Boston — Work has begun on one of the first new Sec. 202 projects to be built with low-income housing tax credits (LIHTC).

The Barnes School in East Boston sat empty and crumbling for years. But by the beginning of 2007, its old classrooms will have turned into a health center, a generous community space, and 74 apartments for low-income seniors.

Developed by East Boston Community Development Corp. (EBCDC), the Barnes School is not a typical seniors affordable housing project. Instead it’s a hybrid: Only 55 of the 74 apartments at the Barnes School are Sec. 202 units. The remaining 19 apartments are subsidized with low-income housing tax credits. Sec. 202 is a federal program that helps finance the construction of housing for low-income seniors.

The building would have been too expensive to complete using just Sec. 202 subsidies: It includes generous common areas like an old auditorium and wide hallways that the Sec. 202 project is not able to support. The project also needed extra financing to make up for the high cost of building in Boston’s expensive construction market.

Unfortunately, rules of the Sec. 202 new construction program made it difficult to raise that money.

It’s relatively easy to take out new loans on Sec. 202 properties that were financed during earlier generations of the program, when the rules were different. These older properties receive a stream of project-based Sec. 8 rental subsidies from the Department of Housing and Urban Development (HUD). The subsidies are based on HUD’s fair market rent estimates for the project’s local market, and are usually enough to both pay the operating costs at a project and still allow the project to support a new loan.

But new Sec. 202 projects don’t have Sec. 8 contracts. Instead the Barnes School has a 20-year project rental assistance contract (PRAC) that is carefully computed by HUD to pay the operating costs of Sec. 202 apartments and nothing more.

“New Sec. 202 units are structured to just break even,” said Patrick Dober, vice president for MMA Financial, based in Boston. MMA was the tax credit buyer.

The PRAC contract at the Barnes School, for example, will provide just $467 per unit per month.

Even soft loans, which are only paid off if the property supporting the loans happens to have extra income, need to be supported by some income which could potentially pay the loan. Otherwise, they would be considered grants, altering the tax status of the property.

At the Barnes School, the higher rents of the tax credit apartments supported a $3.4 million package of soft financing. Those units will earn $840 per month, 80% more than the Sec. 202 apartments.

The 19 tax credit units also generated development fees for the project sponsor. Deferral of those fees helped bring an additional $300,000 in equity into the deal. The tax credit program is also more generous with common space than the Sec. 202 program.

When added to a package of $13.1 million in equity from a variety of tax credits and the project’s $6.3 million Sec. 202 grant, the soft financing and extra equity just made the $23.1 million deal feasible.

The Barnes School will carry no hard, permanent debt. That might seem odd, especially considering that the project’s tax credits are 4% credits that came with an allocation of tax-exempt bond financing provided by MassHousing. Tax-exempt loans typically stay on such projects as permanent financing, but in the case of the Barnes School, the project isn’t expected to generate enough income to service permanent long-term debt.

A reservation of 9% tax credits would have provided more equity. But when the developers began working on the project in 1999, they had no idea how long it would take for HUD to approve the project’s brand-new financial structure.

“We tried to get HUD to do these deals without the regulations,” said Jeffrey Sachs, an attorney with Nixon Peabody, LLP, based in Boston. But HUD refused. The department finally released proposed regulations for mixed-finance Sec. 202 properties in 2003. The final regulations did not appear until 2005.

Although the 4% credits that come with tax-exempt bond financing provide less equity, the process of getting these credits is less rigid. So MassHousing was able to work with the developers to shepherd the project through five years of delays.

MassHousing’s $12 million tax-exempt mortgage acted as a construction loan for the project, and will eventually be taken out by the $13.1 million package of tax equity, provided by both the project’s 4% low-income housing tax credits and a reservation of federal historic rehabilitation tax credits.

To make this mixed financing work, the funders also had to be flexible about what they could control. “We have to credit MassHousing, which let HUD control the construction process,” said David Ennis, a consultant and the president of Affirmative Investments, also based in Boston.

The tax credit investors also had to satisfy themselves that the project’s Sec. 202 subsidies would not be counted against the project’s eligible basis. Eligible basis is the figure that the IRS uses to figure the tax benefits generated by tax credit apartments. If the eligible basis shrinks, then the apartment becomes less valuable to tax credit investors.

HUD supplied roughly $600 million per year for the development of new Sec. 202 projects in recent years. That amounts to just $12 million per state, and means only a few new Sec. 202 projects are built in each state each year. But mixing tax credits with Sec. 202 grants may quickly become the main way that these new projects are financed – especially since the Sec. 202 application process rewards applications that leverage the Sec. 202 grants with other funds, like tax credits.

“It’s a small to medium-sized opportunity,” Dober said. “But a good one.”