ASSET MANAGEMENT
REZNICK RESPONDS
Using State Tax Credits
Q&A with Beth Mullen of the Reznick Group
AFFORDABLE HOUSING FINANCE • SEPTEMBER 2007
Q I am an affordable housing
developer, and I just heard
about the state low-income
housing tax credits
(LIHTCs). How does that
help me finance my affordable housing
development?
A Investors in affordable housing provide
equity in exchange for expected
tax benefits, cash flow, and sales proceeds.
A state tax credit is a way to provide additional
benefits, thus increasing the amount
of capital a partner is willing to invest.
Nearly a quarter of states have some form
of credit associated with the development
of affordable housing. The form the credit
takes varies widely, ranging from a credit
that comes automatically with federal
LIHTCs to a direct refund from the state.
Some state credits are allocated by the state
agency that allocates federal credits, and
some are available from other state agencies.
The starting point is to determine if
your state has a state credit program. Laws
change from year to year, so it pays to look
each year. You may want your tax adviser to
research state laws as well as consulting
with the state’s tax credit allocation agency.
States have used two types of credit
structures to increase equity investments in
affordable housing. The first, used by
California and some others, requires the
state credit to be allocated to the same
partner that receives the federal credit.
This limits the investor to one that has both
federal and California state tax. A number
of syndicators have funds that specialize in
deals with both credits. It’s often unclear
exactly how much investors paid for state
credits because they are also receiving tax
deductions and federal credits that contribute
to their overall return on investment.
The general consensus is that the
price paid for California credits is higher
because the credits are taken over four
years rather than 10. The California credit
was the first state credit, and it has been
very successful at closing the gap between
sources and uses of funds.
Missouri and Georgia use an alternative
approach that allows the credits to be
allocated to a separate state credit investor.
State laws that created the credit provide
that it can be allocated to a partner or
member in accordance with the partnership
agreement. This means that the state
tax credit partner may have a very small
interest in losses and federal credits, but
will be allocated all of the state credits. The
ability to bifurcate the credits usually leads
to negotiation with two separate credit
investors who may each have their own
deal terms and reporting requirements,
but the increased equity is usually worth
the additional effort.
A third type of tax credit includes
credits that are outside the deal. In Illinois,
Missouri, and some other states, credits are
available to individuals and corporations
that make a contribution in support of
affordable housing. These are credits for
charitable contributions rather than credits
allocated from the real estate owner to a
partner. The dollars donated are then contributed
or lent to the affordable housing
project for construction or operations.
Q If my project can qualify for state
credits, what issues do I need to be
concerned with?
A The use of state credits may require
that the property comply with additional
requirements or restrictions, which
may increase development costs. In
California, for example, using state credits
may require paying state prevailing wages,
which could increase costs 15 percent or
more. The owner may have to agree to
trade off federal credits to receive an allocation
of state credits. The developer must
determine if the additional equity to be
gained from state credits is closing the
funding gap rather than widening it.
The allocation of partnership tax
benefits may be complicated by the
capital contributed by the state tax
credit investor. The federal LIHTC
investor makes its investment to
receive nearly all of the LIHTCs and
tax deductions. The federal investor
will receive the allocations as expected
as long as its capital account (basically
capital invested less losses received)
remains positive. When its capital
account gets to zero, losses and federal
credits will be allocated to other partners
or members who have positive
capital, including the state LIHTC
investor. This result is contrary to the
plans of all the partners, so the deal
needs to be structured to minimize this
possibility. Ultimately, the partnership
will be liquidated in accordance with
the capital accounts, so the state
LIHTC investor may receive more cash
out of the transaction than the parties
expect.
Last fall, the Internal Revenue
Service issued Chief Counsel Advice
Memorandum (CCA) 200704028
regarding state tax credit transfers.
One conclusion drawn by the CCA is
that the state credit investor must be a
partner for federal income tax purposes,
based on all the facts and circumstances.
The guidance was specifically
related to state historic tax credits, but
the issues raised also apply to investors
in other state tax credits, including the
LIHTC. One of the important considerations
is that the parties intend to
join together in conducting a business
activity and sharing profits. A profit
motive is not required in a LIHTC deal,
but the state tax credit investor should
have some opportunity to earn a profit
if profits arise from sale or operation.
The special allocation of state credits to
a partner needs to be respected to avoid
having the transaction re-characterized
as a sale of tax credits resulting in taxable
gain to the partnership. The advice
of a knowledgeable tax professional is
critical to assess and avoid structuring
pitfalls in this area.
| 
