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We are regularly asked a number of questions regarding the use of tax-exempt bonds in a low-income housing tax credit (LIHTC) transaction. Here is a sample:
Q I am thinking of doing a tax-exempt bond-financed LIHTC deal. What practical issues should I be aware of?
A The first thing to identify is the availability of tax-exempt bond financing to be used for residential rental property. A tax-exempt bond must be subject to the private-activity bond volume cap in order to qualify as a bond that will potentially allow the owner to also claim the LIHTC. The process to obtain an allocation of volume cap bonds varies from state to state and some states allocate none of their volume cap to qualified residential rental properties. The bonds may be issued by the state agency, a county or other local jurisdiction, so it is critical for the developer to be certain that the bonds are tax-exempt volume cap bonds.
Once an allocation of volume cap bonds has been secured, the development has to go through the low-income tax credit underwriting required by Internal Revenue Code (IRC) Sec. 42(m). The IRC requires that a property that intends to claim tax credits by virtue of IRC Sec. 42(h)(4) – that is, a property financed by tax-exempt bonds - must meet the requirements for an allocation of LIHTC under the applicable qualified allocation plan, and this determination is usually made by the state tax credit agency. The bond issuer has the responsibility to determine that the tax credit amount to be claimed by the property does not exceed the amount necessary for financial feasibility. This responsibility is often delegated to the state agency. The end result of these reviews is the issuance of what is called a 42(m) letter, which most investors will require as a part of the due diligence process.
Q What special tax-exempt bond rules do I need to be aware of?
A The first set of rules determines the types of costs for which the bond proceeds can be spent. In order to be a qualified residential rental exempt facility, 95% of a project’s net proceeds must be used to finance residential rental property, which includes functionally related and subordinate facilities like parking and recreational facilities for the tenants. This analysis is known as the “good money/bad money” test and either the accountant or bond counsel certifies the expected use of proceeds at the time the bonds are issued. The cost of commercial property, certain construction costs incurred prior to bond inducement and the cost of health clubs are among the “bad” costs. Issuers can’t use more than 2% of the bond proceeds to pay for issuance costs – but because these costs often exceed the 2% limit, the developer must be prepared to finance the excess with equity or taxable bond loan proceeds.
Qualified residential rental projects must meet a minimum set-aside requirement that is very similar to the set-aside requirements in Sec. 42. At the time the bonds are issued, the project elects to meet either the 20-50 test or the 40-60 test. The 20-50 test means that 20% or more of the units in the project are occupied by tenants whose income is 50% or less of the area median gross income. The test is met on a project-wide basis rather than on each building as is the basic requirement of IRC Sec. 42. There is no restriction on the rents that can be charged to the tenants, but if the units are going to qualify as LIHTC low-income units, the more restrictive tax credit requirements must be met. The owner must certify compliance with the applicable test annually with the Internal Revenue Service using form 8703. The penalty for noncompliance that is not corrected in a reasonable period of time is that the interest on the bonds becomes taxable to the bond holders. The loan and bond documents are likely to contain severe penalties for the owner who fails to meet the requirements to keep the bonds tax-exempt.
Q What is the 50% test and how is it calculated?
A IRC Sec. 42(h) generally requires a building to receive an allocation of LIHTC from the state tax credit agency in order to claim credits. If 50% or more of the aggregate basis of any building and the land on which the building is located is financed by tax-exempt volume cap bonds, then no allocation is needed from the state agency, though the state agency will ultimately issue the 8609 forms for the project. The numerator of the 50% calculation only includes the bonds that have been used to finance land or building costs, so it is not a good strategy to use bonds to fund reserves or any costs of issuance. The bond proceeds do include interest income earned on the bonds. The bond documents determine how the bond proceeds are to be used for purposes of this test, so it is important to make sure they specify the use for building construction or land acquisition.
As mentioned above, the state agency still must make a determination that the project has met the requirements of the qualified allocation plan and that the project needs the credits for long-term viability. The downside of tax-exempt bond financing is that it only allows a project to qualify for the 30% present value credit (4% credit). Only when the project is complete and the real construction costs are determined does the owner know that the 50% test has been met. Sometimes a project will fail the test based on an initial analysis at completion.
Q What happens if the project fails to meet the 50% test at completion? How can I avoid this result?
A If the project fails to meet the 50% test, only the portion of the eligible basis financed by the tax-exempt bonds will qualify for the 4% credit. The rest of the eligible basis will only get credit if the owner applies for and receives a tax credit allocation from the state agency. This allocation or a binding commitment for a future year allocation must be received in the year that the building is placed in service. As a practical matter, the owners usually come up with a strategy to meet the 50% test.
One approach is to get an additional allocation of volume cap tax-exempt bonds not later than the year the buildings are placed in service. Since getting this allocation usually takes time, the owner should track costs during construction to identify likely cost overruns that will threaten the 50% test. If the owner gets an additional allocation, the loan is not likely to be a permanent source of financing because projected net operating income cannot support additional debt. The additional bonds will usually pay for construction costs and then be retired by investor equity or other financing after remaining outstanding for a relatively short period of time. The IRC does not specify exactly when the 50% test has to be met and most practitioners look to the period of time between the “placed in service” date for all of the buildings and the end of the first year of the credit period.
The other solution to the problem is to reduce the cost of the building and land. The construction contract could be written for a fixed amount with no allowance for change orders in excess of the expected contingency. The general partner may guarantee a maximum construction cost including all of the capitalized soft costs. Cost overruns would be paid for by the general partner or guarantor and thus would not be a cost of the partnership included in the 50% test. The least attractive fix is a reduction of the development fee. This reduction should be documented by an amendment to the fee agreement. Most investors will require some combination of these protections in the partnership agreement to avoid 50% test issues upon completion.
Reznick Group has more than 25 years of experience providing accounting, tax and business advisory services to clients nationwide. The expertise of the firm is broad, ranging from real estate and management advisory to auditing and tax preparation. Ranked among the top 20 public accounting firms in the nation, Reznick Group is on the move – continuing to grow nationally, expanding its services, and building upon its leadership as industry experts.
Beth Mullen is a principal in the Real Estate Consulting Group of Reznick Group, based in Sacramento, Calif.