Low Income Housing Tax Credits

Mixed Finance.

A. Generally.

1. Any affordable housing development in which a public housing authority combines private financing with public housing development funds to develop public housing units is governed by 24 C.F.R. pt. 941, subpt. F.
2. Mixed finance initiatives are not the "privatization" of public housing. Rather, mixed finance projects are the "partnering" of the public and the private sectors to create economically viable but affordable housing and revitalized communities.
3. Mixed finance initiatives cause public housing authorities (PHA) to become owners, developers, general contractors, ground lessors, lenders of construction, gap and permanent financing, landlords and property managers.
4. The primary reason for mixed finance initiatives is reduced federal funding.

B. Current Developments.

Quality Housing and Work Responsibility Act of 1998

QUAHWRA, as included in the FY 1999 VA/HUD Appropriation Act, contains extensive changes to public housing and tenant-based subsidy program finance and operation. The legislation significantly amends the United States Housing Act of 1937 (the 1937 Housing Act). QUAHWRA establishes and confirms certain guidelines for HOPE VI and mixed-finance public housing development. It also revises operational and capital funding methods, permits use of public housing operating funds to pay debt service for debt-financed projects, and confirms HUD's ability to permit public housing assets to be used as collateral for such financing. HUD is now working on a Federal Register notice that will identify changes in the 1937 Housing Act that are effective this year and will provide initial implementation guidance for each new provision.

New methods of financing, funding and collateralizing debt for public housing development under QUAHWRA have moved public housing projects further toward the private development model. With various ownership and financing structures available, and where property or funds are provided as collateral or as credit enhancement, lenders, bondholders and, perhaps, rating agencies may now begin to look at PHAs as being investment grade, allowing for greater draw of private capital to public housing development projects. Where HOPE VI funding is unavailable, a PHA may possess opportunity for investment by private lenders or partners, in combination with other available state and local programs, enough to satisfy community revitalization needs.

HOPE VI

For several years, given reduced availability of capital funding for public housing rehabilitation and redevelopment, and the corresponding deterioration of public housing stock, HOPE VI has been the only means by which PHAs could obtain sufficient funding to undertake extensive development of their public housing communities. HOPE VI funding, and the mixed-financing tools with which the program has been instituted, were largely provided and developed under successive appropriations acts and the mixed-financing guidelines published by HUD on May 2, 1996.

QUAHWRA does not make extensive revisions to many current practices, but does provide legislative confirmation of prevailing public housing revitalization efforts. Section 535 of QUAHWRA establishes a revised Section 24 of the 1937 Housing Act, titled "Demolition, Site Revitalization, Replacement Housing, and Tenant-Based Assistance Grants for Projects." Although the new Section 24 largely leaves the HOPE VI program intact as currently administered, it also contains certain revisions of interest.

QUAHWRA now explicitly permits use of HOPE VI funds for tenant-based assistance in tenant relocations. The new Section 24 also permits demolition without requiring revitalization and relocation. This, combined with the permanent rescinding of the one-for-one replacement, allows PHAs to eliminate under-utilized and dilapidated inventory, but understandably raises concerns among resident groups. Additionally, although successful HOPE VI applications have generally relied on a combination of funding sources, often calling for non-HOPE VI public and private contributions of 50 percent to 65 percent of the total project development budget, QUAHWRA now mandates that grantees supply matching funds equal to 5 percent of the total HOPE VI grant amount. An exception to this matching requirement is provided for grants used solely for demolition or tenant-based assistance.

Former Section 24 had authorized the Secretary to waive certain rules governing rents, income eligibility and preferences, and some of this flexibility is removed from the new provision. HUD is, so far, uncertain of the immediate effect of Section 535 of QUAHWRA, and is working to determine whether the new Section 24 will apply to revitalization projects that have already been funded under prior HOPE VI authority.

Mixed Finance

Perhaps more significantly, QUAHWRA, at Section 539, adds a new Section 35 to the 1937 Housing Act, titled "Mixed Finance Public Housing." Section 539 describes permitted ownership structures of mixed-financed projects, and allows greater flexibility for use of operating funds. Previously, operating subsidies had to be kept isolated from other project sources and could not be used to pay off debt or capital funds of non-PHA owned property. Under the new Section 35, operating fund subsidies may be contributed to mixed financed projects with mixed ownership. A mixed-finance project is defined as a project that receives funding from private resources and also is assisted by public housing capital or operating funds.

