Low-Income Housing Tax Credit

From Wikipedia, the free encyclopedia

Taxation in the United States

This article is part of a series on
Taxation
Federal taxation
Authority · History
Internal Revenue Service
Court · Forms · Code · Revenue
Income tax · Payroll tax
Alternative Minimum Tax
Estate tax · Excise tax
Gift tax · Corporate tax
Capital gains tax
State & local taxation
State income tax · State tax levels
Sales tax · Use tax · Property tax
Federal tax reform

FairTax · Flat tax
Tax protesting

Tax protester arguments
Constitutional
Statutory · Conspiracy
Taxation by country
 view • talk • edit 

The Low Income Housing Tax Credit (LIHTC; often pronounced "lye-tech") is a tax credit created under the Tax Reform Act of 1986 (TRA86) that gives incentives for the utilization of private equity in the development of affordable housing aimed at low-income Americans. The credits are also commonly called Section 42 credits in reference to the applicable section of the Internal Revenue Code. The tax credits are more attractive than tax deductions as they provide a dollar-for-dollar reduction in a taxpayer's federal income tax, whereas a tax deduction only provides a reduction in taxable income. The "passive loss rules" and similar tax changes made by TRA86 greatly reduced the value of tax credits and deductions to individual taxpayers. As a result, almost all investors in LIHTC projects are corporations.

Contents

[edit] Overview

TRA86 adversely affected many investment incentives for rental housing while leaving incentives for home ownership. Since low-income people are more likely to live in rental housing than in owner-occupied housing, this would have decreased the new supply of housing accessible to them. The Low Income Housing Tax Credit was hastily added to TRA86 to provide some balance and encourage investment in multifamily housing for the poor. Over the subsequent 20 years, it has become an extremely effective tool for developing this housing.

As of 2006, as much as 30 to 40% of all new multifamily construction has received a subsidy under the program. The estimated cost to the federal Treasury in FY05 was $3.85 billion. The annual allocations under the program increased significantly in 2001 when Congress increased the state allocations by 40%.

A majority of tax credit projects also receive subsidies from other government sources. These additional subsidies, which can include development grants and loans at below-market interest rates from local and state governments, can account for a third of total capital subsidies. Thirty-nine percent of low-income tenants also receive rental assistance in the form of housing voucher from HUD's Section 8 program. Though common, these are not necessarily present in a project that benefits from the LIHTC.

[edit] How it works

The LIHTC provides funding for the development costs of low-income housing by allowing a taxpayer (usually the partners of a partnership that owns the housing) to take a federal tax credit equal to a large percentage of the cost incurred for development of the low-income units in a rental housing project. Development capital is raised by "syndicating" the credit to an investor or, more commonly, a group of investors. To take advantage of the LIHTC, a developer will typically propose a project to a state agency, seek and win a competitive allocation of tax credits, complete the project, certify its cost, and rent-up the project to low income tenants. Simultaneously, an investor will be found that will make a "capital contribution" to the partnership or limited liability company that owns the project in exchange for being "allocated" the entity's LIHTCs over a ten year period. The amount of the credit will be based on (i) the amount of credits awarded to the project in the competition, (ii) the actual cost of the project, (iii) the tax credit rate announced by the IRS, and (iv) the percentage of the project's units that are rented to low income tenants. Failure to comply with the applicable rules, or a sale of the project or an ownership interest before the end of at least a 15-year period, can lead to recapture of credits previously taken, as well as the inability to take future credits. These rules are described in greater detail below.

[edit] Application process

The first step in the process is for a project owner to submit an application to a state authority, which will consider the application competitively. The application will include estimates of the expected cost of the project and a commitment to comply with either of the following conditions, known as "set-asides":

  • At least 20% or more of the residential units in the development are both rent restricted and occupied by individuals whose income is 50% or less of the area median gross income.
  • At least 40% or more of the residential units in the development are both rent restricted and occupied by individuals whose income is 60% or less of the area median gross income.

Typically, the project owner will agree to a higher percentage of low income usage than these minimums, up to 100%. Low income tenants can be charged a maximum rent of 30% of the maximum eligible income, which is 60% of the area's median income adjusted for household size as determined by HUD. There are no limits on the rents that can be charged to tenants who are not low income but live in the same project.

[edit] Program administration

The program is administered at the state level with each state getting a fixed allocation of credits based on its population. The state housing agency has wide discretion in determining which projects to award credits, and applications are considered under the state's "Qualified Allocation Plan" (QAP). The credits are usually awarded to projects in a few "allocation rounds" held each year, on a competitive basis. Typically, the top ranked project will get credits, then the second, and so on until the credits are exhausted for the round. A portion of each state's credits must be "set aside" for projects sponsored by non-profit organizations, although non-profits more typically apply for credits under the "general" rules, without regard to the set-aside.

This allows each state to set its own priorities and address its specific housing goals. It also encourages developers to offer benefits that are better than the established minimums when competing against other projects (e.g., charging lower rents, or maintaining the low income requirements for a longer number of years, will often improve a project's rank in the competitive process; it is important to check the particular state's QAP and application to see how it makes these judgments).

Not all projects claim the low income credit based on this competitive process. Projects that are financed by tax-exempt bonds can also qualify for the credit. Tax-exempt bonds are also limited on a state-by-state basis, and the state agency responsible for bonds may be different, but it will generally apply similar rules than the agency responsible for the tax credit program.

