In lieu of a tax exemption, tax credit bonds (TCBs) provide a tax credit or direct payment equivalent to the bond’s face value. The majority of TCBs have a defined purpose and were created as temporary tax measures.
What is the purpose of tax-exempt housing bonds?
Purchasers of bonds can deduct interest income from their federal gross income taxes under Section 103 of the Internal Revenue Code. As a result, tax-exempt bonds have a lower interest rate than normal bank financing (usually by approximately 2%), and these savings can help to increase housing affordability.
What is the source of tax credits?
The Low-Income Property Tax Credit (LIHTC) helps low- and moderate-income renters by subsidizing the purchase, construction, and repair of affordable rental housing. The LIHTC was created as part of the 1986 Tax Reform Act, and it has been amended several times since then. Since its introduction in the mid-1990s, the LIHTC program has helped to fund the construction or restoration of nearly 2 million affordable rental units (though there was a sharp drop-off following the Great Recession of 200809).
State and territory governments receive tax credits from the federal government. After a competitive process, state housing authorities distribute the credits to private developers of affordable rental housing projects. To raise money, developers usually sell the credits to private investors. Investors can claim the LIHTC for a 10-year period after the housing project is put into operation (i.e., made available to tenants).
Qualifying for the Credit
Apartment buildings, single-family dwellings, townhouses, and duplexes are among the types of rental properties that qualify for the LIHTC.
Owners or developers of LIHTC-eligible projects agree to meet a tenant income requirement as well as a gross rent test. The income test can be passed in three ways:
- Tenants having an income of 50% or less of the regional median income adjusted for family size occupy at least 20% of the project’s units (AMI).
- At least 40% of the units are occupied by tenants with an annual income of 60% or less of the AMI.
- At least 40% of the units are occupied by tenants with an annual income of no more than 60% of AMI, and no units are inhabited by tenants with an annual income of more than 80% of AMI.
Depending on the percentage of tax credit rental units in the property, the gross rent test mandates that rentals do not exceed 30% of either 50 or 60% of AMI. For 15 years, all LIHTC developments must meet the income and rent standards, or credits will be recovered. In most cases, an extended compliance time (totaling 30 years) is also enforced.
Computing the Credit
A taxpayer’s annual credit is calculated by multiplying the credit percentage by the project’s qualified basis. The percentage is higher for new construction or substantial rehabilitation (roughly 9% but specified in the law as a 70% present value credit) than for properties acquired for rehabilitation or projects funded with tax-exempt bonds (roughly 9% but specified in the law as a 70% present value credit) (roughly 4 percent but specified as a 30 percent present value credit). The qualifying basis is the portion of the housing project’s cost that is rented to tenants who meet the income requirements. The owners or developers of many LIHTC projects hope to rent all of the apartments to qualified tenants. Enhanced tax credits may be allocated by state housing finance agencies to approved projects in locations where there is a high demand for affordable rental housing.
The LIHTC Act initially required the IRS to change the specified credit percentages on a regular basis in order to keep the present value of the 10-year stream of tax credits at 70% or 30% of the qualified base. Since 2008, however, Congress has mandated that the minimum credit rate for the 70% present value credit be at least 9%, regardless of current interest rates. In a low-interest rate environment, the present value of the credits claimed over a 10-year period will be greater than 70% of the qualified basis.
Allocating the credit
The amount of LIHTC that can be provided in any given year is decided by Congress. For 2018, each state received $2.765 million or $2.40 per capita, whichever was greater. However, due to a 12.5 percent increase in funding from Congress from 2018 through 2021, these values have been boosted to $3.1 million and $2.70, respectively, for 2018. Both figures have been adjusted for inflation.
When calculated on a per capita basis, this structure ensures that states with small populations receive a somewhat greater prize. States then distribute these credits to developers based on state-created qualified allocation programs (usually through state housing finance organizations). These plans must prioritize initiatives that benefit very low-income households and provide affordable housing for longer periods of time.
