In the current affordable housing development environment, multifamily projects that are not awarded competitive 9% low-income housing tax credits (LIHTCs) in a particular state are more frequently exploring the 4% credit, which is available for transactions in which at least 50% of the aggregate basis in the project is financed with the proceeds of tax-exempt bonds or loans (collectively “bonds”) issued by state and local housing agencies and certain municipalities using private-activity bond volume cap.
Since the 4% tax credit rate was locked in at the end of 2020, demand for bonds in many jurisdictions has increased significantly, and, due to a variety of associated benefits including those stemming from certain Community Reinvestment Act requirements, it is becoming increasingly common for many banks and other lenders that purchase such bonds to also invest in the 4% LIHTCs. This dual-role approach tends to result in better tax credit pricing and a more streamlined and efficient execution but can trigger the application of certain tax rules that may significantly impact the structure of these transactions.
More specifically, two federal tax implications must be noted when contemplating a deal in which the same entity (or an affiliate thereof) is expected to hold the bonds and invest in the 4% LIHTCs via an ownership interest in the partnership in excess of 50% (whether as a direct limited partner or through a tax credit equity syndicator). The first is the “substantial user” restriction, pursuant to which interest on the bonds, which would otherwise be exempt from federal income taxation, will be taxable to the holder thereof if such holder is a “substantial user” of the project (e.g., the borrower partnership that owns and operates the facility) or is a “related person” of the substantial user.
Practically, this means that a bondholder that is also serving as the tax credit investor on a project would be treated as a “related person” of the borrower, and, thus, interest received on the bonds would not be exempt from federal income taxation. To address this consideration, it is common for lenders to charge interest at a higher rate in this scenario.
The second, and potentially more complicating, tax consequence arises out of the provisions related to restrictions on the fees that an issuer may charge in connection with a bond issue. Under the “purpose investment” and “program investment” rules set forth in the Treasury regulations, if a party “related” to the borrower (such as an investor in the tax credit partnership with an interest greater than 50%) also owns the bonds, the fee collected by the issuer (both up-front and on an ongoing basis) is not permitted to exceed 0.125% on an annual basis (blended for the term of the bonds). This can present a challenge for many deals across the country, as a number of state housing agencies and certain other conduit issuers charge fees well in excess of the prescribed limit; accordingly, additional planning is often needed to enable an organization to serve in both the debt and equity roles in transactions involving the fact pattern described above.
Despite the constraints imposed by the program investment requirements, several strategies have been developed in recent years to allow for an equity investor to also provide construction financing for a given project, including negotiations with issuers on fee modifications and, where such adjustments are not feasible, structuring techniques that focus on eliminating the relationship between the borrower and the holder of the bonds while allowing the various parties to achieve their economic objectives as originally intended. Developers considering 4% LIHTC deals should contact their lenders, equity investors, and experienced counsel to discuss options for addressing these issues.
