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.