The Low-Income Housing Tax Credit (“LIHTC”) is the single biggest tool we have in the United States for financing the construction of new, or the preservation of existing, affordable rental housing. The LIHTC is worth a dollar-for-dollar reduction in federal or state income tax liability, which can be monetized as a development source by both for-profit and nonprofit real estate developers. It is a prime example of how private equity can be used to further public policy goals, with a near 40-year track record of successfully providing profits while “doing good.”
Many of our banking clients are already involved in development projects utilizing the LIHTC on a regular basis, partly to earn Community Reinvestment Act (“CRA”) credits as well as for other reasons. We are also periodically asked by other banking clients whether they should consider LIHTC. LIHTC is a complex issue. While this article may seem a bit technical in parts, it will provide a general overview of the history and different types of LIHTC, how the credits are used, and explain why banks should consider investing in or lending to LIHTC projects here in Massachusetts.
The Federal Low Income Housing Tax Credit is a product of the bipartisan Tax Reform Act of 1986 (the “Tax Reform Act”). Prior to 1986, private investment in affordable rental housing development was mainly limited to wealthy individuals looking for tax shelters. The incentives for such investment were limited by the Tax Reform Act, while the incentives for homeownership (and thus homeownership development) remained robust. The Federal LIHTC program, codified in Section 42 of the U.S. Tax Code of 1986 (as amended, the “Code”), was created to balance this preferential treatment for homeownership and to standardize and increase investment in new rental housing for lower income families.
There are two basic types of Federal LIHTC: the 9% Federal LIHTC and the 4% Federal LIHTC. The 9% Federal LIHTC is competitively awarded to projects involving the construction of new buildings to be operated as affordable rental housing. It cannot be used to finance acquisition costs. The 4% Federal LIHTC can be awarded to finance the cost of acquiring an existing building (the “Acquisition Credit”) but is also given to an affordable housing project that has obtained tax-exempt bond financing for at least 50% of its total development costs. If structured carefully, both the 9% Federal LIHTC and the 4% Federal LIHTC can be used to finance the same project involving both new construction and the rehabilitation of existing buildings.
Congress allocates a certain amount of Federal LIHTC to each state every year. A designated state tax credit agency (a “State Tax Credit Agency”) for each state – here in Massachusetts it is the Executive Office of Housing and Livable Communities (“EOHLC”), formerly known as the Department of Housing and Community Development –awards the state’s allotment of 9% Federal LIHTC and Acquisition Credit to individual rental projects based on the competitive scoring of applications submitted by project developers. Scoring is determined by several factors including: total development cost, the number of affordable rental units created, and the length and depth of the affordability restrictions to which a developer is willing to commit. The annual maximum amount of 9% Federal LIHTC that can be awarded to each project will equal 9% of the project’s eligible basis (as determined in accordance with Section 42 of the Code). The 4% Federal LIHTC (other than the Acquisition Credit) is not competitively awarded by a State Tax Credit Agency, but rather is provided following the issuance of tax-exempt bonds for a project. The annual amount of 4% Federal LIHTC awarded will also be a function of the project’s eligible basis (multiplied by 4%) but must not exceed the minimum amount necessary to ensure the financial feasibility of the development and its viability as a qualified low-income housing project.
A project can claim its annual amount of Federal LIHTC every year for 10 years. In exchange for these credits, the project must be operated for a minimum of 15 years (the “Compliance Period”) in accordance with Section 42 of the Code and the rules and regulations promulgated thereunder (collectively, the “LIHTC Rules”). If a project does not comply with the LIHTC Rules during the Compliance Period, the Federal LIHTC may be subject to recapture. Most notable among the LIHTC Rules are the following: (i) in a development financed with Federal LIHTC, at least 40% of the housing units must be reserved (or “set aside”) for income eligible tenants earning 60% or less of Area Median Income (as defined for a given area by the U.S. Department of Housing and Urban Development) or 20% of the units must be set aside for tenants earning 50% or less of Area Median Income, and (ii) tenants cannot be charged more than 30% of their annual income in rent. These LIHTC Rules, among others, are incorporated into land use restrictions that are recorded against the real property on which a project is located. The terms of these recorded restrictions run for at least 15 years past the Compliance Period – hence they are referred to as “Extended Use Agreements” – and often run even longer than that, sometimes in perpetuity, depending upon what a developer committed to in its initial financing application.
