Investing in Low-Income Housing Tax Credits
By Michael J. Novogradac, Managing Partner, Novogradac & Company LLP
Updated March 2010
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Auburn Courts in Massachusetts is an example of multifamily housing developed with LIHTC investment funds from Massachusetts Housing Investment Corporation, a member of the National Association of State and Local Equity Funds. |
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The Low-Income Housing Tax Credit (LIHTC) Program makes federal tax credits available to community banks that own affordable rental properties. The credits owe their existence to the Tax Reform Act of 1986 and are intended to facilitate the development of low-income rental property. Since its inception, the program has been instrumental in the construction or rehabilitation of more than 1.7 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 is claimed over an accelerated 10-year time frame, beginning in the year the property is placed in service and as units are occupied. Because 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 otherwise taxable income from both federal and state taxation through deductions for depreciation. Additional state housing tax credits may be available in the states in which LIHTC properties are located, further enhancing investment returns. And regulated depository institutions, which are 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 properties' low-income designation for at least 15 years for the tax credits to be fully earned. A 15-year extended compliance period is effective for all projects that received an allocation of credits after 1989; however, once the initial 15-year compliance period is over, the Internal Revenue Service (IRS) may not recapture the tax credits, and bank investors may exit the partnership. Investors may exit the properties at any point without facing recapture as long as the properties continue to operate as affordable housing through the end of year 15. If investors exit the properties during the initial 10-year credit period, they cannot claim any credits remaining for the balance of the 10-year credit period.
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)), which allows banks to be considered passive investors/limited partners and to receive distributive shares of the tax credits and other passive losses. Investments can be made either directly or through funds offered by syndicators, which comprise limited partnerships or limited liability companies (LLC) that invest in numerous LIHTC properties. Both options allow for various 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 that owns an LIHTC property. An investor must assume responsibility for all underwriting and compliance monitoring activities. An investor may have less flexibility in the amount of capital it must commit than if it were to invest in a diversified pool of properties, so this approach can be challenging for a community bank that wants to enter the LIHTC arena.
An alternative to direct investing is investing in a fund established by a syndicator. Unlike direct investing, in which a bank has to perform all due diligence itself, the syndicator generally offers to screen potential investments and monitor ongoing compliance. Many syndicators offer multi-investor funds, allowing investors to purchase a slice of the fund; this approach offers banks 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 investors' risk across several rental markets.
In a syndicated fund, the syndicator sets the minimum investment. Many state and local syndicators allow investments of $1 million or less. The amount of capital required for a direct investment in an LIHTC property depends on the size of the project and the amount of credits generated.
Some syndicators offer guaranteed funds, in which guarantors assure a minimum yield to investors. If funds do not provide the promised yields, the guarantors compensate investors for the difference. Thus, guaranteed funds shift investment risks to the guarantors, with banks' risk being tied to the creditworthiness and experience of the guarantors. With nonguaranteed funds, no performance guarantees are provided, and the banks bear the investment risk. As would be expected, guaranteed funds generally offer lower yields than nonguaranteed funds.
Credits Allocated and Equity Raised |
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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 that the investor would forfeit all future credits and 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 will not have adverse impact on the properties' tax-credit status, if the problems are remedied quickly. But if certain requirements are not met, the properties will lose all or most of their potential tax credits. For example, an LIHTC property could lose its tax credits through failure to maintain the necessary minimum number of low-income units or failure to maintain its low-income status for the full 15-year compliance period.
Banks new to this arena will find that many 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 economic underwriting criteria, the bank can evaluate the transaction from an investment perspective.
As part of the economic underwriting process, during the construction and lease-up phase (which generally lasts one to three years), banks should consider all the sources and uses of construction financing and calculate the expected costs to be included in determining the tax credit. To calculate the LIHTC correctly, banks must determine which of those costs are permissible. [See sidebar, Helpful Hints for First-Time Bank Investors.]
Bank should also calculate the properties' ability to produce sufficient cash flow to cover operating expenses and debt service obligations from the point that the properties achieves stabilized occupancy (generally after the completion of construction and lease-up) to the end of the compliance period.
