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The low-income housing tax credit

By Susan Hobart and Robert Schwartz - posted Monday, 15 May 2000

Though still alive, it has an uncertain future. Here's how the tax credit works.

The Low-Income Housing Tax Credit (the credit), enacted in 1986, represents a significant evolution in federal low-income rental housing policy. Made permanent by Congress in 1993, seven years after its inception, the credit represents a shift from rental subsidy and loan guarantee programs that required annual budget appropriations toward tax expenditures. In this respect, it resembles the form of federal subsidy used to promote production of owner-occupied housing, and it has had a significant impact on the real estate investment industry.

While the 1980s real estate boom was fueled by an abundant supply of debt, the 1990 Section 42 tax credit marketplace is fueled by an abundance of equity. In the past three years, corporate America has invested nearly $4 billion in the production of affordable housing. Typically, 30 to 40 percent of the financing for a development comes from the tax credit equity. And although the supply of equity outweighs the demand, most large syndicators and corporations are very thorough in their underwriting process and look for the blue chip developments in the industry.


Many investors require significant guarantees from developers but will commit to and fund a project before a property is fully leased and seasoned. This enables the developer to raise up-front capital outside of the traditional development loan market. Even large commercial development companies like the Shaw Company of Chicago-with the development of Homan Square, a large-scale, mixed-income community in one of Chicago's most troubled neighborhoods-have gotten involved in the tax credit marketplace. (See "Homan Square: Rebuilding the Inner City, September 1996 Urban Land.)

Although the tax credit program can be cumbersome and baffling for developers, it has many advantages. Because most investors invest for credits, oftentimes the developer as the general partner can benefit from the residual cash flow. The increased competition for tax credits has pushed the cost per credit upward three to five cents in the last year, enabling developers to build high-quality housing similar to market-rate properties, compared with cost-controlled HUD-subsidized housing of the 1960s and 1970s. If the units are rented to working families with modest incomes, the units must be comparable within the general marketplace, so quality is critical. Since most tax credit development has occurred out of central city urban areas and in high-growth suburban areas, developers have been able to compete within the growing marketplace. Tax credits allow developers to obtain significant equity, reducing the size of the mortgage, which can translate into rents as much as 10 to 20 percent below market. Generally, the tax credit properties rent quicker and stay filled longer than comparable market-rate properties.

A major question remains: Will the tax credit program become as institutionalized a part of the tax code as the single-family deduction? In fall 1995, the program was slated for elimination during the budget debate. With Congress's inability to act on the budget, the program is still alive as of this writing, but its survival over the long term remains uncertain. It now appears that the tax credit program is safe for the present. It has survived the first round of federal budget cuts and a nationwide audit by the General Accounting Office (GAO) completed earlier this year. The program has received broad support from both political parties, and recent improvements in the economy and a lower budget deficit have likely secured the program's short-term future.

Birth of the Credit

The 1986 federal income tax reform eliminated most passive loss benefits for investors in real estate, but it retained in the form of a ten-year tax credit similar benefits for investors in affordable rental housing. The 1986 reform created Section 42 of the Internal Revenue Service (IRS) Code. Congressional advocates of a federal production program adopted a strategy of making federal subsidies a tax expenditure rather than a revenue appropriation. Although Congress has scrutinized the subsidy almost annually and until 1993 required annual renewals, its character as a tax appropriation has made the subsidy less publicly visible.

In the past few years, the program has been used in approximately 35 percent of newly constructed rental units nationally. It is used in urban neighborhoods and in suburban as well as rural communities, and it is meeting congressional expectations of providing high-quality housing for low- and moderate-income renter households.

The credit essentially is an equity incentive vehicle and, in one small respect, a debt-enhancement vehicle as well. The credit is large and secure enough to leverage private investor equity-as much as 50 percent of total development costs for newly constructed properties. In short, a developer applies to an allocating agency for a share of the state's credits. Developers raise equity by selling, either directly or through a middle agent or syndicator, ownership interests in properties. Currently, equity interests are being sold at 60 to 70 cents per credit dollar. (Investors price their equity close to the present value of the ten-year stream of credits.) Typically, the developer retains an ownership interest in the property as a general partner and guarantees investment performance, including the flow of credits. The tax credit and passive losses provide the highest yield to corporate taxpayers. Some investors are paying equity for cash flow, but few if any value residual benefits.


Local Control of the Credit

Many federal housing programs are viewed as administratively burdensome and lacking in local direction; therefore, the credit program was designed to allow for local control. In each state, the program requires one or more allocating agents to be designated by the executive (usually the governor). These allocators are usually the state housing finance authorities (HFAs), although some larger cities are suballocators within their states.

Each state receives an annual allocation of tax credits that represents $1.25 per capita. States can also receive additional credits through a reallocation of a national pool of unused credits at the end of the year. Credits for properties financed with federally tax-exempt mortgage revenue bonds come from a separate pool. Until 1989, many states were not able to allocate all their credit. In recent years, almost all states fully allocated their credits, and many states have extremely competitive conditions, receiving applications for three to five times the credit available.

All credits must be allocated in accordance with states' qualified allocation plans (QAP). The QAP is a publicly reviewed and state-executive-approved document that defines the priorities and competitive criteria for allocating the credits. Most tax credits give preference to properties serving the lowest-income residents and having the longest period of rent and income controls. The QAP must also reflect selection criteria for location, housing needs characteristics, development characteristics, participation of local nonprofit organizations, resident populations with special needs (e.g., persons with developmental or physical disabilities), and length of public housing waiting lists.

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This article is adapted from a ULI working paper, Financing Multifamily Housing under Section 42 Low-Income Housing Tax Credits (number 654). This article is reproduced courtesy of the Urban Land Institute.

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About the Authors

Susan Hobart is vice president of real estate acquisition and development for Heartland Properties which develops, finances, owns and manages affordable rental housing throughout America's heartland.

Robert Schwartz is former director of acquisitions for Heartland Properties, Inc., which develops, finances, owns, and manages affordable rental housing throughout America's heartland.

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