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Tax-credit essentials.

Low-income housing tax credits were created by Congress in 1986 to facilitate the rehabilitation and construction of multifamily residential property. Tax credits are spawning an entire sub-industry - structuring them, underwriting them, brokering them, managing tax-credit projects, ... and much more.

From 1986 to 1995, tax credits were used to build or rehab almost 750,000 residential units in the United States. (Figure 1) Although there was less funding available in 1995 than there was for 1994 ($385 million as opposed to $495 million a year earlier), projections for 1995 are that credits will have been used to finance about one-third of all multifamily construction in this country, or roughly 90,000 to 100,000 units. Thus, for anyone working in the real estate industry today, a knowledge of tax-credit financing is essential.

What Is a Tax Credit?

A Section 42 tax credit (so named because it is defined in Section 42 of the IRS code) offers a dollar for dollar deduction against the tax liability of an individual or corporation. The primary purchasers of tax credits today are corporations, accounting for approximately 75 percent of all tax-credit sales in 1994. With a few exceptions, tax credits may be applied to offset tax liabilities for 10 years in the future and may be carried back for three years. Section 42 credits do not affect the basis of a property, so there is no recapture. However, investors may receive some residual value from the sale or refinancing of the property at the end of the hold period.

Properties receiving tax credits must comply with resident requirements for a minimum of 15 years, but the trend in many states is to look for developers willing to extend that compliance for up to 30 years.

The tax-credit program was created by Congress but is administered by the state housing authorities. States have tremendous latitude in determining what projects receive credits, and every state's approach is different.

The positive aspect of state-based administration is that the states can allocate their credits to the areas where they see the greatest need. If there is a shortage of senior housing, more credits can be allocated there; if family housing is most in demand, those projects can receive priority. Currently, many states seem to be increasingly interested in seniors housing projects. However, the majority of credits nationally are still allocated to family projects.

State housing authorities allocate tax credits to projects - or more specifically to the limited partnerships that own the projects. Most typically, the general partner in these limited partnerships is either the developer or a non-profit sponsor that hires the developer. The general partner is responsible for the management of the completed project and generally receives the cash flow and, by law, at least 1 percent of the tax credits. Today, an increasing number of general partners are non-profit - state and local housing authorities, religious groups, and social service organizations.

The limited partners in the partnership are typically corporations, but may be pools of individual investors. These partners provide a substantial portion of the money needed to construct the project. In turn, they receive 99 percent of the tax credits, depreciation losses, mortgage interest deductions, and in some cases, a portion of the project's cash flow. The greater the perceived risk of the project, the more likely the limited partner is to demand a portion of the cash flow. Limited partners may own any percentage of the project, but the tax credits and the profit and loss (depreciation and interest deductions) must be allocated in the same ratio as ownership interest.

Because of an increased awareness and demand for tax credits, prices have risen from an average of $.37 in 1989 to $.55 today per dollar of credit. Interest rate fluctuations during 1994 affected yields, but have now largely stabilized. Today, internal rates of return on tax-credit properties range from 11 to 20 percent. Although the industry discusses "selling" tax credits, what is actually being transferred is the limited partner's position in the partnership, which entitles the new limited partner to use the credits. Tax credits are also syndicated by brokerage firms and sold from pools to corporate users and individuals.

In addition, some partnerships may have a "special" limited partner that provides social services to project residents and receives a part of the cash flow. These special partners provide another dimension to housing and are increasingly being required by housing authorities, especially if the project's developer is a for-profit entity.

Obtaining Tax Credits

To qualify for low-income housing tax credits, a project must set aside at least 20 percent of its units for households earning no more than 50 percent of the areas median income, or at least 40 percent of the units for households earning no more than 60 percent of the area's median income. States may also set special stipulations on the type of housing to receive credits or require special social service programs be added to the housing package. In addition, a project must be at least 80 percent residential to qualify for Section 42 credits.

While there are variations among state procedures, most states review applications for tax credits between May and November. And because most states receive many more applications than they have credits to allocate, it is important to follow application rules strictly.


1989 1990 1991 1992 1993 1994 1995


131.748 76,800 111,700 93,442 106,008 116,863 100,00

Source: National Council of State Housing Agencies

The largest pool of credits is allocated to states based on population - $1.25 of credits per capita, based on the last census. In addition, there are smaller credit pools for states that do an outstanding job in administration of the project and for reallocating unused credits.

