The low-income housing credit--program expansion and investment opportunities: the low-income housing credit reduces developers' and investors' tax liabilities and raises the standard of living for low-income households. This article explains how the credit works and the investment opportunity it offers.

For more than 60 years, the Federal government has provided assistance to improve the condition of low-income housing and to reduce its cost. (1) Initially, Federal housing policies focused mostly on production and development, but were refocused in the early 1980s when President Reagan began to implement voucher and tax credit programs. The Tax ReformAct of 1986 introduced the low income housing credit (LIHC), which revolutionized the Federal Low Income Housing (LIH) Program with the support of private investment. This program currently comprises 26% of the Federal government's funding for low-income housing and is primarily supported by large corporations and financial institutions motivated by tax savings and the Community Reinvestment Act (2) (CRA) credit. This article explains how to qualify for the LIHC, how it operates and the tax consequences to developers and investors.

LIHC Overview

The LIHC was introduced in Section 252 of the Tax Reform Act of 1986 as Sec. 42. At that time, President Reagan sought to encourage corporate involvement in the Federal government's dilapidated low-income housing program, to combat poor resource allocation and rising administrative costs. With the implementation of the LIHC, Congress took a business approach to the housing program, by stimulating business development in economically distressed areas.

The LIHC was specifically designed to promote the development of housing for low-income families, without requiring a lot of government involvement in day-to-day operations. Unlike other government housing programs administered by the Department of Housing and Urban Development (HUD), the LIHC program is governed by the Code and administered jointly by the IRS and state housing agencies. It was approved first on a year-to-year basis, but became permanent with the passage of the Omnibus Budget Reconciliation Act of 1993. (3)

Allocations

State housing finance agencies are responsible for allocating LIHCs to developers in a competitive application and bid process for financially feasible proposals. (4) The Federal government initially allots each state housing agency an annual credit based on the state's population. The allotment is the same for each state and is currently set at the greater of $2 million or an inflation-indexed per-capita rate of $1.85 for 2005. (5) States can allocate LIHCs, which are currently valued at approximately $499 million a year (270 million citizens x $1.85). Each credit has a 10-year life before it reaches maturity. After 10 years, the total value of the credit is $4.99 billion. (6) The credits are distributed to developers for sale to investors (usually corporations). The funds raised from sales become equity in the project, which lowers the funding expenses and subsidizes rent; see Exhibit 1 on p. 558.

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The LIHC gives the state agencies a certain degree of autonomy. They can set their own rules and project preferences within the broad Federal parameters outlined in Sec. 42. This allows them to use the credits for a multitude of diverse rental housing projects, such as new construction, substantial rehabilitation, or acquisition and rehabilitation. These projects have included garden apartments, townhouses, highrise buildings, scattered-site development, lease-purchase homes and single-room-occupancy facilities. Sec. 42 also allows project developments for use by a variety of residents, such as families, seniors and special-needs populations.

Computations

Qualified Basis

The LIHC is based on the qualified basis of a housing project; see Exhibit 2 on p. 559 for the basic LIHC computation.

There are three steps involved in calculating a project's qualified basis under Sec. 42(c)(1).The first involves determining the project's eligible basis under Sec. 42(d). According to Sec. 42(d)(1), a new building's eligible basis is generally its adjusted basis. An existing building's eligible basis hinges on the acquisition cost, based on various holding requirements under Sec. 42(d) (2).

The second step is the determination of the applicable fraction. According to Sec. 42(c)(1)(B), a low-income building's applicable fraction is the lesser of the project's unit fraction or floor-space fraction. Sec. 42(c)(1)(C) defines the unit fraction as the ratio of the occupied low-income units to all residential rental units in the building. The floor-space fraction, under Sec. 42(c)(1)(D), is the ratio of the occupied low-income floor space to the total residential rental floor space in the building.

Example: The eligible basis of a qualified low-income housing building is $1 million. The building consists of 100 units, 60 of which represent Sec. 42 rent-restricted units; the remaining 40 units are rented to market-rate tenants. The floor space of each low-income unit is 500 square feet; the market-rate units are slightly larger, at 600 square feet.

