What is the purpose of the LIHTC program?
The Low-Income Housing Tax Credit (LIHTC) program is a policy tool by the federal government to incentivize the private sector to invest in the development of affordable housing. The program was created by the Tax Reform Act of 1986 (TRA86) and is codified under Section 42 of the Internal Revenue Code. It has gone through several modifications over the years. The purpose of these tax credits is to secure funding for the construction, rehabilitation, and preservation of affordable housing units. Since the program’s inception, nearly 3 million such units have been placed in service (2.97M units across 45,905 projects between 1986 and 2015). Along with the rent voucher program, LIHTC is one way the federal government addresses the general shortage of housing units available for low- and moderate-income households.
How are the tax credits allocated and used?
The federal government grants tax credits to state and territorial governments which hand over the task of allocating the credits to their respective housing agencies (various housing finance authorities or HFAs). The tax credits are awarded to selected property developers based on their project proposals and via a competitive application process. Developers generally sell these credits to institutional investors (typically banks) in exchange for equity funding. The banks take up ownership in these developments are on the hook to ensure that the properties are occupied by the eligible low and moderate income families for the tax allocation period. (typically 10 to 12 years).
The cash that equity investors inject into the project is used along with other soft debt (usually) such as HOME Investment Partnerships or the national Housing Trust Fund to subsidize the creation of affordable housing. This does not cover the cost of development, but the infusion of equity reduces the debt, a developer borrows from commercial banks, Fannie, Freddie, etc as a construction loan. The bulk of the tax credit equity installment is used to pay down the large construction loan to a long term mortgage once the housing project is built and occupied.
How do developers benefit from LIHTC?
Developers don’t usually keep the tax credits, so they don’t directly benefit from them, but selling the tax credits for equity investment reduces their debt considerably and makes the development of new affordable housing possible. The equity subsidizes the cost of development and lower rent income in the compliance period. For LIHTC projects, developers also claim a developer fee (typically 10% of the Total Development Cost (TDC))
How do investors benefit from LIHTC?
Investors directly benefit from the tax credits by receiving a dollar-for-dollar reduction in their payable federal income tax. Investors can claim these tax credits over a 10-year period once the housing project they invested in is completed, and is placed in service (PIS). Most investors are corporations (mainly large financial institutions) with substantial income tax liabilities and long enough planning horizons who are able to fully use these non-refundable tax credits. Large banks are also required to invest in the community under the Community Reinvestment Act (CRA). This law is intended to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income (LMI) neighborhoods, consistent with safe and sound banking operations. So banks are able to reduce their tax burden but more importantly satisfy their CRA requirements. Individual investors are very rare (less than 10%).
What makes a project eligible for LIHTC?
A typical affordable housing project is a multi-story apartment complex with managed rental units, but LIHTC is not limited to that (single-family units, townhouses, and duplexes are also eligible, although rare). In the majority of affordable housing projects, all the units are set aside to be rented out at affordable rates, but it is possible to have mixed-income or mixed-use projects under the LIHTC program. The primary target of the program are low- and moderate-income families, but it also supports the construction and rehabilitation of senior housing, homes for people with special needs and permanent supporting housing for the homeless.
A housing unit is considered affordable if the occupants are spending no more than 30% of their combined household income for housing (rent and utilities). To be eligible for LIHTC, the developer must agree to meet a gross rent test and an income test for tenants.
To pass the income test, the units are set aside for tenants whose household income (as adjusted for family size) is below a certain percentage of the area median income (AMI). The units need to be allocated in one of these three ways:
- Min. 20% of the units are set aside for tenants with max. 50% AMI
- Min. 40% of the units are set aside for tenants with max. 60% AMI
- Min. 40% of the units are set aside for tenants with an income average of max. 60% AMI.
To pass the gross rent test, rents cannot exceed 30% of either 50% or 60% AMI, depending on the share of LIHTC units within the building.
For how long do LIHTC projects need to be kept affordable ?
To qualify for LIHTC, rents of such ‘set-aside units’ must be guaranteed to pass the income and rent test for 15 years else all tax credits are recaptured. After this 15-year compliance period, the units are usually kept affordable for another 15 years of ‘extended use period’. So the answer is: they remain affordable for usually 30 years with some states requiring even longer commitment periods.
Monitoring compliance means to regularly check that only targeted income-eligible households live in the set-aside units and they pay compatible rents. There are further regulations on housing quality and the availability of basic amenities.
In states where the 30 year period is not mandated, the property owner can decide to convert the units to market-rate rentals after the 15-year compliance period is over, but needs to first send a request to the HFA. If the HFA wants to make sure the rents stay at affordable rates, they have one year to find a buyer (called a ‘preservation purchaser’) who is willing to keep the rents low for another 15 years. If there aren’t any buyers, the owner can adjust the rents to market-rate, but the original LIHTC eligible tenants can stay for another 3 years and receive rent vouchers to be able to pay the higher rents.
What type of tax credits can be requested?
There are two types of tax credits under the LIHTC program:
- 9% tax credits for new construction or substantial rehabilitation projects
- 4% tax credits for the acquisition of properties singled out for rehabilitation or for projects funded using tax-exempt bonds
It is possible to combine the two: for example, an older property can be acquired with 4% tax credits and then substantially rehabilitated with 9% tax credits. Where there is an extreme shortage of affordable rental housing, individual state HFAs may even allocate ‘extra’, enhanced tax credits to qualified projects.
How are tax credits calculated?
The exact dollar amount of the tax credit allocated to a single project is the result of multiplying the credit percentage (4% or 9%) by the project’s qualified basis. The qualified basis equals the combined construction cost of each LIHTC unit within the housing project. (less certain fees, etc that are not qualified). To maximize equity funding, developers often aim to set aside all the units as LIHTC units.