cannot afford to lose.

If you still have questions about the scope, process or implications of LIHTC, here are some helpful resources:

Low-Income Housing Tax Credit Program, by Ed Gramlich, Director of Regulatory Affairs, National Low Income Housing Coalition

Housing Credit (LIHTC) -How it Works, an illustration of LIHTC by Affordable Rental Housing A.C.T.I.O.N.

Low-Income Housing Tax Credit Impacts in the United States, a fact sheet also by Affordable Rental Housing A.C.T.I.O.N

About the LIHTC, by Novogradic Affordable Housing Resource Center

LIHTC Basics, by HUD

 

 

 

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