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David Black, Community Development Expert, OCC
The federal low-income housing tax credit (LIHTC) program promotes public-private partnerships1 that create affordable rental housing. The program uses federal tax credits to attract private equity to qualified affordable housing projects. Since the program's inception in 1986, banks have been significant investors in LIHTCs.
The program has been successful in developing new affordable rental housing, with more than 2.7 million affordable housing units placed into service.2 Rents must be affordable to households earning 60 percent or less of area median income.
Housing financed with LIHTCs has time limitations on the rental affordability restrictions. Initially, the program mandated rent restrictions for 15 years. But in 1989, just three years after the program's inception, Congress introduced several measures to improve the efficiency of LIHTCs. Among these, the program was made permanent in 1994, and awarding credit allocations became a competitive process. Another key change added 15 years to the existing 15-year compliance period (the additional 15 years is known as the "extended-use period"). As a result, properties placed in service after 1990 are generally required to remain affordable for at least 30 years.3
During the compliance period, limited partner (LP) investors generally receive 10 years of annual allocations of federal tax credits provided the properties are rented to income-qualified tenants at affordable rents and meet federal property quality guidelines. Failure to comply with program guidelines can result in recapture of previously claimed credits. The tax benefits of the credits and related losses are the investor's principal economic benefit from the investment. After the 15-year compliance period, the tax credits are exhausted and previously claimed tax credits may no longer be recaptured, although owners may still be sued for not following the terms outlined in the regulatory agreements. At this time or sooner, investors may choose to exit their interest in the properties, usually by selling or transferring the LP's interest to the general partner (GP) or by selling the property to a third party.
This transfer of ownership after year 15 creates two critical challenges to the property operating and remaining affordable through the extended-use period. First, the property owner must have the managerial and financial resources to effectively maintain and manage the property over the remaining years of rent restrictions. The viability of the property can be compromised by excessive debt, or if reserves or other financing are not in place to meet growing capital requirements as the property ages.
Second, the property owner can choose whether to preserve the property as affordable housing once the rent restrictions expire after year 30 or later, depending on the state's use restriction agreement requirements. Community needs and strategies are important components of the decision whether to maintain affordable housing. For example, rapidly gentrifying areas may have a critical need to preserve rent-restricted units. In other cases, affordability restrictions may run counter to community development strategies of income diversification.
The market for rental housing may also affect this preservation decision. Where there is little difference between market and restricted rents, there may be little need to maintain mandated rent restrictions. Where significant differences between market and restricted rents exist, however, there may be substantial community benefits in the units remaining rent restricted. This community benefit objective may conflict with the interests of the property owner, who may gain considerable financial benefits by converting the units to market rate.
More than 1 million LIHTC-financed affordable units will reach the end of their year 15 compliance period by 2020.4 Earlier research by the U.S. Department of Housing and Urban Development (HUD) on year 15 transfers indicated few problems in the process.5 More recently, however, affordable housing advocates have raised concerns that, in some cases, profit-taking at transfer has threatened the long-term affordability of LIHTC properties and public support for the LIHTC program. Advocates were concerned about projects being stripped of operating reserves,6 affordable housing developers being unable to compete with financially motivated investors when properties were placed for sale,7 and property owners financially benefiting from rental assistance contracts that exceed allowable LIHTC rents,8 a practice that could potentially erode public support for the LIHTC program.
During the compliance period, the LP investor receives tax benefits from its investments when the properties are leased to income-qualified tenants at affordable rents. The staff of state housing credit allocating agencies (HCAA) oversees compliance with LIHTC program requirements and reports noncompliance to the Internal Revenue Service (IRS). Failure to comply with program regulations may result in the recapture of some or all previously allocated credits.
A land use restriction agreement (LURA) is required on all LIHTC properties. A LURA is a binding agreement between the property owner and the HCAA to limit the use of the property to affordable housing through the extended-use period, and includes certain income qualifications and rent restrictions. The LURA may contain additional requirements, such as the provision of supportive services or units targeted to specific populations (e.g., the elderly or people with special needs). The LURA is binding on all successor owners of the property, except under the exceptions described below, and is enforceable under state law. In addition, many LIHTC properties have soft debt from public sources as part of their financing package that may also carry affordability restrictions and reporting requirements.
During the extended-use period, the economic benefits of LIHTC properties come from the properties themselves, rather than the LIHTCs. The HCAA carries out its compliance responsibilities by reviewing annual reports and conducting periodic site inspections. Compliance violations are no longer reported to the IRS. The properties may be sold at a price established by the buyer and seller, although, depending on state requirements, the sale may require HCA approval.
LIHTC regulations provide for two exceptions to the extended-use requirement. First, if LIHTC properties are acquired by a valid, arms-length foreclosure, the extended-use period terminates on the date of acquisition. Few LIHTC properties, however, enter into foreclosure.9 Second, completing the qualified contract (QC) process allows property owners to discontinue the affordability restrictions.10 The property owner starts the process with a request to the HCA to find a buyer to make a bona fide offer for a price determined by a statutory formula. If a buyer makes such an offer,11 the extended-use requirements remain in effect. If the HCA is unable to find a buyer within one year of the request, the LURA can be terminated.
Under both exceptions, for a period of three years, the owner may not terminate existing tenancies without good cause or raise rents by more than what would be allowed under the program rules.