The project's unit fraction is 60% (60 low-income units/100 total units). The floor-space fraction is 56%, representing 30,000 low-income square feet ((60 x 500)/54,000 total square feet). The applicable fraction is 56%, the lower of the two. The qualified basis is $560,000 ($1 million x 56%).

Basis Boost

Once the eligible basis and the applicable fraction have been determined, the final step in calculating qualified basis involves applying any adjustments to the calculation, to account for any HUD-designated high cost area (HCA) under Sec. 42(d) (5)(C).When a development project is located in an HCA, state housing agencies have the discretion to award an additional 30% LIHC to ensure its economic feasibility (a "basis boost"). A project basis boost only applies to new construction or rehabilitation, and specifically excludes acquisition costs. An HCA is an area designated as a qualified census tract (QCT) or difficult development area (DDA); these designations became applicable after 1989, and are listed by HUD in the Federal Register. If a project is initiated in an HCA, the state agency indicates this on line 3 of Form 8609, Low-Income Housing Credit Allocation Certification (which specifically asks if the HCA provisions of Sec. 42(d)(5)(C) have been applied). The state agency would then fill in the appropriate percentage increase. (7)

According to Sec. 42(d)(5)(C)(ii), a QCT is an area designated by HUD in which 50% or more of the households have an income which is less than 60% of the area median gross income (AMGI) for such year or a poverty rate of at least 25%. Under Sec. 42(d)(5) (C)(iii), a DDA is an area designated by HUD with high construction, land and utility costs relative to its AMGI.

Restricted Rent Guidelines

When qualifying LIHC projects, developers must operate within Federal and state restricted rent guidelines. Under Sec. 42(g), projects have to meet and maintain their minimum set-aside requirements (indicated on line 10c of Form 8609),by the close of the first credit period. The minimum set-aside requirements available are the 20-50 or 40-60 test. These tests require reserving a minimum of either (1) 20% of the units for residents whose income does not exceed 50% of AMGI or (2) 40% of the units for residents whose income does not exceed 60% of AMGI. (8) A third set-aside option, the 25-60 test, is available for New York City developers. (9)

Not all the units in a complex have to be part of the credit program; however, the LIHC applies only to the portion of a project that serves qualified low-income tenants. The rent for the qualified units must meet the guidelines. The typical rent for a unit is based on its size (i.e., the number of bedrooms) and is calculated at 30% of a tenant's annual income. (10)

Credit Amount

If the project meets and maintains Sec. 42's guidelines, the housing sponsor will receive an annual credit that depends on the financing terms. Under Sec. 42(b)(2)(B),the IRS prescribes an annual credit percentage that yields a present value of 70% of the qualified basis (30% when Federal or tax-exempt financing is used) over a 10-year period. The percentage changes monthly and is fixed for the project on election. For example, for buildings placed in service in June 2005, the annual credit rate is 8% and 3.4%. (11) In certain cases, the acquisition cost associated with rehabilitation WIU also be included in the project's qualified basis.

Exhibit 3 at right shows the qualified basis and credit calculations for the following examples:

Example 1: A developer constructs a 100unit building in 2005 at a total cost of $60,000 per unit with taxable financing, and reserves all of the apartments for low-income tenants.

Example 2: A housing sponsor using taxable financing acquires a 15-unit building in 2005 for $120,000, spends $200,000 on substantial rehabilitation and subsequently rents six units to low-income residents.

Before finalizing a project, a developer must submit the project's rental guidelines to the state's housing agency for approval. Typically, the rent allocated for each unit will include basic utilities, but exclude telephone service and other optional services. If the project's rental agreement requires tenants to pay their own utilities, they are then subtracted from the gross restricted rent level. A standard utility cost per unit is published by the state housing agency. The maximum rents established by the state housing agency are all-inclusive on a gross basis. Qualifying tenants may not be charged additional monthly fees if the cost of an item was included in the qualified construction costs. If it was not included, the sponsor can offer it to tenants for an additional fee, but cannot require them to take it as part of the rental agreement. (12)

Recapture

To take advantage of the LIHC, the program mandates that housing credit projects be privately owned. Typically, a limited partnership owns a project; the developer is the general partner (GP), with a 0.1% interest, and one or more investors are limited partner(s) (LP(s)), with the remaining 99.9% interest. The LPs are passive investors with no input into the project's day-to-day operations. They are only liable to the extent of their capital contribution and the potential LIHC recapture. If the project decreases its qualified basis or is noncompliant or voluntarily removed from the program before the end of the 15-year Federal partnership requirement, the investors are subject to recapture and have to file Form 8611, Recapture of Low-Income Housing Credit.