[edit] Terms & Conditions

The project owner must agree to comply with Section 42 and maintain an agreed percentage of low income units in a "Land Use Restriction Agreement" (LURA) which is recorded. Under the LURA, the project is required to meet the particular project's low income requirements for a 15-year initial "compliance period" and a subsequent 15-year "extended use period" (or longer, if required by the local authority; the extended use rules were added in 1989, and do not apply to projects developed in the first few years of the program.) The credits are subject to "recapture" if the project fails to comply with the requirements of Section 42 of the Tax Code during the 15-year compliance period.

[edit] Eligible basis

The "eligible basis" of a project is the cost of acquiring an existing building if there is one (but not the cost of the land), plus construction and other construction-related costs to complete the project. (For example, the costs of obtaining permanent financing, or "syndicating" the credits to an investor are not included. Adjustments must be made for federal grants as well.). This is then multiplied by the percentage of the units that are "low income", in accordance with the conditions described above, to determine the project's "qualified basis" that actually qualifies for the credit. For this reason, many developers agree to make 100% of the units low income in order to maximize the potential tax credits. Projects for (1) new construction and (2) the cost of rehabilitating an existing building, if not funded by tax-exempt bonds or "below market federal loans", can receive a maximum tax credit allocation of approximately 8% to 9% of the project's eligible basis annually. The cost of acquiring an existing building (but not the land), provided the building was (in general) last "placed in service" at least ten years earlier, and projects financed in whole or in part with tax-exempt bonds or below market federal loans, are eligible for a credit of approximately 3 to 4% annually. The credit percentages are announced monthly by the Internal Revenue Service.

[edit] Credit limitations

Regardless of the result of these computations, the credit cannot exceed the amount allocated by the state agency. For example, suppose a project cost $100,000 for land, $400,000 for an existing building that was most recently placed in service more than 10 years ago, and $1,000,000 for rehabilitation; also suppose that the applicable percentages are 8.5% and 3.5%, that the project will be 80% low income, that there are no tax-exempt bonds or below market federal loans, and that the state agency awarded $70,000 per year of credits. The credits are computed as follows -- (1) the cost of the land is not eligible for credits; (2) the maximum annual credit for the purchase of the building is $400,000 times 80% times 3.5%, or $11,200; (3) the maximum annual credit for the rehabilitation is $1,000,000 times 80% times 8.5%, or $68,000. The total maximum annual credits, $79,200, is more than the amount of credits awarded by the state. As a result, the project is limited to $70,000 of credits per year.

The credits are not provided in a lump sum but instead are claimed in equal amounts over a 10 year "credit period" (many projects claim credits over 11 years, due to the rules governing how many credits can be claimed in the first year of the credit period). Thus, the $70,000 of annual credits described in the illustration will yield a total of $700,000 of credits over the credit period.

[edit] Syndication & Partnership

As mentioned above, the credit is used to generate private equity, often prior to, or during, the construction of the project. Developers typically "sell" the credits by entering into limited partnerships (or limited liability companies) with an investor, with 99.99% of the profits, losses, depreciation, and tax credits being allocated to the investor as a partner in the partnership. The developer serves as the general partner/managing member, and receives a majority of the cash flow (either through the payment of fees, or through distributions). The funds generated through the syndication vary from market to market and year-to-year. Although 85-95¢ for each total dollar of tax credits was common in the first several years of the 21st century, recent turmoil in the financial markets has reduced some of the demand for tax breaks, meaning that investors are paying somewhat less, as of early 2008. So, for example, $10,000 credits annually for the next 10 years would be $100,000 total, and a developer could probably raise $75,000-$85,000 through syndication, which is less than could have been raised for the few years prior to 2008. Further, due to the fact that depreciation on the buildings owned by the partnership is also tax deductible, and that depreciation is allocated 99.99% to the investor, investors may pay still more for the total tax benefits. (Indeed, when the credit alone was selling for 95 cents per dollar of credit, there were some cases where investors actually paid slightly more than a dollar for a dollars worth of tax credits plus other tax benefits.)

An investor will typically stay in the partnership for at least the compliance period, because a reduction in its interest can also result in recapture of the credits. An investor wishing to exit the partnership before the end of the compliance period may post a surety bond to avoid credit recapture.

The following table summarizes the relationship between the developer and outside investors. NOTE: This is only meant to demonstrate the concept of partnerships for such projects and is not to be taken as literal guidelines for developing a LIHTC project.

LIHTC Partnership Structure
Party Developer Investor
Partner Level General or Managing Limited
Management of Project Yes No
Partnership Control Primary some veto rights
Share of LIHTC 0.01% 99.99%
Share of Initial Equity 0.01% 99.99%

States are also responsible for monitoring the ongoing development costs, quality and operation of approved projects, as well as the enforcement threat of notifying the IRS of "noncompliance" if the project deviates from the applicable requirements of the Code and the LURA, described above. Such a notice can lead to recapture of previously taken credits and inability to claim credits from the project in the future. The IRS has published Form 8823 for the purpose of reporting possible problems with the project, and its Guide to the Form 8823 that details the IRS view on various issues related to noncompliance.

[edit] See also

[edit] External links

[edit] State Agencies Allocating Low Income Housing Tax Credits