When Congress passed the Tax Reform Act of 1986, it was then-President Reagan's top domestic priority and it was a landmark piece of legislation. The purpose of the law was to simplify the tax code, reducing the number of tax brackets and lowering the top tax rate from 50% to 28%. But, that wasn’t the only major change. The law also created the Low Income Housing Tax Credit Program (LIHTC Program).
The LIHTC program is still used today as the federal government's primary housing policy tool to promote the development of affordable housing for US Citizens. The goal of the program is to provide developers with incentives for the construction of affordable rental housing. However, the execution of it can be confusing and bureaucratic.
The purpose of this article is to simply describe the federal low-income housing tax credit program. We'll discuss the different types of credits available and how they are used to promote development. We'll dive into how the credits are allocated and their use in financing the construction of LIHTC projects. Let’s start with a simple definition.
What Are Low Income Housing Tax Credits?
Low-income housing tax credits are incentives provided to developers that are used to offset the cost of constructing rental housing. In exchange for receiving the credits, developers must agree to reserve a portion of their newly constructed units for low-income households.
Types of Low Income Housing Tax Credits
There are two types of low-income housing tax credits; the “9% credit” and the “4% credit.”
What is the 9% Low Income Housing Tax Credit?
The 9% tax credit is reserved specifically for new construction projects or substantial rehabilitations. It is commonly referred to as the "new construction tax credit." It is by far the most popular of the two types because it can be used for a 70% subsidy of the funds needed to finance the construction project.
What is the 4% Low Income Housing Tax Credit?
The 4% tax credit - sometimes referred to as the "rehabilitation tax credit" - is used for rehabilitation projects that are financed with a minimum of 50% in federal tax-exempt bond financing. The 4% credit is designed to provide 30% of the funds needed to finance the project.
Now, this is where it can start to get a bit confusing. The United States Department of the Treasury uses a formula to calculate the credit rates that produce the 30% and 70% subsidies. The formula is dependent upon three factors: the length of the credit period, the desired subsidy level, and the current interest rate. Given these factors, the Treasury's formula determines the LIHTC rates that will deliver the desired subsidy levels. More on this below.
Regardless of the type used, the project must meet certain eligibility requirements to qualify for tax credit subsidies.
How Does a Property Qualify For Low Income Housing Tax Credits?
Per a report generated by the Congressional Research Service, properties must meet three eligibility requirements to receive an allocation of low-income housing tax credits. The requirements are property type, the rent charged, and tenant income levels.
With regard to property type, LIHTC eligible projects include multifamily buildings, single-family homes, duplexes, and townhouses. Eligible projects may include more than one building. For example, a garden-style multifamily apartment complex could have multiple buildings and still be eligible.
With regard to the rent charged, qualified LIHTC properties must meet the "gross rents" test, which mandates that the monthly rental price cannot exceed 30%, 50%, or 60% of the area median income, depending upon which "income test" the property is subjected to.
There are two types of income tests, the 20-50 test or the 40-60 test. With the first type, at least 20% of the affordable units must be occupied by individuals whose income limit is 50% or less of the area median income, which is adjusted for family size. With the second test type, at least 40% of the units must be occupied by individuals whose income is 60% or less of the area median income, which is also adjusted for family size (NOTE: NOVOGRADAC produces a handy calculator that can be used to calculate these income limits for every MSA in the United States).
If awarded, the property must offer affordable units for a 10-year period. Upon expiration of this compliance period, the units may or may not convert to "market rate" housing units.
How Are Low Income Housing Tax Credits Allocated?
Like many governmental processes, the allocation of low-income housing tax credits can be complex and lengthy. It starts in Washington DC at the federal level with the Internal Revenue Service (IRS) who administers the LIHTC program.
Federal Allocation to States
The credit allocation process begins when the federal government awards tax credits to each state based on their population. In 2021, states will receive a LIHTC authority equal to $2.8125 per capita with a minimum allocation of $3,245,625 for states with small populations. It should be noted that these are the "9% credits" which are competitive. The 4% credits are automatically awarded with tax-exempt bond-financed projects.
At the state level, the LIHTC allocation is managed by state housing finance agencies.