If there is a decrease in qualified basis due to a change in an investor's at-risk amount, the investor has to recalculate the LIHC taken in prior years under Sec. 42(k), before calculating the recapture. In most cases, a project will fall out of compliance due to the occupancy of unqualified tenants.

However, recapture does not apply if: (13)

1.The investor posted a satisfactory bond or pledged eligible U.S.Treasury securities as collateral;

2. The investor disposed of ownership held through an electing large partnership; or

3. The decrease in qualified basis does not exceed additions to qualified basis.

The GP is responsible for project management and for day-to-day operations. In an effort to offset the project's development costs, the sponsors (developers) receive a dollar-for-dollar reduction in their Federal tax liabilities, based on a percentage of the qualified project development costs, less any Federal grants received. This enables them to "sell" the housing credits to investors, which provides equity capital in exchange for tax benefits.

If a housing project is shown to be noncompliant and subject to LIHC recapture, the state housing agency must file Form 8823, Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition. Under Sec. 42(m)(1)(B)(iii), the housing agency must inform the IRS within 45 days of a project's noncompliance or disposition. This provides the Service with vital information about the project's failure, including project identification, owner's interest and disposition or noncompliance dates.

Investment Opportunities

Tax advisers recommend investment in qualified development projects as a way to qualify for the LIHC. However, like most investments, there is a degree of risk. If a housing project is poorly managed and goes bankrupt, investors could lose both their LIHCs and their initial investment. If this happens, they could claim an ordinary loss for the unrecovered investment; the tax treatment will be similar to a sale of depreciable property.

For investors that qualify for the LIHC, the credit is subtracted from their tax liability for the credit year. The credit continues for 10 years and, in some cases, may exceed the original investment. The credit is a general business credit; thus, it does not reduce an investor's alternative minimum tax.

Additional deductions may also be available to investors. Various deductions and real property ownership rights, such as loan interest deductions and cashflow after debt service, are typically passed through to equity investors and reported on their Federal and state returns. Further, if a low-income housing unit is held for 16 years and eight months, none of the additional depreciation is subject to recapture as ordinary income; hence, taxpayers will not record any Sec. 1250 ordinary income for the sale of the unit. (14)

To comply with Federal requirements and avoid LIHC recapture, investors must have an interest in the partnership for a minimum of 15 years. If a project remains in the program for the extended-use period of 15 years, both the income and rent restrictions are imposed for 30 years. After the requirements have elapsed, the GP can sell the project and distribute the proceeds to investors. If there is a profit from the asset sale, the partners qualify for the 15% long-term individual capital gain rate under Sec. 1(h)(1)(C).

The LIH program accounts for about 26% of the Federal government's funding for low-income housing. (15) Typical investors are large public corporations; however, investment opportunities are also available to high-net-worth individuals, C corporations and middle-income clients who expect to pay Federal income taxes for the next 10 to 12 years and have investment dollars available for a 15-year illiquid investment. In total, about 70% of LIHC credits are purchased by large public corporations through syndicated funds.

In recent years, LIHC pricing has begun to reflect a more mature market. In the early years, corporations motivated by tax savings rushed to the market to acquire $1 of tax relief for as little as $0.50. However, the laws of supply and demand have brought the industry to the point at which that same $1 of tax relief now costs as much as $0.80. The after-tax yields that were historically in the 12%-15% range have shrunk to 7.5%-8%. (16)

The higher prices and lower yields that come with a more mature market have also created a shift in investor activity for LIHCs, similar to the dynamics of other maturing real estate investments. The investment opportunity has moved from high-yield investors to lower-yield, risk-averse ones.

