A low-income housing alternative.

A Low-Income Housing Alternative

In December 1989, President Bush signed legislation that provided about $3 billion in additional funding for the low-income housing tax credit (LIHC) program. The LIHC is expected to continue to be a critical piece of the administration's low-income housing legislative agenda. President Bush has asked for more funding for the LIHC program in the next budget he provided to Congress.

LIHC projects present a wide variety of opportunities for lenders and mortgage brokers willing to invest the time needed to understand the program. Through the LIHC program lenders have an excellent opportunity to make multifamily residential loans, to generate a high rate of return on an equity investment, and to satisfy certain Community Reinvestment Act obligations.

Mortgage brokers will find that the LIHC program is misunderstood by many lenders, and because of that LIHC developers often have a difficult time arranging financing. Developers often welcome the participation of mortgage brokers who have a working understanding of the LIHC.

The Low-Income Housing Tax Credit (LIHC or credit) was enacted as part of the Tax Reform Act of 1986. The credit was generally effective as of January 1, 1987. The LIHC is an indirect federal subsidy of low-income housing. To claim the subsidy, eligible taxpayers claim a tax credit on their federal income tax returns. The LIHC offsets taxes dollar for dollar because it is a tax credit and not a tax deduction.

The credit is claimed pro-rata over 10 years and can be used in connection with both new and existing buildings. To claim the credit, taxpayers must apply to the pertinent state allocation agency. These state agencies are responsible for allocating the limited quantity of credits to low-income housing projects. The one exception to these allocation rules is for projects financed by tax-exempt bonds. Low-income housing projects financed by tax-exempt bonds are generally not required to obtain a tax credit allocation in order to be eligible for the credit.

For new projects, the credit was initially funded through January 1, 1991. Projects that receive approval by December 31, 1990 were given until December 31, 1992 to be placed in service, if they satisfied certain transition rules. President Bush has announced his support for further funding of the LIHC program beyond December 31, 1990.

Once a project is placed in service, it is generally eligible for the credit every year for 10 years. To continue generating the credit and to avoid tax credit recapture, a LIHC building must satisfy specific low-income housing compliance rules for either a 15-year or a 30-year period. The applicable period generally depends on the year the project owner receives his tax credit allocation. Projects receiving a credit allocation before 1990 are subject to a 15-year period. Projects receiving a credit allocation after 1990 aresubject to a 30-year compliance period.

The LIHC is an extremely technical income tax area. Because the LIHC is a new income tax provision, it is not supported by a large body of administrative or judicial guidance. This lack of guidance is further complicated by the many nuances contained in the LIHC law.

Project economics

The credit is generally designed to subsidize either 30 percent or 70 percent of the costs of the low-income units in a low-income project. The 30 percent subsidy is for new construction using additional federal subsidies and for the acquisition of existing buildings. The 70 percent subsidy is for new construction without any additional federal subsidies. The term "new construction" includes the costs of rehabilitating an existing building if a minimum per-unit expenditure threshold is satisfied within a certain time period.

The 30 percent or 70 percent subsidy is realized by claiming federal income tax credits every year for 10 years. The amount of the annual credit is calculated to yield a present value of either 30 percent or 70 percent of certain building costs. For projects located in difficult to develop areas, the credit can be effectively increased by 30 percent--yielding a 91 percent present value credit in lieu of the 70 percent credit, and 39 percent in lieu of 30 percent.

The actual credit percentages are recomputed on a monthly basis such that the present values are achieved. The credit percentage for a given project is generally determined in the month the project is placed in service. However, the building owner can choose to use the credit percentage in effect for the month in which the credit allocation is received. To be effective, such a choice must be made within five days after the end of the month in which the credit allocation is received. For the 70 percent credit, the annual nominal credit percentage is generally around 9 percent. For the 30 percent credit, the annual nominal credit percentage is around 4 percent.

In exchange for receiving the LIHC, the project owner agrees to rent units to low-income individuals at reduced rental rates. Theoretically, the credit is designed to provide the additional return that is necessary to compensate low-income building owners for the reduced rental income. The effect of the reduced rental income stream must be factored into the project analysis.

General economic principles influence where tax credit subsidized low-income housing generally will be built. Such housing is located where the land costs are low and the LIHC allowable rents are close to market rate rents.

