New Hampshire is currently facing a critical shortage of affordable housing. In the years between 1993 and 2003 New Hampshire's population grew more than any other New England state. While that growth fostered many economic opportunities, it put intense pressure on the housing market. The shortage in housing drove average house prices up, resulting in an even greater shortage of affordable housing.
One tool that developers have used over the past twenty years to develop affordable housing is the Low Income Housing Tax Credit. The Low Income Housing Tax Credit ("LIHTC") program was enacted as part of the Tax Reform Act of 1986. It is embodied in Section 42 of the Internal Revenue Code (the "IRC"). Development of affordable housing using LIHTCs is extremely complicated and subject to many complex tax rules. The purpose of this article is to present a "tree top" level analysis of some of the concepts involved in the LIHTC program. The ultimate decision about whether to undertake a development using LIHTCs must be made with careful consideration of the specific factors relating to the particular project, and the advice of both an accountant and attorney experienced in the use of LIHTCs.
I. The Program
The objective of the LIHTC Program is to provide investor equity to reduce the need for debt and thereby reduce rents. An investor buys credits and gets a dollar for dollar reduction against the investor's tax liability. The investor takes the tax credits over a ten-year period. One of the many quid pro quos of receiving tax credits is that the property will be burdened by restrictions insuring that the property is kept affordable for at least 30 years and as long as 99 years.
Although the LIHTC is a federal program set forth in the tax code, LIHTCs are awarded, and largely monitored, by state housing agencies. In New Hampshire the program is run by the New Hampshire Housing Finance Authority ("NHHFA"). Developers apply for the credits from NHHFA. There is basically a competition for 9% credits (as defined below) between developers. The competition takes place in two rounds. One round is held in the winter with credits awarded in early spring. The second round is held in the late spring with credits awarded in early summer.
In order to compete for credits the developer is required to fill out and submit an application to NHHFA. To qualify the development must satisfy the criteria set forth in NHHFA's Qualified Allocation Plan. The Qualified Allocation Plan sets forth the guidelines for administering the LIHTC program and sets forth the scoring criteria for developer's applications. In each of the two rounds NHHFA scores the applications and awards credits. Not every applicant receives credits. Every state has a finite number of credits to be awarded each year based on the population of the state. The current annual allocation for New Hampshire is approximately $2,500,000.
II. The Credits
There are two types of LIHTCs, the 9% (or 70% present value) credit and the 4% (or 30% present value) credit. Although they are called the "9% credit" and the "4% credit", the Treasury recomputes the annual percentage for each credit such that it will yield a present value of 70% and 30% over a ten-year period. By way of illustration the 9% credit may actually be set at 8.69% and the 4% credit may be actually set at 3.76%.
III. The Types of Credit
A. The 9% Credit
The 9% credit can be used for the cost of constructing a new building and substantial rehabilitation of an existing building, both of which are not federally subsidized. The definition of "new building" includes residential rental properties, i.e. an apartment building, single family dwelling, condos and row houses. The term "new building" means a building where the initial use of that building is by the taxpayer receiving the credits. For a building to be "substantially rehabilitated" the expenditures during any 24-month period must equal 10% of the building's depreciable basis, determined the first day of the 24-month period or an average of $3000 per low income unit, whichever is greater. The 9% credit for substantial rehabilitation is available even if the owner has held the building for a number of years.
In order for a project to fully utilize 9% credits it cannot also be receiving federal subsidies. This is a fairly complex area. Section B, below will discuss the use of tax-exempt bonds, but there are also various rules surrounding federal grants and loans. An overly broad general rule is that federal grants and loans reduce the eligible basis of a project. The concept of eligible basis will be broadly discussed below. However, certain federal funds are nevertheless excluded from the definition of federal subsidies if certain requirements are met; examples of these types of federal funds are HOME funds and CDBG Funds.
B. The 4% Credit for New Buildings and Substantial Rehabilitation
The 4% credit can also be used for the cost of a new building or substantial rehabilitation, but unlike the 9% credit discussed in A, above, this credit can be taken when the building is federally subsidized. Although there are special rules that deal with federal grants and loans, the scenario where the 4% credit is generally utilized in New Hampshire is where the development receives the proceeds of a tax-exempt bond, which will be issued by NHHFA.
