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INTRODUCTION TO LOW-INCOME HOUSING TAX CREDITS
Structuring a Project’s Limited Partner Equity
October 2011
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The Tax Credit Program
A housing subsidy program for rental housing
Created within Section 42 of the Internal Revenue Code Modified by 2008 and 2009 Legislation
Administered by each state’s housing finance agency
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The Tax Credit Program
Each state receives an amount of credits annually in tax credits to allocate to projects $1.75 per capita in 2003, inflated annually $2.00 in 2008 (“published rate”)
Increased to $2.20 by 2008 legislation Similar increase for 2009
Returned to published rate after 2009 2010: $2.10 2011: $2.15
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What Do Tax Credits Finance?
New construction and rehab projects Acquisition in some cases Housing for families, special needs tenants, single
room occupancy and the elderly Urban, rural and suburban locations Additional tax incentives for projects in high-cost or
difficult-to-develop areas
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How Do Housing Tax Credits Work?
Rental units with tenants earning no more than 60% of area median income
Investors earn dollar-for-dollar credits against their federal tax liability
Investors also get tax benefits from losses Generally, tax credits are received over the first 10
years of operation Some tax credits are recaptured by the IRS if the
project does not comply for 15 years
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Unit Restrictions
Threshold Elections – Who can live there?40/60 election20/50 electionAll tax credit units must be within election parameters
Rent Restricted – How much can tenants pay?Rents and utilities – limited to 30% of threshold income
Allowable rent based on size of unit
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Tenant Income Restrictions
Families must earn less than threshold income
Based on HUD median income data, adjusted for family size
Next Available Unit Rule
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Tax Credits vs. Tax Deductions
No Tax Credit/ No Deduction Deduction
Net Income from Operations
1,000,000 1,000,000
Tax Deductions none (300,000)
1,000,000
none
Taxable Income 1,000,000 700,000
Tax Credit
Tax Liability:Tax at 40% tax rate $ 400,000 280,000
Low-Income Housing Tax Credits none
none
Net Tax Liability $ 400,000 $ 280,000
400,000
(300,000)
$ 100,000
1,000,000
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No Tax Credit/ No Deduction
Additional Deductions
and Credits
Net Income from Operations
1,000,000 1,000,000
Tax Deductions none (300,000)
Taxable Income 1,000,000 700,000
Tax Liability:Tax at 40% tax rate $ 400,000 280,000
Low-Income Housing Tax Credits none 300,000
Net Tax Liability $ 400,000 ($ 20,000)
Tax Credits vs. Tax Deductions
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Structure –Tax Credit Syndication
Limited partnership structure
General partner owns just 0.01%, but controls and operates the project
Passive limited partner invests equity in return for 99.99% ownership
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Sale to Investor Limited Partner of most of the tax credits and tax losses maximizes investor equity
More investor equity reduces other financing needs and helps project development
L.P. is a passive investor, and gets its return almost exclusively from the tax credits and losses
Structure –Tax Credit Syndication
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The Parties in a Tax Credit Syndication
Development Team Developer General contractor Architect Attorney Accountant Property manager Consultants
Lenders Construction lender Permanent lenders Lender attorneys
State Housing Finance Agency
Syndicator Underwriter Fund manager Attorney
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Types of Tax Credits
9% Credit and
4% Credit
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Types of Tax Credits: New Construction/Rehab
9% New Construction/ Rehab Credit - the standard kind of tax credit
4% New Construction/ Rehab Credit - used when project is financed by tax-exempt bonds (and subsidized federal financing if placed in service before 07/31/08)
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Types of Tax Credits
Actual Credit rates published monthly
November 2011:
7.44%* and 3.19%
*For 9% credit projects, 2008 legislation allows buildings placed in service after 07/30/08 and prior to 2014 to use minimum rate of 9%
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Types of Tax Credits:Subsidized Federal Financing
For buildings PIS before 7/31/08 Federal Financing with rate below AFR
and Tax-Exempt Bonds, must Use 4% credit, or Reduce basis by the amount of subsidized federal financing
or tax exempt bonds Exceptions:
CDBG Loans not considered to be subsidized HOME Loans – additional restrictions Interest rate on federal loans raised to the AFR
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Use of Tax-Exempt Bonds and 9% Credits
General Rule: Eligible for 4% Credit
Exceptions: Reduce Basis by amount of tax-exempt bond financing AFR rate does not allow for use of 9% credit
Not changed by 2008 Legislation
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Tax Exempt Bonds
Eligible for 4% credits No allocation of credits needed No carryover allocation required
No 10% Test
50% Test: Bond amount must exceed 50% of depreciable basis plus land Construction period bond financing Bonds must stay in place until at least one month after completion
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Types of Tax Credits: Acquisition Credit
4% Acquisition Credit –
used when you purchase an existing building that qualifies
Substantial rehab 10 year rule, if applicable
Exceptions No basis boost
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Computing Tax Credits: Basis
Eligible Basis
X
Applicable Fraction
X
Basis Boost (if applicable)
=
Qualified Basis
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Computing Tax Credits: Annual Tax Credits
Qualified Basis
X
Tax Credit Rate
