Investing in Low-Income Housing Tax Credits

By Michael J. Novogradac, Managing Partner, Novogradac & Company LLP

For community banks that may be unfamiliar with the concept, the Low-Income Housing Tax Credit (LIHTC) Program makes federal tax credits available to owners of affordable rental properties. The credits owe their existence to the Tax Reform Act of 1986 and were intended to facilitate the development of low-income rental property. Since their inception, the program has been instrumental in the construction or rehabilitation of more than1.6 million affordable housing units that otherwise might not have been built.

How Banks Benefit from LIHTCs

The chief economic benefit derived from an LIHTC investment is the opportunity to claim a federal tax credit. The credit is earned over a 15-year period, but claimed over an accelerated 10-year time frame beginning in the year the property is placed in service and occupied. Since qualifying investments result in decreased tax liability, the economic return is not subject to state or federal taxation. Thus, the tax credits they generate are inherently more valuable than the same dollar amount of taxable income earned from an alternative investment.

Owners of LIHTC properties are also able to shelter taxable income from both federal and state taxation through deductions for depreciation. Additional state housing tax credits may be available in the state in which the LIHTC property is located, which can enhance investment returns even further. And as a final added benefit, regulated depository institutions, which are all subject to the requirements of the Community Reinvestment Act (CRA), may receive consideration for LIHTC investments in the determination of their CRA ratings.

Owners of LIHTC properties must maintain the property's low-income designation for a minimum of 15 years for the LIHTC to be fully earned. There is also a second 15-year extended compliance period effective for all projects receiving an allocation of credits after 1989. However, once the initial 15-year compliance period is complete, the Internal Revenue Service cannot recapture the tax credits, and investors can exit the partnership.

How LIHTC Investing Works

Banks seeking LIHTCs may purchase interests in entities (e.g., limited partnerships and limited liability companies) that provide bank investors with a stream of tax credits and losses generated by an underlying affordable rental property. LIHTC entities are structured as real estate partnerships under the Internal Revenue code (26 UCS 704(a)) in order for a bank to be considered a passive investor/limited partner to receive a distributive share of the tax credits and other passive losses. Investments can be made either directly or through a fund offered by a syndicator. Both options allow for differing degrees of investment size, asset diversification, compliance monitoring, and investment screening.

A direct investment is generally made by taking an ownership interest in a limited partnership; or limited liability company (LLC) that owns a LIHTC property. The investor must assume responsibility for all of the underwriting and compliance monitoring activities. An investor may have less flexibility in the amount of capital it would have to commit than if it were to invest in a diversified pool of properties. As such, this approach can be challenging for a community bank that wants to make its first entry into the LIHTC arena.

An alternative to direct investing is to invest in a fund established by a syndicator - a limited partnership (or LLC) that invests in numerous LIHTC properties. Unlike direct investing, where the bank would have to perform all due diligence itself, the syndicator generally offers to screen potential investments and monitor the ongoing compliance of the properties. Many syndicators offer multi-investor funds, allowing investors to purchase a slice of the fund, thereby offering greater flexibility in determining how much capital to invest. Most funds purchase partnership interests that own affordable rental properties in many geographic areas, which diversifies the investor's risk across several rental markets.

For investors making an investment through a syndicated fund, the minimum investment is set by the syndicator. Many state and local syndicators allow for investments of $1 million or less. The amount of capital required for a direct investment in a LIHTC property will depend upon the size of the project.

Some syndicators offer guaranteed funds, in which the syndicator guarantees a minimum yield to the investor. If the fund does not provide the promised yield, the syndicator compensates the investor for the difference. Therefore, a guaranteed fund shifts the investment risk to the syndicator, with the bank's risk being tied to the creditworthiness and experience of the syndicator. With non-guaranteed funds, no performance guarantees are provided by the syndicator, and the bank would bear the investment risk. As would be expected, guaranteed funds generally offer lower yields than non-guaranteed funds.

Credits Allocated and Equity Raised Click graphic for a larger image

The Risks of LIHTC Investing

The principal risk of LIHTC investing is the loss of the tax credit itself and its recapture by the IRS - which means the investor would forfeit all or a portion of the previously claimed credits, plus interest, and might also have to pay a penalty. Owners of LIHTC properties must meet specific requirements during the planning, construction and operation of the property to claim the credits. Failure to meet many of these requirements, if remedied quickly, will not have an adverse impact on the property's tax-credit status. However, if certain requirements are not met, the property will lose all or a major portion of its potential tax credits. Two examples of how a LIHTC property could lose its tax credits would be the failure to maintain the necessary minimum number of low-income units, or to maintain its low-income status for the full 15-year compliance period.

Banks new to this arena will find that all of the fundamental underwriting considerations associated with LIHTC investing are also found in market-rate multifamily housing lending. Once a transaction meets a bank's underwriting criteria, a bank can then evaluate it from an investment perspective. For example, during the construction and lease-up phase (which generally lasts one to three years), a bank should consider all the sources and uses of construction financing and calculate the expected costs to be included in determining the tax credit. A bank must determine which of those costs are permissible to calculate the LIHTC correctly. See the sidebar, Helpful Hints for First-Time Bank Investors.

A bank should also calculate the property's ability to produce sufficient cash flow to cover operating expenses and debt service obligations from the point that the property achieves stabilized occupancy (generally after the completion of construction and lease-up) through to the end of the compliance period.

Special care should be taken to ensure that the rents to be collected are less than the rental limits required by the LIHTC program. If the project is unable to generate sufficient cash flow to cover its operating expenses and debt service obligations, the project should be restructured until this is achieved. Finally - and of ultimate importance - a bank should calculate its investment yield and make sure that it is comfortable with the transaction.