Special care should be taken to ensure that amount of rent to be collected is below the rental limits required by the LIHTC program. If projects cannot generate sufficient cash flow to cover operating expenses and debt service obligations, they should be restructured until this balance is achieved. Finally-and most importantly-banks should calculate their investment yields and ensure that they are comfortable with the transactions.
When done carefully, investing in LIHTC properties can provide banks with significant economic and regulatory benefits while also helping to strengthen the communities in which they do business. Over time, these tax credits have stimulated investments and leveraged equity for the development of more than 1.7 million affordable units. [Click here to see how LIHTCs have leveraged equity over 18 years.] LIHTCs merit consideration by any banks thinking of adding to their investment portfolios.
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1. Tax planning: Because LIHTCs are designed to shelter taxable income, prospective investors must be able to project some level of taxable income over the near term. HERA allows taxpayers to offset alternative minimum tax (AMT) for credits generated by properties placed in service beginning in 2008. For properties placed in service before 2008, banks as investors should evaluate their exposure to AMT, as the tax credits may be used to reduce ordinary tax liability but not AMT liability. Banks that expect to be subject to the AMT during the 10-year LIHTC credit period should carefully evaluate to what extent they will be able to use LIHTCs to reduce their overall tax liability when calculating their return on investment. In addition to AMT restrictions, for many smaller banks that are taxed as S-corporations, current tax law requires that they pass the credits through to their shareholders, who are generally individuals and are subject to limitations on their ability to use the credits to offset income generated by the banks. Congress has introduced reforms that would allow these S-corporations to use the LIHTCs to offset taxable income from bank operations. Although these changes have not yet been passed, S-corporations should keep a close eye on the proposed legislation.
2. Liquidity: The 15-year compliance period for LIHTCs requires that most investments be held for at least that long. If investors want to sell their position before the end of the 10-year credit period, a secondary market provides an early exit mechanism. However, the market for LIHTC properties after the end of the 10-year credit period is much less robust. Since July 1, 2008, HERA has allowed investors to dispose of their interest in the properties without facing recapture, as long as the properties continue to be operated as affordable housing. Before HERA's enactment, to avoid recapture of tax credits for investments sold before the end of the compliance period, the seller would post a bond with the U.S. Department of the Treasury or provide U.S. Treasury bills in an amount equal to the tax credits subject to potential recapture. This provision in HERA enables banks to shorten their investment hold period from 15 years to 11 years if they can comfortably conclude that the properties will continue to be operated as affordable housing through the end of year 15. Although some of the barriers to exiting prior to year 15 have been lowered, significant contractual and logistical issues remain, so most investors should plan to hold their LIHTC investments for at least 15 years.
3. General partner due diligence: Investors in LIHTCs must be comfortable with their general partners. If a bank is investing in a fund, the syndicator is the general partner. If a bank is investing directly, the developer is most likely the general partner. Experience in developing LIHTC properties and assembling a fund is paramount to a successful partnership. The general partner is traditionally expected to provide investors with an unconditional guarantee of construction completion, as an unfinished project will never produce tax credits. Because the investor should expect to remain in the partnership for 11 to 15 years, a bank should have confidence that the general partner will perform as agreed.
4. Know the market: Many the normal underwriting considerations for market-rate multifamily housing lending hold true when investing in low-income housing tax credits. Such factors as location in a neighborhood, market demand, rents and expenses, project financing rates and terms, and partnership terms in a competitive market are all important when reviewing potential investment opportunities. If a bank is investing through a fund, the bank will rely on the syndicator to provide this information. In essence, the bank will be underwriting the underwriter.
5. Retain good advisors: A project development team or fund syndicator involves many different players, including developers, contractors, architects, lawyers, and accountants. A first-time bank investor should retain experienced and independent third-party consultants to advise it throughout the process.
6. Comparing returns: A bank should compare projected returns with actual returns in previous direct or fund investments. The prospective bank investor should make sure that the general partner has a track record of delivering on its promises to other investors and that the projected return meets the bank's hurdle rate for similar risk-adjusted investment vehicles. |
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