=
Annual Tax Credits
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Computing Tax Credits: Total Tax Credits
Annual Tax Credits
X
10 (Years)
=
Total Tax Credits
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Computing Tax Credit Equity
Total Tax Credits
X
Pay Price (Cents per dollar)
=
Equity
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Computing Basis to Calculate Credits
Eligible Basis - Depreciable basis of
residential rental housing eligible for
tax credits
Qualified Basis - Adjust Eligible Basis for
non-income qualified tenants, using
“Applicable Fraction”
(the % of units qualifying for credits)
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Applicable Fraction
Lesser of:
The number of qualifying rent-paying residential units over the total number of rent-paying residential units
or The square footage of qualifying rent-paying residential
units over the total square footage of rent-paying residential units
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Basis Boost – Increase tax credit basis by 30% if project is in a “qualified census tract” (QCT) a “difficult to develop area” (DDA) or
A state designated difficult development area Does not apply to tax-exempt financed projects Applies if building or project is placed in service
after 07/30/08
Computing Basis to Calculate Credits
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Eligible Basis – Excludes the following:
land and land-related costs
building acquisition and related costs
historic tax credits taken on residential part of project
fees and costs related to permanent loan financing
syndication-related costs
tax credit fees
reserves
post-construction working capital
federal grants
non-residential costs
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Includes Impact Fees Onsite Roads, sidewalks and parking lots
Offsite if adjacent, functionally related and owner maintained
Cost of Utility Hookup Landscaping if adjacent to building Final grading of building site
Eligible Basis
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Excludes: Initial grading Landscaping not adjacent to building
Includes: Common area Full time manager’s unit Community space
Eligible Basis
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Space used to provide services that will improve the quality of life for community residents, and be appropriate and helpful to individuals
in the area of the project
Examples: day care center, medical clinic, Meals on Wheels
Included in eligible basis if: Project located in a Qualified Census Tract Designed to serve families earning less than 60% AMI
Community Service Facility
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Amount included in basis limited to:
Projects placed in service after 07/30/08 25% of first $15 million of eligible basis 10% of remaining eligible basis
Projects placed in service before 07/31/08 10% of eligible basis
Community Service Facility
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Computing Acquisition Basis
Cost of purchasing building can qualify, including acquisition-related costs, only if: building is substantially rehabilitated building meets requirements of 10-year rule
No basis boost is permitted for a project’s acquisition basis
If not 100% low-income, only low-income percentage of cost can qualify
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Computing Annual Tax Credits
Total Development Budget $9,632,000 Less ineligible costs 1,062,500 Eligible Basis $8,569,500 Applicable Fraction x100% QCT/DDA Basis Boost x 130% Qualified Basis $11,140,350
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Computing Annual Tax Credits: 9% Credit
Qualified Basis $11,140,350
Applicable Rate*** x 9.00%
Annual Tax Credits $ 1,002,631
***Published rate would apply if PIS before 07/31/08 or after 2013.
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Computing Total Tax Credits and the Equity Raise: 9% Credits
Annual Tax Credits $ 1,002,631 10 Years x 10 years Total Tax Credits $ 10,026,310 Price Paid x $0.80 Equity $ 8,021,048
Equity represents 83% of development costs
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Computing Annual Tax Credits: 4% Credit
n Qualified Basis $11,140,350
n Applicable Rate (Nov. 2011) 3.19%
n Annual Tax Credits $355,377
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Computing Total Tax Credits and the Equity Raise: 4% Credits
n Annual Tax Credits 355,377$ n 10 Years x 10 yearsn Total Tax Credits 3,553,770$ n Price Paid x $0.80n Equity 2,843,016$
Equity represents 30% of total development costs
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Structuring the Project
Step 1: Estimate tax credit basis Step 2: Estimate tax credits generated Step 3: Estimate investor equity Step 4: Estimate first mortgage amount Step 5: Estimate the funding gap Step 6: Fill the gap with a combination of
other funds
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Sources of Funding to Fill the Gap
HOME, CDBG funds AHP Funds ARRA Funds – TCAP and Exchange Other Local Funds Deferred Development Fee Cost Savings (development or acquisition) Modification of First Mortgage Terms Income or Expense Modifications
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Tax Credit Timeline
Apply for tax credits Get a tax credit
reservation Receive carryover
allocation Incur more than 10% by
required date Complete project and
place it in service
Apply for 8609s for all buildings
Record extended use agreement
Rent tax credit units to qualified tenants
Elect when to start tax credits
Keep tax credit units in compliance
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Placing a Project in Service
Project must be “placed in service” by the end of the second year following the Allocation Year
Example: Credits allocated in 2010 Carryover met in 2011 All buildings in project must be placed in service by
December 31, 2012
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Placing a Project in Service
New Construction When first unit is ready Certificate of Occupancy
Rehabilitation – more flexibility No earlier than the date when the rehab equals the greater of:
$6,000 per unit or 20% of acquisition price