The state housing finance authority does not require a separate credit allocation for projects financed with private activity tax-exempt bonds. The use of these bonds, however, must be approved by the state, which serves as a limit on developers’ ability to obtain 30 percent current value LIHTCs.
Developers typically sell tax credits to investors, who may be better positioned to take advantage of the tax credits and other benefits associated with the housing project (e.g., depreciation, interest paid, net operating losses). Investors also provide equity, which is usually done through syndication or partnership. The investors or limited partners normally take a back seat, collecting the project’s tax benefits but not being involved in day-to-day management and monitoring.
The majority of LIHTC investors are corporations with enough income tax obligation to fully utilize nonrefundable tax credits. Because they have significant income tax burdens, a long planning horizon, and typically obtain Community Reinvestment Act credit from their regulators, financial institutions have traditionally been large investors. Taxpaying investors will not be able to claim credits until the project is operational.
Calculating Costs and Benefits
The annual cost of the LIHTC is anticipated to be roughly $9.5 billion. It is by far the most significant federal program promoting the development of affordable rental homes for low-income families. Supporters consider it as a successful initiative that has significantly boosted the supply of affordable homes for over 30 years. The Low-Income Housing Tax Credit (LIHTC) addresses a key market failure: a dearth of high-quality, affordable housing in low-income areas. The use of private-sector business incentives to create, manage, and maintain affordable housing for lower-income tenants results in efficiencies.
The federal subsidy per unit of new construction is larger than it needs to be, according to critics of the LIHTC, because of the multiple intermediaries engaged in its financingorganizers, syndicators, general partners, managers, and investorseach of whom is reimbursed for their work. As a result, a large portion of the federal tax subsidy does not go toward the construction of new rental housing stock. Another major flaw, according to critics, is the statute’s and regulations’ complexity. Another disadvantage is that certain state housing finance agencies authorize LIHTC projects in ways that concentrate low-income residents in historically segregated areas with limited economic opportunities. Finally, while the LIHTC may assist in the construction of new affordable housing, preserving that affordability once the mandatory compliance periods have passed is difficult.
How does the 50 bond test work?
Under present law, if tax-exempt PABs finance 50% or more of the aggregate basis of a residential rental property’s land and building, the building owner is generally allowed to claim tax credits without obtaining an allocation from the allocating agency’s LIHTC volume cap.
What is the LIHTC 50 percent test?
A variety of queries about the use of tax-exempt bonds in a low-income housing tax credit (LIHTC) transaction are frequently asked. As an example, consider the following:
Q I’m considering a LIHTC venture backed by tax-exempt bonds. What practical considerations should I keep in mind?
A The first step is to determine whether tax-exempt bond financing for residential rental property is available. In order to qualify as a bond that may allow the owner to claim the LIHTC, a tax-exempt bond must be subject to the private-activity bond volume cap. The method for obtaining a volume cap bond allocation varies by state, and some states do not distribute any volume cap bonds to qualified residential rental units. Because the bonds could be issued by a state agency, a county, or another local government, the developer must ensure that the bonds are tax-exempt volume cap bonds.
After securing a volume cap bond allocation, the project must go through the low-income tax credit underwriting required by Internal Revenue Code (IRC) Sec. 42. (m). According to the Internal Revenue Code, a property that intends to claim tax credits under 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, which is usually determined by the state tax credit agency. It is the responsibility of the bond issuer to ensure that the tax credit amount claimed by the property does not exceed the amount required for financial viability. This task is frequently entrusted to a state agency. The end outcome of these audits is the issuance of a 42(m) letter, which is required by most investors as part of the due diligence process.
A The first set of guidelines establishes the types of expenses that bond proceeds can be used for. To qualify as a qualified residential rental exempt facility, a project’s net revenues must be utilized to finance residential rental property, which includes functionally linked and subordinate facilities such as parking and recreational facilities for tenants. The “good money/bad money” criteria is used in this study, and either the accountant or bond counsel verifies the expected use of proceeds when the bonds are issued. Commercial property expenditures, certain building costs incurred prior to bond inducement, and health club costs are all examples of “poor” costs. Issuers are only allowed to utilize 2% of bond proceeds for issuance costs; however, because these costs frequently exceed this limit, the developer must be prepared to fund the difference with equity or taxable bond loan profits.