Mixed-finance projects are allowed great flexibility in their ownership structure. They may be developed and owned by:

• A PHA or affiliate entity;
• A partnership, limited liability company or other entity in which a PHA or its affiliate is a general partner, managing member or otherwise participates; or
• An entirely private entity that grants the PHA a first right of refusal to purchase the project at the end of the compliance period.

For tax credit properties, rents for tax credit units may be set at the maximum level for the LIHTC program, provided that rents for public housing residents do not exceed public housing restrictions.

Operating Funds

QUAHWRA replaces the current Performance Funding System, and establishes an Operating Fund as a new vehicle to provide Section 9 operating subsidies to PHAs. The new funding method is to be in place by October 1, 1999. The Secretary is charged with establishing the formula for distributing this funding to PHAs. QUAHWRA lays out the following criteria that the Secretary may consider in establishing the Operating Fund formula:

1. Standards for costs of operation, taking into account project, tenancy and community characteristics;
2. Number of units owned or assisted by a PHA;
3. Number of chronically vacant units, and amount of assistance appropriate for such units;
4. Level of economic self-sufficiency programs and services provided by a PHA;
5. Need for anti-crime and anti-drug activities; and
6. Amount of public housing rental income lost by a PHA due to tenant escrow savings accounts established under its family self-sufficiency program.

Well-managed PHAs are also to receive the full benefit of their successful efforts to increase the earnings of their public housing residents and to reduce utility and waste management costs.

The final formula for funding under the Operating Fund will be developed over the next year through negotiated rulemaking with participation by PHAs and other affected parties. In the event that a funding formula can not be agreed to by the end of FY 1999, the Secretary may extend the Operating Fund's effective date for up to six months, until April of FY 2000.

Once established, QUAHWRA allows that Operating Fund moneys may be used by PHAs to pay debt incurred in financing the rehabilitation and development of public housing units, subject to "reasonable requirements" imposed by HUD. In addition, PHAs will be permitted to provide private and public/private developers of mixed-financed projects a pro rata share of the operating subsidy for any public housing units in such projects.

Capital Funds

Section 522 of QUAHWRA repeals Section 14 of the 1937 Housing Act, eliminating the Modernization Fund. Capital assistance is now provided under Section 9(d) of the 1937 Housing Act, through a Capital Fund. PHAs with fewer than 250 units will be permitted to combine their Capital Fund and Operating Fund resources for use in either area, allowing greater flexibility in meeting the immediate needs of these smaller PHAs.

Collateralization Permitted

In addition to QUAHWRA, the VA/HUD Appropriations Act, at Section 208, contained another significant amendment to the 1937 Housing Act. In a revision of Section 14(q)(1), the Appropriations Act allows drawdown of PHA capital funds for use as collateral or credit enhancement of bond financed projects. By amending Section 14(q)(1), Congress confirmed HUD's ability to permit collateralization, a practice that was already in use for several PHA projects throughout the country. Flexible modernization funds may be drawn down on a schedule, commensurate with construction draws, for deposit in an interest bearing trust account to serve as collateral or credit enhancement for bonds issued by a public agency to finance construction or rehabilitation.

Grant of Security Interest in PHA Property Permitted

Under Section 516, QUAHWRA now also permits HUD to authorize a PHA to mortgage or grant a security interest in any public housing project or other PHA property. The provision is included as part of a new Section 30 to the 1937 Housing Act, titled "Public Housing Mortgages and Security Interests," and states that the Secretary may permit such mortgaging of PHA property after considering:

1. The ability of the PHA to use the mortgage proceeds for low-income housing uses;
2. The ability of the PHA to make payments of the secured loan; and
3. Such other criteria as the Secretary may specify.

Merger of Certificate and Voucher Program PIH 98-64

QUAHWRA, at Section 545, also codified the permanent merger of the Section 8 certificate and voucher programs into a single voucher program. As specified in PIH Notice 98-64, issued on December 18, 1998, the new voucher program will go into effect after HUD completes its review of recommendations from organizations representing PHAs, owners and management agents, Section 8 participants and legal advisers. In the meantime, PHAs are to continue to administer their voucher and certificate programs in accordance with current program regulations and requirements until otherwise notified by HUD.

Now that the 90-day delay in reissuing Section 8 assistance is eliminated, PIH 98-64 also states that PHAs may immediately issue all authorized turnover certificates and vouchers if the PHA has sufficient annual budget authority.