A typical Federal LIHTC structure will involve a single purpose entity (“SPE”) – either a limited partnership or a limited liability company – that serves as the owner and operator of the project (the “Project Owner”). The general partner or managing member of the Project Owner will be another SPE controlled by the developer(s) of the project. While this entity will control the Project Owner and make all of the day-to-day operating decisions throughout the Compliance Period, it will hold only a tiny portion of the ownership interests in the Project Owner. The vast majority of the ownership interests – often 99.99% of them – will be held by a LIHTC investor (the “Investor”) that will enjoy limited liability so long as its authority to make decisions for the Project Owner is proscribed in the Project Owner’s partnership or operating agreement (the “Owner Agreement”). The Investor is often a bank or other financial institution but can also be a syndication fund comprised of one or more for-profit investors including a variety of large and small banks. The Owner Agreement will specify that the Federal LIHTC received by the Project Owner for the project will be allocated to the Project Owner’s partners or members in accordance with their respective ownership interests. In other words, as much as 99.99% of the Federal LIHTC will end up in the hands of the Investor and can be used to reduce its federal tax liability. In exchange for the Federal LIHTC, the Investor will contribute equity financing to the Project Owner for the project based on a negotiated price per credit. This equity contribution can then be leveraged to obtain private and/or publicly subsidized debt financing to fully fund the project’s development budget.
Following the success of the Federal LIHTC program, many states created analogous State LIHTC programs to further support the development of affordable rental housing in their own cities and towns. The Massachusetts Low-Income Housing Credit (the “MA LIHTC”) is competitively awarded just like the 9% Federal LIHTC and requires compliance with many of the same LIHTC Rules. Annual MA LIHTC awards are claimed over a 5-year period (not 10), so they generate only half of the revenue that Federal LIHTC can generate. But unlike Federal LIHTC, which cannot be sold and requires long-term investment in the project’s operating company, the MA LIHTC is a certificated credit that can be sold. Typically, a Project Owner will allocate or donate its MA LIHTC to a nonprofit corporation that will turn around and sell the MA LIHTC to a for-profit entity based on a pre-negotiated price per credit, then lend the proceeds of the sale to the Project Owner. It is not unusual for the purchaser of a project’s MA LIHTC to be the same financial institution providing Federal LIHTC equity and/or senior construction loan financing to the project. It is also not unusual for a bank that is not familiar with LIHTC transactions to “dip a toe” into transactions by purchasing MA LIHTC and relying on the existing underwriting of the project by other parties.
Thus, between the equity generated by Federal and MA LIHTC, public subsidy dollars, and debt financing during both the construction and permanent periods, much needed affordable housing can be built and preserved. Banks can generate valuable credit under the CRA for both debt and LIHTC investments in an affordable housing development. But that isn’t the only reason why banks should care about the LIHTC.
Compared to the volatility of the construction industry in general, the market rate housing market, and other commercial real estate sectors, affordable housing development has one of, if not the lowest, foreclosure rates. These development projects have predictable and relatively high investment yields, especially when a bank can combine a role on both the debt and equity sides of the deal. In short, a bank can invest wisely, underwrite a stable and successful project, and “do good” all at the same time.
We are available to speak with you more specifically about our experience representing lenders and developers in LIHTC-funded projects and help you consider your bank’s appetite for such a financial commitment.
This communication is for informational purposes only and is not legal advice on any specific facts or circumstances. In addition, the firm undertakes no obligation to update the information discussed in the foregoing article.