CRA

Given current yields and the prospect of rising interest rates, it is difficult to determine whether many of the traditional investors will remain in the LIHC market. There is a strong probability that many corporate investors will exit; however, financial institutions will likely continue accepting lower yields on these investments in return for CRA credits. (17) The CRA has been playing a larger role in these investment decisions, especially as financial institutions have positioned themselves for mergers since the 1999 repeal of the Glass-Steagall Act. (18)

Congress passed the CRA in 1977 to encourage depository institutions to meet the credit needs of low-income neighborhoods. The CRA directed Federally insured depository institutions to help meet the credit needs of the communities in which they operate. (19) The CRA directed bank regulators to evaluate the effectiveness of depository institutions in meeting the credit needs of their communities, including those of lower-income borrowers and neighborhoods, consistent with safe and sound banking operations. (20) It requires that a depository institution's record in meeting such needs be considered when the institution applies for depository facilities. (21) The focus on depository institutions reflected the fact that, at a time when intra- and interstate branching was largely proscribed, depositories were responsible for the majority of home mortgage and small-business lending in communities across the country.

In 1989, Congressional concern over the effectiveness of the CRA's oversight coincided with the Federal Reserve's denial, on CRA grounds, of an application by the Continental Bank Corporation to acquire Grand Canyon Bank of Scottsdale. The Federal Reserve ruled that, in light of inaccurate filings and a lack of significant efforts to ascertain the credit needs of its community, Continental Bank's commitment to improve its CRA performance did not absolve a weak CRA record. (22) In an equally significant move on the same day as that decision, the Federal Reserve released a policy statement outlining a more aggressive stance on the CRA, including a checklist of items that regulators should consider, when deciding whether to approve an application to merge, and a statement acknowledging the importance of public hearings and community input in the decisionmaking process. (23)

The most recent changes to the CRA occurred with the Gramm-Leach-Bliley Financial Modernization Act of 1999 (GLBA). (24) The GLBA mandates that depository institutions must have satisfactory CRA ratings before the institution, or its holding company, affaliates or subsidiaries, can engage in any of the expanded financial activities permitted under the law. The GLBA also requires public disclosure of agreements entered into by depository institutions and community organizations or other entities in fulfillment of CRA obligations. (25)

Millennial Housing Commission

In 2000, Congress created the Millennial Housing Commission to examine, analyze and explore the importance of affordable housing in the U.S. In a published report to Congress, "Meeting Our Nation's Housing Challenges," (26) the Commission stated its vision was to produce and maintain more affordable housing in healthy neighborhoods and to create economic opportunities for American families. The commission was appointed to review HUD's existing programs and to look for possible ways to increase the private sector's role in providing affordable housing.

Although the commission praised the LIHC and cited its success, it proposed one modification. It concluded that some of the requirements of the LIH program are outdated and prevent states and municipalities from responding to local production and preservation needs.

The Commission included four recommendations for addressing these concerns. First, it would allow sponsors of tax credit properties in low-income rural areas to set rental ceilings based on statewide median incomes. This would allow states to extend eligibility to areas in which the median income is low relative to construction costs, to stimulate housing production. Second, the Commission would remove restrictions preventing acquisition credits if the property changed hands within 10 years, because it believes these are an impediment to preservation. Third, the Commission recommended removing the limits against combining LIHC with assistance under HUD's Moderate Rehabilitation Program. Fourth, due to ambiguity, the Commission asked Congress to clarify which project costs can be included in eligible basis, because IRS Technical Advice Memoranda addressing this issue in 2000 were contrary to common industry practice. (27)

Conclusion

The LIH program accounts for 26% of the 5.2 million low-income households receiving housing aid from the Federal government. (28) In its current form, it has been extremely successful, raising the standard of living for low-income households, while maintaining a low program cost. The program's success can be attributed to minimal government intervention and the oversight of state housing agencies. This arrangement enables the continued investment of the private sector and provides developers with the necessary funding for new projects. When determining the scope of a proposed program expansion, Congress must take into consideration the current program's success and ensure that the same principles are maintained.

EXECUTIVE SUMMARY

* The Federal government allots a limited amount of LIHCs to state housing finance agencies, which are responsible for allocating them to developers in a competitive application and bid process.

* Taxpayers receiving allocations are generally entitled to an annual credit percentage that yields a present value of 70% of the building's qualified basis (30% when Federal or tax-exempt financing is used) over a 10-year period.

