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We are regularly asked a number of questions regarding the use of HOME funds in a low-income housing tax credit (LIHTC) transaction. Here is a sample:
Q My development has received a tax credit allocation from the state, but I still have a funding shortfall. The city has offered to provide a grant of HOME Investment Partner-ship Act (HOME) funds to close the gap. What issues should I be thinking about?
A HOME funds are federal money that originally came from the Department of Housing and Urban Development (HUD), so there are a number of issues to consider.
The primary concern is that eligible basis must be reduced by a federal grant that is made with respect to the building or the operation thereof. If the development has eligible basis in excess of the amount necessary to support the credit allocation this rule will not be a problem. Most developments do not have sufficient excess basis.
The other concern is that a grant is taxable income. The owners of the property could find themselves subject to a substantial tax liability with no cash available to pay the taxes. For these reasons, HOME funding usually is provided to a deal in the form of a loan.
Who would be the lender? In some cases the city would be willing to loan the money directly to the development.
In other cases, the city may make a grant to another entity affiliated with the owners of the partnership, and the affiliate would lend the money to the development. Because of the income issue discussed above, the lender is often a not-for-profit entity that is making the loan to further its exempt purpose.
What should be the interest rate on the loan? A below-market federal loan would cause a deal that would otherwise qualify for the 70% present value credit (9% credit) to receive the 30% present value credit (4% credit). If the loan has a market rate of interest, then this pitfall is avoided.
A market rate of interest is defined as a rate at least equal to the applicable federal rate at the time the loan is made. The interest on the loan does not have to be paid currently, but the obligation to pay must be noncontingent and unpaid interest must accrue and compound. If the owner would prefer a below-market interest rate, then there are a few options.
The owner may elect to reduce eligible basis by the amount of a below-market federal loan in order to preserve the 9% credits.
This election makes sense if the development has excess eligible basis or the HOME loan is small, and the other structuring options are not feasible.
Alternatively, it is possible to preserve the 9% credits with below-market HOME funds if certain additional conditions are met. Internal Revenue Code (IRC) Sec. 42(i)(2)(E) provides an exception to the definition of a below-market federal loan for a building with HOME financing if 40% of the units in the building are rented to tenants whose income is 50% or less of area median gross income (AMGI) (40/50 test).
Owners who are using this rule to avoid the definition of a below-market federal loan cannot qualify for the 30% eligible basis increase for qualified census tracts (QCT) or difficult to develop areas (DDA). Most owners in a QCT or DDA will not choose to structure the loan to meet the special exception.
The application of the 40/50 test raises questions because of some definitions associated with the HOME program. The HOME program allows an owner to either specifically identify which rental units are HOME units or the units may float among all of the units in the project.
HOME units have to meet specific rent and tenant income rules in addition to those that normally apply to the LIHTC program.
The number of HOME units is generally determined by comparing the amount of HOME funding to all funding sources and multiplying that percentage by the number of rental units in the project. For example, if 10% of the financing is from HOME funds, then 10% of the units would be designated as HOME units.
If an owner decides to designate all the units in one building as HOME units, the owner must still meet the 40/50 test on each building in the project to qualify for the special tax credit exception.
Revenue Ruling 2004-82 clarified a number of issues related to the 40/50 test, including the rent limitations that apply to a project that uses the special HOME exception.
The 40/50 test applies only to the income of the tenants and does not impact the rents that can be charged to those tenants. If the owner elects to use the 40/60 test for the minimum set-aside, then rents for the entire project will be calculated based on 60% of AMGI, not 50%.
The owner would need to consider the ability of a tenant whose income is less than 50% of AMGI to pay the rents based on 60% of AMGI.
Occasionally the HOME lender or the state housing credit agency may require that an owner using the 40/50 exception make the rents affordable to tenants whose income is 50% or less of AMGI.
Q The local jurisdiction would like to provide HOME funds to the transaction in the form of rental assistance to the tenants. What issues do I need to consider?
A There are two potential problems with using HOME money as rental assistance in a LIHTC property. The first concerns the definition of gross rent in IRC Sec. 42(g)(2)(B). A residential rental unit is rent restricted if the gross rent with respect to the unit does not exceed 30% of the income limitation that applies to the unit.
The income limitation is a combination of the minimum set-aside elected and the number of bedrooms in the unit. Gross rent does not include any payments under Sec. 8 of the United States Housing Act of 1937 or any comparable rental assistance program with respect to the unit or the tenant.
Based on this exception, if the HOME rental assistance was structured to be comparable to Sec. 8 rental assistance, it is not likely to be considered to be gross rent. The more challenging question concerns federal grants.
Rental assistance from HOME funds could be considered to be a federal grant under the definition in IRC Sec. 42(d)(5)(A). The money is from a federal source and the cash is used for the operation of the building during the compliance period. IRS Regulation ¦1.42-16 and several Revenue Rulings have clarified that rental assistance under Sec. 8, Sec. 9 and several other programs are not to be treated as federal grants that reduce basis.
The list does not include rental assistance provided by HOME funds.
Interestingly enough, Chapter 6 of the IRS audit guide for the LIHTC states that “Eligible basis does not have to be reduced if the proceeds of a Federal grant are used as rental assistance payment under Sec. 8 of the United States Housing Act of 1937 or any comparable rental assistance program.”
The tax law from the IRC, Regulations and Revenue Rulings all carry more legal weight than the audit guide, so an owner should avoid the use of HOME funds as rental assistance until the IRS clarifies the grant issue.
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.