Section 42 credits may be used for either new construction or rehabilitation. A 9 percent credit is given for new construction or substantial rehabilitation of projects. However, if the new construction or rehabilitation has used tax-exempt bonds to finance the project, only a 4 percent credit is available.

Projects in hard-to-develop areas, such as central business districts with high land costs, may receive credits based upon 130 percent of the cost basis of the project, making these developments more viable.

Because tax credits cover only a portion of development cost, state agencies granting credits are also concerned about available debt financing for the project. An obvious source is local lending institutions. Because banks can also qualify for lender tax benefits and receive credit under the Community Reinvestment Act, they will buy down the interest rates by as much as 300 basis points. The lender then receives the tax credits, and the developer receives cheaper financing.

Banks are also forming consortiums to underwrite tax-credit projects, although the lending decision still rests with the individual bank. Efforts to securitize mortgages for tax-credit projects may also have the effect of increasing lending.

Another source of debt for tax-credit projects is bond financing. One possible structure is to finance the project with taxable bonds - in order to obtain the higher 9 percent credit - and then sell the bonds to a pension fund, which has no tax liability.

The tax-credit developer may need additional financing components, such as block grants, local housing agency grants, or state financing seconds, to get the project constructed. Development fees may also need to be deferred until construction is complete or until the project sells. Typical loan-to-value ratios from banks are approximately 50 percent. If the tax-credit buyer only supplies 43 percent, there is still 7 percent of construction costs to cover.

Another prerequisite for obtaining credits is the ability to cover the initial expenses of development - design and architectural specifications, land options, and utility installation. This work may have to be done before the tax credit will be awarded. And, because there are no guarantees of receiving credits, these initial development costs are at risk.

The state authority also wants to know that the developer has either the expertise to manage the project or is committed to hiring someone who does. Most of our company's projects today have third-party fee managers with experience managing government-assisted housing. While the compliance requirements are different than Section 8 issues, compliance is a very important part of tax-credit management.

Monitoring Tax-Credit Code Compliance

States were given the responsibility to monitor tax-credit code compliance, but no funds to do the monitoring. The solution in most states is to charge the property owners for audits. All projects are audited when they are put in service so that the credit can finally be awarded. After that, a percentage of properties in a state are audited each year. (As an aside, many states are hiring third-party real estate managers to do audits.) Credits for any year may be decreased or may even be lost if the residents do not meet low- and moderate-income housing guidelines.

Who Benefits?

Communities benefit from new affordable housing and from the ancillary social services now being required by many states. Corporations benefit from tax credits to offset their income tax liability. Brokers benefit from commissions to put the deals together and from land sales to non-traditional buyers such as non-profit agencies.

Managers benefit from providing management or consultation to tax-credit properties, and in some cases from acting as state auditors for tax-credit compliance.

A Management Need

As the tax-credit housing industry matures, it is becoming increasingly evident that quality management is not only helpful but mandatory for Success.

In 1994, it is estimated that as many as 50 percent of tax-credit projects had compliance failures that resulted in the loss of credits. The first year of occupancy is especially critical. In most cases, knowledgeable management and continual monitoring could have prevented many of these problems and preserve credits now lost forever.


1. Federal government allocates credits to states.

2. State housing authority allocates credits to properties.

3. General partner creates residential rental property.

4. Limited partner owns project.

5. Corporate investor/limited partner uses credits.


Financial Analysis

Credit costs and rate of return Total invested dollars Available debt financing Limited partner exit strategy City, state, and sponsor commitment

Physical Analysis

Quality of constrution Development team experience Unit cost allocations

Market/Management Analysis

Regional and neighborhood trends Projected occupancies and tenant profile Property management qualifications

Ann Becher-Smead, CPM[R], is the director of real estate investment for Kaiser Aerospace & Electronics Corp., Foster City, Calif. The firm's real estate activity includes financing commercial and recreational properties, and the financing and development of affordable multifamily housing under the federal tax-credit program. Ms. Becher-Smead is responsible for the acquisition and management of all of the company's investment real estate.

Ms. Becher-Smead is the 1995 Course Board Director for IREM Course 400, a member of the IREM national faculty for Courses 400 and 500, and a member of several IREM national committees. She is a past president of IREM Chapter 29 and the recipient of the chapter's 1993 Special Achievement Award for Continued Chapter Service.
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Title Annotation:low-income housing tax credits
Author:Becher-Smead, Ann
Publication:Journal of Property Management
Article Type:Cover Story
Date:Mar 1, 1996
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