An investor can exit a LIHTC project in several ways.12 The method of exit depends on several factors, including the agreement the investor has with its partners, applicable laws and regulations, tax and other financial issues, and relationship and reputation issues.
The most common exit involves the sale of a property or the transfer of a partnership interest.13 When a property is sold, the partnership is dissolved and the LP, the GP, or both exit the transaction. The HCAA and other lenders holding debt on the property need to approve the sale, depending on the agreements in the partnership documents. In the transfer of a partnership interest, the underlying business remains intact. In many LIHTC transactions, the GP purchases the LP interest at the end of the compliance period. The nature of this transaction, including the parameters for establishing a purchase price, is typically delineated in the partnership agreement.
Qualified nonprofit organizations, government agencies, tenants, and certain tenant organizations may negotiate a right of first refusal (ROFR) to purchase the LIHTC property for all outstanding debt and any tax liabilities generated as a result of the transaction.
The LP investor may sell its interest in the project to the GP through a put option, usually for a nominal price (e.g., $1,000). The put option is negotiated up front and included in the partnership agreement.
Finally, the LP investor may donate all or a portion of its partnership interest to a nonprofit entity, usually the GP. The donor may take a charitable contribution tax deduction on the donation.
If the property needs extensive rehabilitation, the rehabilitation work may be financed through the property owner obtaining new LIHTCs. Resyndication of the property with a new allocation of LIHTCs requires rehabilitation costs of at least approximately $6,000 per unit.14 Some HCAs require rehabilitation expenditures that significantly exceed this federal minimum. LP investors usually require higher rehabilitation thresholds.
The least common type of exit is conversion of the affordable property to market-rate rentals or condominiums. There are two paths to this type of conversion. A tenant or tenant organization may purchase a property through the ROFR process, and at some predetermined time the tenant will have the option to buy the unit. Alternatively, a property owner or investor that is unable to find a new buyer for its property with the extended-use restrictions may pursue the QC process previously described.
According to industry experts, banks have accounted for approximately 85 percent of the equity raised using LIHTCs.15 This equity has allowed the properties to be developed and leased at affordable rents.
While banks have been invaluable as investors, they have done much more to make the LIHTC program a success. Financial institutions have also been valuable partners in providing debt financing and facilitating the high levels of performance achieved by LIHTC-financed properties. This leadership has been critical.
In all exits, banks need to balance financial and community concerns. As investors, banks may view making legitimate claims on partnership assets as part of their fiduciary responsibility. As business partners, banks may want to consider the impact of various exit strategies on long-term business and community relationships. And as participants in public-private partnerships designed to meet public goals, banks may want to consider the impact of their exit on the preservation of the affordable housing asset.
For more information, contact David Black.
1 The World Bank defines a public-private partnership as "a long-term contract between a private party and a government entity, for providing a public asset or service, in which the private party bears significant risk and management responsibility, and remuneration is linked to performance."
2 U.S. Department of Housing and Urban Development, "Low-Income Housing Tax Credits."
3 Certain exceptions are discussed in a later section. Some housing credit allocating agencies require longer commitments, and some property owners pledge affordability for longer periods.
4 HUD, Office of Policy Development and Research, "What Happens to Low-Income Housing Tax Credit Properties at Year 15 and Beyond?," August 2012.
6 Halliday, Toby, "Squeezing the Housing Credit at Both Ends," Bipartisan Policy Center, March 11, 2014.
7 See "Preserving America's Affordable Rental Housing: The Role of the Nation's Banks" in this edition of Community Developments Investments.
8 According to the California Tax Credit Allocation Committee (CTCAC), the concern is that the property owner is receiving value not as a result of its own performance but as a result of the policy decisions made by a public agency. Rather than the value being taken out at sale, the CTCAC felt the value should remain with the project and be available to finance rehabilitation needs. See the CTCAC memo "Proposed Regulation Changes With Initial Statement of Reasons," July 16, 2015. Commentators to the proposed regulatory change noted that the so-called Section 8 "overhang," when the project-based rental assistance contract rents exceed LIHTC rents, is often used to finance supportive services for tenants. This proposed regulatory change was not finalized.
9 CohnReznick, "The Low-Income Housing Tax Credit at Year 30: A Focus on Recent Property Performance (2013-2014)," December 2015.
10 Many property owners give up the ability to request a QC when submitting their application for LIHTC allocations.
11 There is no requirement for the sale to actually happen. Treas. Reg. section 1.42-18(a)(1)(iii).
12 For a more extensive description of different types of transfers, please see the Novogradac LIHTC Year 15 Handbook, Novogradac & Company, 2015.
13 HUD, Office of Policy Development and Research, "What Happens to Low-Income Housing Tax Credit Properties at Year 15 and Beyond?," August 2012.
14 The threshold is inflation adjusted.
15 CohnReznick, The Community Reinvestment Act and Its Effect on Housing Tax Credit Pricing, May 2013.
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Collection: Community Developments Investments
Clockwise from top left: R Street Apartments, residents of the St. Dennis Apartments, St. Dennis Apartments, and Galen Terrace Apartments, all in Washington, D.C. (Photos courtesy of the National Housing Trust)
Call (202) 649-6420 or email firstname.lastname@example.org. This and previous editions are available on the OCC's website at www.occ.gov/communityaffairs.
Articles by non-OCC authors represent the authors’ own views and not necessarily the views of the OCC.