Resident Homeownership Modification

Section 518 of QUAHWRA eliminated Sections 5(h) through 5(k) of the 1937 Housing Act. Section 5(h) of the U.S. Housing Act provided the statutory authority for resident homeownership programs of public housing. The revised homeownership authority is now found in a new Section 32 of the 1937 Housing Act.

Section 536 of QUAHWRA adds Section 32, which now authorizes resident homeownership programs. A program under this new section can cover any existing public housing dwelling units or projects, and any other units acquired for use under such program by the PHA. Only low-income families assisted by a public housing agency, other low-income families, and entities formed to facilitate sales to low-income families through resale are eligible.

The new Section 32 also allows a PHA to use Capital Funds, or other earned income, to assist public housing residents in purchasing a principal residence, including a residence outside a public housing project.

The Mixed-Finance Guidebook

HUD recently made available its Mixed-Finance Guidebook, which will likely take a prominent place on the shelves of PHA administrators and others involved in public housing redevelopment. The guidebook contains useful information on the mixed-finance development process, and addresses issues concerning procurement and the HUD-approval process that had remained ambiguous under previous guidance.

The guidebook can be ordered at no charge by calling 1-800-955-2232.

Low-Income Housing Tax Credits - An Overview.

A. The Low-Income Housing Tax Credit was enacted as part of the Tax Reform Act of 1986. The credit was generally effective as of January 1, 1987.

B. The credit is an indirect subsidy of low-income housing. Eligible taxpayers receive the subsidy by claiming a tax credit on their federal income tax returns.

C. The credit is claimed pro-rata over ten years and can be used in connection with both newly constructed and renovated residential rental buildings.

D. Allocation of the credit is administered independently by the states. Taxpayers must apply to the applicable state housing agency to obtain an allocation.

E. Once a project is ready for occupancy, it is generally eligible for the credit every year for ten years. To continue generating the credit and to avoid tax credit recapture, the affordable housing project must satisfy specific low-income housing compliance rules for a full fifteen year period.

F. The credit percentage is about 9% for new construction and qualified rehabilitation costs, and about 4% for qualified acquisition costs. No credits will be allowed with respect to a project unless the project constitutes a qualified low-income housing project by the end of the second calendar year after credits are allocated.

G. Every project must make a minimum set aside election: agree to either rent 40% or more of the units to persons making 60% or less of area median income (the 40/60 test) or 20% or more of the units to persons making 50% or less of area median income (the 20/50 test). Based upon the minimum set-aside election, a project will be a qualified low-income housing project only if: (1) 40% or 20%, as applicable, or more of the residential rental units in the project are occupied by individuals with an annual income, as adjusted for family size, that is 60% or 50%, as applicable, or less of area median gross income; and (b) the annual rent charged for each otherwise qualified low-income rental unit does not exceed 30% of 60% or 50%, as applicable, of area median gross income. The minimum set-aside requirement must be initially satisfied no later than the close of the first year of the credit period and must then continue to be satisfied throughout the 15-year compliance period in order to avoid the reduction of credits and/or the recapture of credits previously claimed.

H. The "qualified basis" of a project for each taxable year of the credit period will be its "eligible basis" multiplied by the lower of the "unit fraction" or the "floor space fraction," computed each year as of December 31 (the applicable fraction). The unit fraction is the ratio of low-income units in a building to the building's total residential rental units. The floor space fraction is the ratio of the floor space of the low-income units in a building to the total floor space of all residential rental units. A unit will not be a qualified low-income unit includable in the numerator of the applicable fraction unless it is "for use by the general public." A project complying with the housing policies governing nondiscrimination as evidenced by rules and regulations issued by the U.S. Department of Housing and Urban Development (HUD) will be considered to satisfy the so-called "general public" requirement. Therefore, project units must be advertised and rented in compliance with HUD rules to avoid a reduction of the anticipated applicable fraction.

I. The third component in computing the annual credit for a project is the applicable percentage. The applicable percentage remains the same throughout the credit period. The applicable percentage can locked-in at the carryover or when the project is placed in service.

