Low Income Housing Tax Credit

The Low Income Housing Tax Credit (LIHTC; pronounced “ly-tech”) is a tax credit created under the Tax Reform Act of 1986 (TRA86) that gives incentives for the utilization of private equity in the development of affordable housing aimed at low-income Americans. The credits are also commonly called Section 42 credits in reference to the applicable section of the Internal Revenue Code. The tax credits are more attractive than tax deductions as they provide a dollar-for-dollar reduction in a taxpayer’s federal income tax, whereas a tax deduction only provides a reduction in taxable income.

As of 2006, 40% of all new multifamily construction projects received section 42 credits.

How it Works

The LIHTC provides funding for the development costs of low-income housing by allowing a taxpayer (usually the partners of a partnership that owns the housing) to take a federal tax credit equal to a large percentage of the cost incurred for development of the low-income units in a rental housing project. Development capital is raised by “syndicating” the credit to an investor or, more commonly, a group of investors.

To take advantage of the LIHTC, a developer will typically propose a project to a state agency, seek and win a competitive allocation of tax credits, complete the project, certify its cost, and rent-up the project to low income tenants. Simultaneously, an investor will be found that will make a “capital contribution” to the partnership or limited liability company that owns the project in exchange for being “allocated” the entity’s LIHTCs over a ten year period.

The amount of the credit will be based on (i) the amount of credits awarded to the project in the competition, (ii) the actual cost of the project, (iii) the tax credit rate announced by the IRS, and (iv) the percentage of the project’s units that are rented to low income tenants. Failure to comply with the applicable rules, or a sale of the project or an ownership interest before the end of at least a 15-year period, can lead to recapture of credits previously taken, as well as the inability to take future credits.

Application Process

The first step in the process is for a project owner to submit an application to a state authority. The application will include estimates of the expected cost of the project and a commitment to comply with either of the following conditions, known as “set-asides”:

* At least 20% or more of the residential units in the development are both rent restricted and occupied by individuals whose income is 50% or less of the area median gross income.
* At least 40% or more of the residential units in the development are both rent restricted and occupied by individuals whose income is 60% or less of the area median gross income.

Typically, the project owner will agree to a higher percentage of low income usage than these minimums, up to 100%. Low income tenants can be charged a maximum rent of 30% of the maximum eligible income, which is 60% of the area’s median income adjusted for household size as determined by HUD. There are no limits on the rents that can be charged to tenants who are not low income but live in the same project.

Here Are Some More Frequently Asked Questions

When and why was the Low-Income Housing Tax Credit Program created?
In the early 1980s, the federal government eliminated many publicly funded housing-development programs. To help offset the resulting loss in the production of affordable housing, Congress passed the Low-Income Housing Tax Credit (LIHTC) program. Part of the Tax Reform Act of 1986, the LIHTC program provides an incentive to the private sector to invest in low-income multifamily housing. The program gives investors a dollar-for-dollar reduction in their federal tax liability in exchange for providing financing to develop affordable rental housing.

Today the Low-Income Housing Tax Credit program is the only federal affordable rental housing production program available to developers. Currently it provides more than $400 million in annual subsidies for developing low-income rental housing. Since the national program went into effect, a number of states have established their own LIHTC programs.

Who administers the LIHTC program?
The Internal Revenue Service (IRS) oversees the LIHTC program, but most administrative and monitoring responsibilities have been delegated to the states. Each state receives an annual allotment of tax credits based on the size of its population. For 2008 and 2009 the state volume cap is $2.20 per resident or $2,557,500, whichever is greater.

State agencies review and rank tax credit applications submitted by developers and allocate credits to the highest-scoring affordable housing projects. Each state sets its own criteria for awarding credits to proposed projects and lists the criteria in a document called the “Qualified Allocation Plan” (QAP). The IRS requires that QAPs prioritize projects that serve the lowest-income tenants and ensure affordable housing for the longest period. The law also requires that states set aside a minimum of 10 percent of their allotted credits for nonprofit developers/owners.

The allocation process is highly competitive. Some states can receive applications requesting as many as three times or more credits than they have authority to allocate.

How does the low-income housing tax credit program work?
Most developers who receive an allocation from their states sell their tax credits to corporate investors (and in some cases individuals) for cash. By investing in LIHTC developments, corporations (or individuals) can then claim the tax credit on their income tax returns over a 10-year period and thereby reduce their tax liability. Federally regulated financial institutions (e.g., banks and savings institutions) not only reduce their tax liability when they invest in LIHTC projects; they also receive, as an additional incentive, Community Reinvestment Act (CRA) credit.

The money developers receive from the sale of tax credits is in the form of an equity contribution that is used to pay costs related to the project. By receiving equity capital, developers can reduce the sum they need to borrow and, consequently, their debt service costs. Typically, the amount of equity raised from the sale of tax credits ranges from 50% to 55% of the total development costs. These savings allow the developer to charge below-market-rate rents.

Are there any limitations placed on the rent that owners of LIHTC properties may charge?
Yes. First of all, to be eligible to participate in the LIHTC program, projects must meet either of the following requirements: at least 20 percent of the units must be rented to households whose incomes do not exceed 50 percent of the area median income (AMI) or at least 40 percent of the units must be set aside for households whose incomes do not exceed 60 percent of the AMI. In practice, usually 100 percent of the units in a development qualify for LIHTCs.

The Department of Housing and Urban Development (HUD) calculates the area median income for each county in each state. Low-income rents, including utilities, are restricted based on family size, the number of bedrooms in the apartment, and the AMI. In all cases, the project owner cannot charge a rent that is greater than 30 percent of a qualified tenant’s income (i.e., 30 percent of 50 or 60 percent of AMI).

By statute LIHTC projects must adhere to the rent restrictions for a minimum of 15 years (also known as the “compliance period”). Most states include an additional 15 years through an extended use agreement. The long-term structure of tax credits helps ensure that the units remain available for low-income occupancy for at least fifteen years. Should the number of low-income units drop below the required percentages within the first fifteen years, the number of tax credits available to the investor is reduced.

Are there any limitations on the types of projects tax credits can be used for?
Tax credits can be used to finance family projects and developments serving elderly residents, the homeless, or disabled individuals as well as other special needs groups. It is important for developers to be familiar with their states’ QAPs, for when reviewing and ranking applications, some states award points to projects that give priority to meeting the needs of specific population groups.

If a developer wants to build a rental project using Low-Income Housing Tax Credits, what steps should be followed?
First, the developer should obtain a copy of the QAP from the state allocating agency where the project will be built and become thoroughly familiar with its contents. Second, the developer should get a copy of the tax credit application and find out the date(s) for submittal. Third, if the developer, even an experienced developer, has never built a tax credit project, it is strongly recommended that an experienced consultant be retained to assist with the preparation of the application, project structuring, financing, and other matters unique to the tax credit program.

Tax credits are big business and for a lucky few, can mean big cash. Something to think about if you are exploring multifamily rehab or development.