* As a general business credit, the LIHC is subtracted from the investor's regular tax liability annually for 10 years, and may sometimes exceed the original investment.

Exhibit 2: Basic credit calculation

LIHC (Sec. 42(a)) = qualified basis (Sec. 42(c)(1)) x applicable percentage (Sec. 42(b))

Qualified basis (Sec. 42(c)(1)(A)) = eligible basis (Sec. 42(d)) x applicable fraction (Sec. 42(c)(1)(B))

Applicable fraction (Sec. 42(c)(1)(B)) = lesser of unit fraction (Sec. 42(c)(1)(C)) or floor-space fraction (Sec. 42(c)(1)(D))

(1) See DiPasquale, Fricke and Garcia-Diaz, "Comparing the Costs of Federal Housing Assistance Programs," 9:2 Economic Policy Review 147 (June 2003).

(2) P.L. No. 95-128; 12 USC Section 2901.

(3) For further discussion, see Hawkins, "Misconceptions Associated with Low-Income Housing Tax Credit (LIHC) Valuations," 69 The Appraisal Journal 388 (October 2001).

(4) See Sec. 42(m).

(5) See Rev. Proc. 2004-71, IRB 2004-50, 970.

(6) See Symond, "Public Housing Finally Gets It Right--But It's Not Enough," 3625 Business Week (Industrial/Technology Edition) 124 (4/19/99).

(7) See the Instructions for Form 8609, p. 3.

(8) See id. at p. 4.

(9) See id.

(10) See Sec. 42(g)(2)(C); see also Hawkins, note 2 supra, at p. 390.

(11) See Rev. Rul. 2005-38, IRJ3 2005-27, 6.

(12) See Hawkins, note 2 supra, at p. 390.

(13) See the Instructions to Form 8611, p. 2.

(14) See Pope, Kramer and Anderson, Federal Taxation 2004: Comprehensive (Prentice Hall 2003), Individuals, Ch. 13, p. 15.

(15) See DiPasquale, note 1 supra.

(16) See Freeman, "Signs Point To A Maturing Industry," 41 Nat'l Real Estate Investor 58 (12/1/99).

(17) See id.

(18) 12 USC Section 377, repealed by P.L. No. 100-104.

(19) See 12 USC Section 2901(a).

(20) See 12 USC Section 2903(a)(1).

(21) 12 USC Section 2903(a)(2); for a discussion, see Dreier, "The Future of Community Reinvestment: Challenges and Opportunities in a Changing Environment," 69 J. of the American Planning Ass'n 341 (Autumn 2003).

(22) See Apgar and Duda, "The Twenty-Fifth Anniversary of the Community Reinvestment Act: Past Accomplishments and Future Regulatory Challenges," 9 Federal Reserve Bank of N. Y. Econ. Policy Rev. 169 (June 2003).

(23) Id.

(24) P.L. No. 106-102; 12 USC Section 1811.

(25) See Apgar and Duda, note 22 supra, at p. 174.

(26) See Report of the Bipartisan Millennial Housing Commission (5/30/02), available at www.mhc.gov/front.doc.

(27) See Schon and Tluchowski, "Millennial Housing Commission Delivers Report to Congress," 19 Real Estate Finance 26 (October 2002).

(28) See DiPasquale, note 1 supra.

Sean Showers, MBA

Senior Financial Analyst

Comerica, Inc.

Detroit, MI

Exhibit 3: Qualified basis and credit calculation examples

                                        Example 1     Example 2

Development cost                        $6,000,000
Less: land                                (200,000)
Eligible basis                          $5,800,000
Percentage of low-income units                100%

Acquisition costs (building and land)                  $120,000
Less: land                                               20,000
Eligible basis                                         $100,000
Percentage of low-income units                              40%
Qualified basis                                         $40,000
Applicable credit percentage                               3.4%
Acquisition credit                                       $1,360

Rehabilitation costs                                   $200,000
Percentage of low-income units                              40%
Qualified basis                                         $80,000
Applicable credit percentage                                 8%
Rehabilitation credit                                    $6,400

Total qualified basis                   $5,800,000
Applicable credit percentage                    8%
Annual credit                             $464,000       $7,760
Period of credit (years)                        10           10
Total credit over 10 years              $4,640,000      $77,600