State Allocation to Developers
At the state level, tax credits are allocated to developers of eligible affordable housing projects according to a federally mandated "qualified allocation plan (QAP)." Federal law requires that the QAPs give priority to the housing projects that serve the lowest income census tracts and remain affordable for the longest period of time. Typically, credits are allocated two times per year and developers must apply for them by making proposals to state agencies for the development of rental units whose affordability will serve low-income families.
If a developer's application is successful, it does not necessarily mean that the tax credits will be claimed, it just means that they are set aside. Once received a developer generally has two years to complete their project and the credits may not be claimed until the project is completed and "placed into service."
Any tax credits that have not been allocated by individual states are placed into a national pool and redistributed to states that apply for them. To be eligible to receive these credits, a state must prove that they have exhausted their previous allocation. This approach encourages states to use all of the credits that they are allocated.
How Do Developers Use The Tax Credits?
Once awarded, a developer sells or exchanges their credits to investors and uses the money as an equity investment in their project.
In most cases, the sale of the tax credits is structured as a limited partnership between the developer and the investor and it is administered by tax credit syndicators. In the partnership, the developer acts as the general partner and owns a small percentage of the project, but has the authority to make all day-to-day management decisions. The investors act as limited partners and they have a larger ownership percentage, but their role is passive.
Unlike a typical equity investor, tax credit investors do not necessarily expect a traditional return from their investment. Instead, they purchase the credits for their tax benefits. Their "return" comes in the form of reduced tax liability through the application of the credits and any tax losses produced by the project by mortgage interest and depreciation. On the open market, the price for tax credits can vary, but they typically trade for 80 to 90 cents per dollar of tax credit available. The bigger the difference between the tax credit price and the face value of the credits, the larger the "return" for the investor.
In most cases, tax credit investors are large, profitable corporations who need the tax benefits and are incentivized to purchase them because they count towards compliance with provisions in the Community Reinvestment Act.
It should be noted that tax credits do not necessarily provide all of the equity financing needed to get a project off of the ground. In most cases, they only provide a portion of the total development costs and are usually combined with other sources of financing like traditional mortgage loans. In addition, individual tenants may also receive some sort of voucher or public housing assistance that can be used to pay their monthly rent once the project is complete.
To illustrate how this financing process works, an example is helpful.
LIHTC Project Financing Example
Suppose that a developer is looking to finance the construction of an affordable housing development with a total cost / qualified basis of $1,000,000.
Since the project involves new construction, it is eligible for the "9% credit." This means that the tax credit voucher will generate a stream of tax credits equal to $90,000 (9% x $1,000,000) per year for 10 years or $900,000 total. At the appropriate interest rate, this stream of tax credits is discounted so that the present value is equal to $700,000, which creates the 70% subsidy under the "9% credit" program.
With this reward in hand, the developer can sell these tax credits to private investors/taxpayers who can use them to offset their taxable income for the same 10-year period. The credits are sold as part of a syndication where the developer acts as the General Partner and the investor(s) act as the Limited Partner(s).
The developer uses the money received from investors and combines it with traditional mortgage financing and other sources of equity to complete the financing necessary to start construction.
Once construction is complete, a certain percentage of the units are "market rate" and a certain percentage are set aside for individuals whose gross income is at or below a certain percentage of the area's median income. These low-income tenants will occupy the property for 10 years, at which point the units usually switch to market rate.
To visualize the financing process, the following diagram created by the Tax Policy Center is helpful.
Summary & Conclusions
Passage of the Tax Reform Act of 1986 created the Low Income Housing Tax Credit Program. The aim of this housing program is to increase the nation's supply of affordable housing.
There are two types of tax credits. The 9% credit is used for new construction projects and the 4% credit is used for rehabilitation projects.
Tax credits originate at the federal level and are awarded to each state based on their population. In turn, states are responsible for allocating the credits to individual developers with eligible projects. In return for the tax credits, developers pledge to set aside a portion of the units in their project for residents whose income is at or below a certain percentage of the area's median income.
Once awarded, developers sell the tax credits to investors and use the proceeds as equity in their development projects. These funds are combined with traditional mortgage financing and possibly other grants from government agencies like the U.S. Department of Housing and Urban Development (HUD) and other nonprofits and used to construct the project.
Once complete, the project is “placed into service” and affordable units must remain in place for a period of 10 years. Once this time period expires, they switch to market rate. Though complicated, this program has been used successfully by governmental agencies, in partnership with private developers, to incentivize the construction of affordable housing.