J. Previously claimed credits could be recaptured if, prior to the close of the 15-year credit compliance period (a) the project is sold or otherwise disposed; (b) the project ceases to be a "qualified low-income housing project;" (c) the qualified basis of the project is less than the amount of such basis in the prior taxable year; or (d) the person taking the credit disposes of more than 1/3 of its interest in the entity which owns the project. The amount of additional tax liability incurred with respect to a credit recapture event occurring during the 10-year credit period generally would be the sum of (i) one-third of the difference between all credits previously claimed and the credits which would have been available if the credit recapture event had occurred in the first year of the credit period; and (ii) statutory interest on the recaptured credits commencing with the taxable year in which the recaptured credits were claimed. The credit recapture amount in (i) above is reduced by 20% per year for credit recapture events occurring in years 11 through 15 of the 15-year compliance period. Notwithstanding the occurrence of a credit recapture event arising from the sale of the project, no credits would be recaptured if the project entity furnishes an adequate bond to the IRS and it is reasonably expected that the building will continue to be used as low-income housing for the duration of the 15-year compliance period. If such a bond were furnished, it would be drawn against if there were subsequent credit recapture events with respect to the building.

K. The credit and certain other credits allowed by the Internal Revenue Code constitute a taxpayer's "current year business credit" under Code Section 38(b). The current year business credit is of benefit to a taxpayer only to the extent the taxpayer otherwise would have a tax liability for the taxable year, and then only to the extent that the credit for that year does not exceed certain limitations contained in Code Section 38(c). In general terms, Code Section 38(c) limits the amount of business credits that a taxpayer may use in a year to the excess (if any) of the taxpayer's net income tax over the greater of (a) 25% of so much of the taxpayer's net regular tax liability as exceeds $25,000; or (b) the taxpayer's tentative minimum tax for the taxable year, reduced by the lesser of the taxpayer's regular investment tax credit not used against the normal limit or 25% of the taxpayer's tentative minimum tax for the year. Section 39 of the Code provides that the unused credit may be carried back three years or forward 15 years.

Low-Income Housing Tax Credits - Select Topics.

A. Anatomy of the Deal.

1. Players:
2. • Sponsor - applies for the tax credits and has the project vision.
   • Developer - often times the same entity or person as the sponsor and receives a fee for putting together the project. Sometimes there are co-developers, particularly in the instance of nonprofit involvement in the project.
   • General Partner - usually related legally or otherwise with the sponsor or developer. Although the general partner appears to have very broad obligations to the project, more often than not those obligations are delegated to the developer, general contractor or architect and property manager.
   • Limited Partnership or Limited Liability Company - owns the project and is the entity contractually obligated for the financing, construction and operation of the project. In reality, the entity passes the obligations and tax benefits to its partners and members.
   • Investor - the "silent" partner in the transaction who provides the equity and receives the tax benefits of the project.
   • State Housing Authority - allocates the credits, may provide financing and monitors compliance issues.
   • Lenders - there are construction, permanent and bridge lenders. Lenders receive interest or other returns (e.g., community reinvestment act) on their loans.
3. Components:
4. • Concept - Imagine a project and make sure that it pencils.
   • Site control - locate a potential site and purchase or "control" (e.g., get option, place under agreement of sale) it. Relevant business and legal matters include drafting agreement of sale, title matters, survey, environmental assessment and market study.
   • Tax Credit - apply for and obtain tax credits and then hold on to them until you are able to close.
   • Land use - obtain necessary zoning and site development approvals -- potential NIMBY issues. Relevant business and legal matters include negotiation with town and community groups and township zoning and subdivision hearings.
   • Construction - obtain bids, engage contractors and an architect. Relevant business and legal matters include drafting AIA contracts, plans and specifications and obtaining payment and performance bonds.
   • Financing - obtain commitments from construction, permanent and bridge lenders as well as grants and subsidies from the private and governmental entities (e.g., FHLB, county, municipality). Relevant business and legal matters include negotiation of loan terms and loan documents, including promissory notes and mortgages, and provision of closing checklist items, including construction contracts, survey, title insurance, insurance, organizational documents and legal opinions.
   • Equity - obtain and negotiate investment proposals. Relevant business and legal matters include amount and timing of the investment and amount and type of guaranties (e.g., construction guaranty, operating deficit guaranty and tax credit recapture guaranty).
   • Management - lease up, maintain and monitor tax credit compliance of the project.