Lower amount of rehab required if placed in service prior to 07/31/08
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Financial Structuring: Kinds of Debt and Grants
“Hard” Debt:
Must pay, conventional bank debt
Generally amortizing
“Soft” Debt:
Generally from governmental agencies
Cash flow contingent or accruing
Repayable
Grants: not repayable
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Grants
Grants – funds that are not repayable or cannot be repayable under reasonable assumptions Outright grants Forgivable loans Cannot be repaid at maturity
Tax treatment Income recognition Potential basis reduction if federal funds
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Development Grants – funds that are used directly or indirectly to fund development costs Basis must be reduced Could flow through GP as a loan
At the AFR, if 9% deal PIS prior to 07/31/08 Lower rate allowed if after 07/31/08 Caution – reallocation and residual test issues
Federal Grants
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Operating Grants – funds that support the operations of the project Building PIS after 07/30/08:
No basis reduction Income must be recognized
Building PIS before 07/31/08: Reduction of eligible basis Income must be recognized Exceptions for Sec. 8, Sec. 9, Shelter plus care
Federal Grants
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Special Situations
Historic Tax Credits Add value to a deal, but rigid procedures and approvals are
involved. Eligible basis for LIHTC reduced by the amount of the
historic credit
Energy Credits and Green Subsidies Credits for energy efficient appliances, solar energy property
and other environmentally beneficial enhancements to project
Special needs deals have structuring issues related to the length and strength of subsidies
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American Recovery and Reinvestment Act of 2009
Recognized Economic Conditions and Shortage of Investor Equity
Significant Funding for Housing related issues Tax Credit Assistance Program –
$2.25 billion for LIHTC gap funding through HOME
Exchange of LIHTC Authority for Grants Allowed state agencies to exchange:
All of their 2008 and earlier unused allocations, and 40% of their 2009 allocations
Credit exchanged for $ .85 per credit dollar
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The Syndicator’s Approach To Underwriting
Quality of the Development Team Project Characteristics Evaluation of the Development Budget Rents/ Market/ Marketability Operating Costs Reserves Sponsor Guarantees
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Concerns Being Evaluated
Reputations of the developer, general contractor and other members of the team
Design considerations of the project Quality of materials to be used Timelines for construction and lease-up Useful life analysis – will it continue to attract tenants
as it ages? Market analysis – are rents supported by outside
analysis?
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Quality of the Development Team
Sponsor/ general partner experience Architect/ engineer – design, supervision General contractor – size and type of construction,
capacity to produce on time Attorney and Accountant – experience with tax credit
partnership structure and issues Property manager – experience with low-income
tenants and management capability Consultants to fill in holes in experience
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Evaluation of Project Characteristics
Need - does it answer a real need in the community? Finances - does it meet the syndicator’s financial
threshold? Quality - will it continue to attract tenants? Strategic Interest - does it meet the syndicator’s
programmatic needs? Geography - is it located where syndicator and its
investors want to invest?
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Evaluation of Development Budget
Can the project be completed in the time and within budget What will it cost to build the project? How much is needed to place it in service? What are reasonable timelines?
What are the key risk areas to lenders and equity investors and how can the risks be ameliorated?
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Rents/Market/Marketability
Are rents realistic for the market area? What is demand for proposed housing?
neighborhood what demographics will project address
Are tax credit rents sufficiently below area market rents?
Are HOME, other requirements factored in?
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Evaluation of Operating Costs
Examine assumptions for proposed costs Are insurance, etc. costs confirmed by bid? Are repair and maintenance costs consistent
with housing type and family size? If there’s an elevator, are its costs included? Are legal, accounting and administrative
costs high enough? Are reserves funded in a plausible way? Do costs need to be restructured for cash flow?
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Structuring Project Reserves
Reserves are a way to structure for the project’s risks
Operating and lease-up reserves protect against inadequate cash flow
Replacement reserves provide funds for capital replacement when needed
Other reserves (for tenant services, etc.) are structured for specific needs or risks0
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Sources of Funds for Reserves
Operating reserves usually come from
investor equity, but may come from cash flow Operating reserves are paid in over time to optimize the
use of equity Replacement reserves usually are funded
from cash flow, but may come from equity Some projects need replacements reserves earlier than
cash flow permits, requiring equity Special-needs housing may not have
cash flow for reserves, which may be funded from equity
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Sponsor Guarantees
Allocate costs related to specific risks to the developer and related parties
Areas where guarantees apply may include: development cost overruns delays in construction completion and lease-up operating deficits until stable operations reduced or delayed tax benefits partnership management
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