There are some rules developers must keep in mind when using this type of 4% credit. First, the issuance of the bonds will be subject to the amount of bond availability awarded to NHHFA by the State in any given year. Sometimes NHHFA has excess bond capacity, but in recent years the demand has been high, and they have been bumping up against their bond cap. Second, and very complex, is the 50% test. Section 42 (h)(4) of the IRC states the general rule that a project may qualify for LIHTCs only for that portion of the eligible basis of the project financed with tax exempt bond proceeds. For example, if tax exempt bonds are 40% of the project's eligible basis, the project would qualify for 40% tax credits, however, this would generally still leave a gap in the dollars necessary to fund a development. A developer could always go into the competitive round for the difference, but this really isn't a practical solution. If a developer could score high enough in the competitive round he would just go after 9% credits at the outset. In order to deal with this problem Section 42 (h)(4)(B) sets forth the "50% test". The 50% test states that if 50% or more of the aggregate basis of the building and the land on which the building is located are financed with tax-exempt bonds the tax credits can be obtained and no allocation (i.e. the need to go through the competitive rounds discussed in A, above) is needed for any portion of the tax credits. Careful planning is necessary to satisfy the 50% test.
C. The 4% Acquisition Credit
This 4% credit is available for the acquisition cost of an existing building. In order to be eligible for this credit a number of requirements must be satisfied. More specifically:
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The building must be "substantially rehabilitated" to qualify for the acquisition credit.
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The building must be purchased from an unrelated party.
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The building must satisfy the so-called "10 year rule". The 10 year rule states that at least ten years must have elapsed between the date the owner acquires a building and the later of:
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The building must not be previously placed in service by the taxpayer or by any person who was a related person.
The most difficult component to satisfy is generally the "10 year rule". If there was a change in ownership anytime in the past ten years a new "placed in service date" is set and the 10-year rule cannot be satisfied.
D. Fundamental Basis Calculations
Generally speaking the tax credit is computed using the project's "qualified basis". The qualified basis is arrived at by taking the project's "eligible basis" and multiplying it by the "applicable fraction" (both as defined below).
Calculation and timing rules with respect to eligible basis are a bit different for new construction and substantial rehabilitation, but the items that can be included in eligible basis are fairly consistent. "Eligible basis" includes costs attributable to engineering studies, architectural specifications, certain relocation expenses, construction hard costs, certain legal and accounting costs, contractor fees, developer fees (subject to certain rules), construction period interest and construction period taxes. The cost of land is explicitly excluded from eligible basis.
The "applicable fraction" is the lower of the number of occupied "low income units" vs. total units or the floor space of occupied "low income units" vs. total floor space.
E. A Very Rough Example
Let's take a project utilizing the 9% credit, and apply the following specifics:
| A 100 unit project with 80 low income units
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| Total Development Cost (including land):
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$5,500,000
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| Land Value and other ineligible costs:
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($ 500,000)
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| Eligible Basis:
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$5,000,000
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| Qualified Basis (the Eligible Basis x Applicable Fraction-$5,000,000 x 80%-the 80% being 80 low income unitsout of 100)
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$4,000,000
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| Applicable Percentage (assume the 70% present value/9% credit is being used)
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| Annual Credit ($4,000,000 x 8.25%)
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| 10 Years of Credits
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$3,300,000
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The price an equity investor will pay for credits fluctuates. The past 2-3 years have seen unprecedented high purchase prices for each tax credit dollar. However, in the last 6-9 months prices have been dropping. Currently investors are paying somewhere between $.88 and $.94 per tax credit dollar, so in our scenario above, assuming $.88 per tax credit dollar, an investor would pay in roughly $2,904,000 as equity.
F. Comparing the Pros & Cons of Each Credit
Although there are many pros and cons in choosing one credit over the other, here are a few of the considerations developers must face when determining which type of tax credit to use to finance an affordable housing development:
1. Pros of the 9% Credit
- Majority of cost of development funded through equity
- Project can carry less debt
- Active and competitive equity investor market
2. Cons of the 9% Credit
- Credits awarded only twice per year.
- Very competitive-Although both for profit and not for profit developers can receive tax credits there is a non-profit set aside where 10% of a state's availability is set aside for not for profit developer. Sometimes as many as ten applicants with only two or three awarded credits.
3. Pros of the 4% Credit
- Somewhat lower cost of capital due to tax exempt rates
- Not as competitive as 9% credits
4. Cons of the 4% Credit
- Project carries higher debt
- Subject to state bond cap
In order to fully analyze the pros and cons of the two types of credits, it is important to sit down with someone who can really "crunch the numbers".