Economically-defined parameters make it difficult to build low-income housing in major cities because land costs are higher and low-income rents are substantially below market rates. However, additional federal, state, local, and not-for-profit subsidy programs can make development in these cities more feasible. For instance, the federal Section 8 program subsidizes tenant rents and generally does not limit the ability of a building owner to claim the LIHC.

When reviewing whether or not to apply for a LIHC allocation, building owners should consider four major criteria: the value of the credit, the economic value of additional government subsidies, the economic cost of the reduced rents and the administrative burden of complying with the LIHC program.

The credit is most valuable if it is used in the year in which it is generated. If a building owner is unable to use the credit currently, then the credit can be remarketed to investors who can use the credit on a current basis. Both public and private investment funds exist with the sole purpose of acquiring LIHC projects. Many widely held corporations also invest in LIHC projects.

When calculating the expected financial return from an LIHC project, equity investors should include:

* Tax credits;

* Tax losses;

* Operating cash flow;

* Cash flow from disposition of the investment.

It is common for LIHC projects to forecast after-tax investment returns in excess of 20 percent.

Community Reinvestment Act

The Community Reinvestment Act (CRA) of 1977 generally requires that regulated financial institutions demonstrate that they serve the communities in which they are chartered to do business. The needs of the community include both lending and depository needs, with special emphasis placed on satisfying local credit requirements.

The CRA was enacted in 1977 as a response to the perception that regulated financial institutions treated some prospective borrowers unfairly and had unnecessary differences in lending policies based on geographic locations.

CRA was amended by the Financial Institution Reform, Recovery and Enforcement Act. Under CRA, financial institutions are required to prepare a CRA statement describing the community served by the institution and listing the types of credit offered. This statement must be reviewed at least annually by the board of directors of the institution.

In addition, under CRA, federal agencies responsible for supervising regulated financial institutions must prepare written evaluation after examining an institution. The written evaluation should assess the institution's performance in satisfying the credit needs of the entire local community, including low-and moderate income areas.

This evaluation contains public and private information. The public information addresses the financial institution's historical performance and current plan for improvement. This form also contains a rating of the institutions degree of CRA compliance. Disclosure of these ratings is scheduled to begin after July 1, 1990. The private section of the evaluation covers areas that should not be disclosed to the general public.

Institutions have substantial leeway in developing specific policies and programs to satisfy their CRA obligations. The actual steps taken to satisfy an institution's CRA responsibilities will depend upon a number of factors, including the following:

* size of the institution;

* its business strategy and objectives; and

* the size, nature and needs of the community involved.

The 1980 community Reinvestment Act Information Statement, list steps that are indicia that an institution is meeting its CRA responsibilities. This list of steps includes the following:

* increasing efforts to provide loans to help satisfy identified local community credit needs;

* creating and implementing marketing efforts to inform low- and moderate-income groups of available loan and deposit services;

* implementing services to benefit low- and moderate-income persons;

* underwriting state and municipal bonds;

* establishing or funding a community development corporation or a small business investment corporation; and

* making lines of credit and other financing available: (1) to non-profit developers of low-income housing and small business developments, (2) for low-income multifamily rehabilitation and new construction projects, and/or (3) for creating a secondary market for non-profit developer paper.

LIHC projects clearly serve a local community need. Furthermore, they satisfy some of the credit needs of the lower income neighborhoods. According to discussions with federal agency representatives, loans to and equity investments in LIHC projects will contribute toward an institution's compliance with its CRA obligation. However, "no rule or specifications" exist with respect to complying with CRA, so an institution will not know to what degree the credit it provides to an LIHC project will satisfy its CRA obligation.

Summary

The low-income housing tax credit (LIHC) is an indirect federal subsidy of low-income housing. LIHC projects provide after-tax returns often in excess of 20 percent. Also, loans to and equity investments in LIHC projects qualify toward satisfying a financial institution's obligations under the Community Reinvestment Act of 1977 (CRA). Financial institutions should consider using LIHC projects to achieve their investment objectives and to satisfy their CRA obligations.

Michael J. Novogradac is a partner with Spectrum Tax Consulting Group in San Francisco. He specializes in the area of low-income housing tax credits. Eric J. Fortenbach is a partner with Spectrum Tax Consulting Group in San Francisco. Mr. Novogradac and Mr. Fortenbach are coauthors of the Low-Income Housing Tax Credit Handbook, published by Clark Boardman Company, Ltd.