The Tax Reform Act of 1986 included the adoption of Section 42 of the Internal Revenue Code creating the low-income housing tax credit as a means of encouraging private investment in affordable housing. Today, more than 15 years later, the low-income housing tax credit is widely recognized as a hugely successful public-private partnership — a viable tool for building affordable apartments for low to moderate income individuals and families. Here is how it works:

The low-income housing tax credit is a dollar-for-dollar tax credit taken against federal income taxes. The credit is available to owners of qualified low-income residential buildings. To qualify as low-income, a residential building must meet either the “twenty-fifty test” or the “forty-sixty test.” Under the twenty-fifty test, at least 20 percent of the residential units must be leased to occupants with incomes no greater than 50 percent of the area’s median income as established by the United States Department of Housing and Urban Development. Under the forty-sixty test, at least 40 percent of the units must be leased to occupants with incomes no greater than 60 percent of the area’s median income. Once the building meets one of these two requirements, it must then continue to qualify as low-income for a period of 15 years, beginning with the year the building is issued a certificate of occupancy — the so-called “placed-in service date.” The building owner must also enter into an extended use agreement providing that the building will be used as low-income housing for an additional 15 years, and in some states, up to 30 years. The agreement is a restriction on the land binding future owners, subject, under certain circumstances, to foreclosure and termination in the event the owner is unable to sell the building as low-income housing.

The credit is generally taken in equal amounts over a 10-year period and is set at an amount so that the discounted present value of the tax credit stream is equal to 70 percent of the taxpayer’s “qualified basis” in the low-income building. If tax exempt bond financing is used, the amount is set so that the discounted present value of the tax credit stream is equal to 30 percent of the taxpayer’s “qualified basis” in the building. The discount factor used to determine present value is set monthly by the Internal Revenue Service. Qualified basis is essentially the taxpayer’s depreciable basis at the time the building is placed in service multiplied by the percentage of either low-income units in the building or total floor space dedicated to low-income units, whichever is smaller. If all of the units in a building are rented to low-income tenants, the entire eligible basis is used to determine the credit amount. If some of the units are rented at market-rates, a proportionate amount of the eligible basis will be used.

Congress has limited the total dollar amount of credits available to taypayers each year. Last year, the total dollar amount available to taxpayers in each state was increased from $1.50 to $1.75 multiplied by the state population, which was based on recent census tracts. This year and in future years, the amount will be adjusted for inflation. The total credits available within a state are allocated among eligible taxpayers, on a building-by-building basis, by an agency or government authority. Each state has a qualified allocation plan which it must follow in selecting projects for tax credit allocation. The allocation process is highly competitive and often oversubscribed. The housing credit allocation process may be bypassed, however, if tax exempt bond financing is used and at least 50 percent of the total cost of the building and the land is funded by tax exempt bonds properly allocated from a state’s tax exempt bond ceiling.

A taxpayer can obtain an advance allocation — called a carryover allocation — to raise the equity necessary to construct the project. If a carryover allocation is made with respect to a building, the taxpayer must incur at least 10 percent of the total anticipated costs of development within 6 months of the allocation and construction must be completed by the close of the second year after the allocation.

Upon completion of a project, taxpayers must apply to the state agency to have a Form 8609 (Allocation of Tax Credits) issued to the taxpayer, with a copy to the IRS, in the year the building is placed in service. A Form 8609, with an individual building identification number (BIN), is issued for each building, although each project must apply for its own. Although the Form 8609 represents a state allocation of credits to a building, it is not a determination by the IRS that the building is entitled to a specific amount of credits. There remains the risk that the amount of credits will be reduced because the IRS, on audit, disallows a portion of the basis claimed. In addition, if the taxpayer fails to lease units to qualified low-income individuals over the full 15-year compliance period, fails to certify the tenants as such, does not make the necessary annual filings or fails to function within the statutory framework, there is a risk that the credits will be recaptured by the IRS.

Recapture can occur any time that a taxpayer’s share of the eligible basis of a building is less than it was the previous year. This can arise if the taxpayer sells its interest in the partnership owning the building, if the partnership sells the building or loses it in foreclosure, if some or all of the low-income units in the building are rented at market rates or to ineligible tenants or if proper documentation or paperwork is not maintained to demonstrate compliance. If recapture results from a sale of the building or of the taxpayer’s interest in the partnership owning the building, and if the building will continue to qualify as a low-income building, the taxpayer can avoid recapture by posting a bond with the IRS in the amount of the recapture that would be owed. If eligible basis is reduced by reason of improper leasing or document retention, recapture can generally be avoided by taking reasonably prompt measures to bring the building back into compliance. If recapture does occur, the amount of recapture is equal to the excess of the amount of tax credits that the taxpayer would have been allowed had the same total credit amount been taken over 15 years instead of 10 years, plus interest from the year(s) the credits were taken to the year of the recapture.

In most transactions, the developer of the low-income housing project assumes some of the risk of recapture and certain other risks associated with the project. The developer or an affiliate serves as the general partner of the partnership owning the project. As such, it provides guaranties to the tax credit investor, as limited partner. The general partner guarantees completion of construction, funding of operating deficits, payment of costs associated with environmental contamination and the flow of tax credits. These guaranties are often limited in amount and duration. In consideration of these guaranties and the other services rendered by the general partner, it is paid a substantial development fee and certain other fees. Investors seek tax benefits, not cash, so the general partner is also allocated most of the project’s net cash flow and residual value. In some instances, the general partner’s fees and interest in net cash flow are subordinated to the guaranties. Certain other structural protections for the investor are incorporated into the transaction.

The tax credit investor, as limited partner, is required to make a capital contribution to the partnership. The amount of the capital contribution is based on the projected flow of tax credits over 10 years multiplied by the price per dollar of tax credits. Payment of the limited partner’s capital contribution is made in installments, with a substantial amount deferred until the project is complete, leased-up and Forms 8609 are issued — a point in time when much of the risk of the investment is mitigated. Also, at that time, the amount of the limited partner’s capital contribution is adjusted to reflect the actual amount of tax credits allocated pursuant to the Forms 8609, as opposed to the projected flow of tax credits originally assumed. This adjuster mechanism assures the investor that it is only paying for tax credits actually received. Most transactions also provide for a repurchase of the limited partner’s interest by the general partner, if certain benchmarks such as construction completion, funding of the permanent loan and breakeven are not met.

Guaranties, fees and statutory frame-work aside, it is important for the parties to remember that the formation of a partnership to develop, fund and operate low-income housing is a long-term venture. The partners must remain partners for 15 years or risk recapture. The conduct of the parties must be guided by a long-term vision and the documentation should anticipate and facilitate the parties’ needs. Very few low-income housing tax credit projects fail, in no small part due to the commitment of developers and tax credit investors to work together for the benefit of individuals and families of low and moderate income. The next step is a tax credit designed to increase the production of for-sale housing in hard to develop neighborhoods so that low and moderate income individuals and families may own their own homes. The home-ownership tax credit is currently under consideration by Congress and the outlook is favorable due, in large part, to the success of the low-income housing tax credit.

Jana Cohen Blackman is chairman of Sonnenschein Nath & Rosenthal's national Real Estate Practice Group.


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