IV. Other Basic Requirements
A. Set Asides
In order for a project to receive tax credits it must set aside units within the project to be designated for qualified low income tenants. More specifically, for a project to be eligible for tax credits it must satisfy, at the election of the developer, either the so-called "20-50 test" or the "40-60" test". The 20-50 test mandates that 20% or more of the residential units must be rented to tenants with incomes of 50% or less of the median gross income, adjusted for family size. The 40-60 test mandates that 40% or more of the residential units must be rented to tenants with incomes of 60% or less of the median gross income, adjusted for family size. In order to fully understand these tests we need to discuss the concepts of adjustment for family size and median gross income.
1. Adjustments for Family Size
Adjustments for family size are generally done on the same basis as under the HUD Section 8 program. In determining whether the set asides have been satisfied the combined incomes of all occupants of a unit, whether legally related or not, is compared to the appropriate percentage of median family income for a family with that number of members. The following Table reflects the approximate adjustments for families with 1 to 4 members:
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Family Size
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50% Test
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60% Test
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5
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55%
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66%
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4
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50%
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60%
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3
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45%
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54%
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2
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40%
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48%
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1
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35%
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42%
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The Treasury Department is authorized to adjust the income limits.
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2. Area Median Gross Income
Area median gross income figures are published for certain standard metropolitan statistical areas by HUD annually in January or February and are applicable for the entire year. For example towns like Plaistow and Atkinson are located in the "Lawrence, MA-NH area". The median family income level for this area is $78,200. HUD also prints the adjustments for family size applying roughly the percentages set forth above.
B. Rent Restriction Rules
Gross rent (including utilities) cannot exceed 30% of the qualifying income standard (i.e. 50% or 60% of area median income) applicable to the project. In calculating the rent restriction an imputed income limitation applies based on the number of bedrooms in the unit. Prior to 1990 adjustment were made on the actual size of the family. After 1990, in order to provide some degree of certainty in upfront calculations, the tax code was amended to base rent restrictions on the number of bedrooms, as opposed to the number of persons actually occupying a unit. The rent restriction is based on 1 individual per unit in a studio apartment and 1.5 individuals per bedroom in the case of a unit that has a separate bedroom(s). So a three bedroom unit would be presumed to have 4.5 persons living in the unit.
C. A Very Rough Example #2
Using the limitations set forth above with respect to set asides and rent restrictions, it may be useful to do a very rough and approximate example with respect to a family living in the Lawrence, MA-NH area.
Let's make the following assumptions: assume a developer elects the 40-60 test, and his project has a two bedroom apartment for rent and a four member family wants to rent the apartment.
- Test #1 set aside income limitation: Based on the table set forth in A, 1 above, in order to satisfy the income limitation this family can have total income no greater than 60% of area median gross income, or $78,200 x 60%=$46,920.
- Test #2 the rent restriction test: To satisfy this test no more than 30 percent of the qualifying income standard may be used to pay gross rent. First, multiply the number of bedrooms in the unit x 1.5. This yields an imputed family size of 3 (the fact that the actual family has 4 members has nothing to do with this computation). The rent for this unit may not exceed 30% of the area median gross income for a family of three ($78,200 x 54% = $42,228).
To plug the above into our example for a four member family to satisfy the 40-60 test the family's income may not exceed $46,920. The rent charged for that two bedroom unit may not exceed 30% of $42,228 or $12,668.40 per year, or approximately $1055.70 per month.
As stated above, this example is very rough. It does not include any utility allowances and naturally rent limits may change with changes in median income.
V. Conclusion
As stated above, the purpose of this article was to provide a very broad view of some of the issues involved in utilizing LIHTCs in an affordable housing development. The concepts set forth in this article are only the tip of a very large iceberg. There are a lot of other important and complex requirements and considerations that a developer has to wrestle with when undertaking a tax credit project, including, but not limited to, NHHFA's construction standards, the many requirements of equity investors, carryover allocations, the role of soft debt, caps on developer fees, NHHFA's maximum investment limitations and a host of other issues. Notwithstanding the level of complexity, however, the Low Income Housing Tax Credit program has been a valuable tool to help fill the gap in the shortage of affordable housing in the State of New Hampshire. If a developer is truly serious about undertaking an affordable housing development, the LIHTC program can be an important tool in making the development a reality.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.
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