B. Reservations and Allocations.

1. Although a tax credit on federal income, the credits are allocated by the states.
2. The tax credits available in each state is determined by the population of the state: $1.25 per person. For example, in 1997, Pennsylvania had 15,070,000 credits to allocate and Delaware had only 906,250. States may also have access to returned or unused credits from a prior year and credits in the national pool.
3. Each state is required to devise a qualified allocation plan (QAP) to determine the state's priorities in awarding credits -- i.e., targeted or blackout areas, new construction or rehabilitated housing, studios or four bedroom units, elderly or rural. Each state is required to set aside at least ten percent of its tax credits for housing sponsored by nonprofit entities. In many states, the involvement of a nonprofit entity in project may be determinative of its ranking.
4. Competition for credits is keen. In many states, the number of project seeking credits outnumbers the amount of available credits by a factor of five or more. Application are ranked based on the QAP, with the highest ranking project receiving tax credit reservations (i.e., letters of intent).
5. A tax credit allocation is generally made when the state housing agency issues IRS form 8609. The allocation must be made in the calendar year in which the project is placed in service (i.e., ready for occupancy), unless the project is financed by tax-exempt bonds or the owner of the project and the state housing authority enter into a tax credit carryover agreement.
6. While the requirements for a valid carryover are relatively straightforward, the pitfalls are numerous and the implications of an invalid carryover are draconian: loss of tax credits.
7. To carryover tax credits, the taxpayer must incur at least ten percent of its reasonably expected total basis in the project by the end of the year in which the credit is allocated. There is no grace period for meeting these requirements and if they are missed, the project may not qualify for tax credits.
8. The following are some recommendations to avoid some common pitfalls in the process of preparing valid carryover allocations:
9. • incur a 2% to 5% buffer on the minimal 10% test B incur more than the 10% of reasonably expected total basis to provide a buffer in case the IRS reviews the costs and finds that some of them should not have been included.
   • obtain title to the real property B the taxpayer is not required to own the real property on which the project will be located, it is only required that the taxpayer have a basis in land or other depreciable property equal to 10% by the end of the year.
   • • (1) if the property will be acquired with purchase money financing, a small cash down payment and/or below market rate of interest may result in a reduction of the cost of the land.
   • make sure that the entity to which credit has been allocated is the same entity which incurs the 10% B the entity owning or have the requisite interest in the property must be the one or incur or is obligated to pay the 10% costs, not the sponsor, the developer or an affiliate.
   • determine which costs can be included in meeting the 10% test B not all costs are includable, however, many are, including acquisition costs of land and existing buildings, transfers taxes, architectural design fees, engineering fees and construction costs.
   • adhere to accounting rules -- costs do not have to be paid, they only need be incurred (i.e., the amount is fixed and determinable, there is a legal obligation to pay and title and risk of loss to property and materials has passed).
   • avoid dependence on accrued developer's fees -- an agreement between the project owner and the developer should properly document the services to be performed by the developer, the time or times when the developer's fee is earned and the time or times when the developer's fee is due and owing.
   • avoid improper spending of grants -- expenditures using grant proceeds may not count towards the 10% test unless the proceeds of the grant are contributed or loans to the owner of the project before the funds are spent.
   • complete allocation documentation properly -- a valid carryover agreement must include the address of the building, the name, address and EIN of the building owner, the name and address of the state housing credit agency, the EIN of the agency, the date of the allocation, the credit dollar allocable to the project, the owner's reasonably expected basis in the project as of the close of the second calendar year following the calendar year in which the allocation is made, the owner's basis in the project as of the close of the calendar year in which the allocation is made and the percentage such basis bears to the total reasonably expected basis of the project, the expected date that the building will be placed in service and the building identification number for each building. The state housing agency has the authority to make administrative corrections.
   • consider locking in your credit rate.

C. Soft Financing.

1. Because the rent restrictions for housing units for which low-income housing tax credits are available limit rent to no more than thirty percent of the imputed income limitation applicable to a unit, which generally cannot exceed more than sixty percent of the area median income, the amount of conventional financing that may be used to construct or rehabilitate a building is limited. Therefore, developers of affordable housing often rely on alternative sources of funds to assist in the financing of a project. Examples of such funds are the Community Development Block Grant (CDBG), HOME funds, Housing Opportunities for Persons with AIDS (HOPWA), Act 137 and grants.
2. The common characteristics of soft financing is low or no interest rate, debt service accruals or deferrals and long terms.
3. Each of these sources of funds may raises structuring issues. For example:
4. • tax credits require eligible basis and grants to not provide basis
   • federal grants (e.g., HOPWA) reduce basis
   • federal subsidies (e.g., proceeds of tax exempt bonds and loans funded in whole or in part with federal funds at an interest rate below the applicable federal rate) are only entitled to the 4% credit
5. Even if soft financing can be structured to avoid a loss in basis or reduction of credit percentage, several other important tax principles may come into play including problems arising from large interest accruals and premature reduction in limited partner capital accounts potentially causing a reallocation of credit from limited partners to the general partners.