Residential rental developments must meet a minimum set-aside requirement that is substantially comparable to Sec. 42’s set-aside standards. The project chooses whether to meet the 20-50 or 40-60 criteria when the bonds are issued. The 20-50 test determines if 20% or more of the units in a project are occupied by tenants earning 50% or less of the area median gross income. The test is passed on a project-wide level rather than on a building-by-building basis, as required by IRC Sec. 42. The rents that can be charged to renters are unrestricted, but if the units are to qualify as LIHTC low-income units, the more stringent tax credit conditions must be met. Annually, the owner must file Form 8703 with the Internal Revenue Service to attest compliance with the appropriate test. The penalty for noncompliance that is not addressed within a reasonable amount of time is that the bondholders’ interest becomes taxable. If the owner fails to meet the requirements to keep the bonds tax-exempt, the loan and bond papers are likely to include harsh penalties.
In order to claim credits, a building must get an allocation of LIHTC from the state tax credit agency, according to IRC Sec. 42(h). If tax-exempt volume cap bonds fund 50% or more of the aggregate basis of any building and the land on which the building is located, no allocation from the state agency is required, however the state agency will eventually issue the 8609 forms for the project. Because the numerator of the 50 percent computation only covers bonds used to finance land or building expenditures, using bonds to fund reserves or any issuance charges is not a smart strategy. Interest income collected on the bonds is included in the bond proceeds. For the purposes of this test, the bond paperwork establish how the bond proceeds will be utilized, therefore make sure they specify that they will be used for building construction or land acquisition.
As previously stated, the state agency must still determine whether the project meets the qualified allocation plan’s requirements and whether the credits are required for long-term survival. The disadvantage of tax-exempt bond financing is that it only qualifies a project for a 30% present value credit (4 percent credit). The owner will only know if the 50 percent test has been fulfilled once the project is completed and the true construction costs have been established. An initial analysis at the end of a project might sometimes cause it to fail the test.
Q What happens if the project fails to pass the 50% test when it’s finished? What can I do to avoid this outcome?
A Only the portion of the qualifying basis financed by tax-exempt bonds will qualify for the 4 percent credit if the project fails to fulfill the 50 percent threshold. Only if the owner asks for and receives a tax credit allocation from the state agency will the rest of the eligible basis be credited. This allocation, or a binding commitment for a future year allocation, must be received in the year the structure is put into service. Practically speaking, the owners normally devise a strategy to pass the 50 percent test.
One option is to obtain an additional allocation of volume cap tax-exempt bonds before the structures are put into operation. Because obtaining this allocation takes time, the owner should keep track of costs throughout the construction process to identify possible cost overruns that would jeopardize the 50 percent test. Even if the owner receives an additional allocation, the loan is unlikely to be a long-term funding source because predicted net operational income cannot support more debt. The additional bonds will typically be used to cover construction costs before being repaid by investor equity or other financing after a short length of time. The IRC does not define when the 50 percent test must be fulfilled, but most practitioners use the time between the “put in service” date for all of the buildings and the end of the first year of the credit period as a guideline.
The problem can also be solved by lowering the building and land costs. The construction contract might be written for a set price, with no allowance for change orders beyond the projected contingency. A maximum construction cost, including all capitalized soft costs, may be guaranteed by the general partner. Cost overruns would be paid for by the general partner or guarantor, and so would not be included in the 50 percent test as a cost of the partnership. A reduction in the development fee is the least appealing solution. An update to the fee agreement should be used to document this reduction. To avoid 50 percent test concerns after completion, most investors will want a combination of these protections in the partnership agreement.
The Reznick Group has over 25 years of expertise providing accounting, tax, and business advising services to clients throughout the United States. The firm’s experience ranges from real estate and management consulting to audits and tax preparation. Reznick Group, ranked among the top 20 public accounting firms in the country, is on the rise, with plans to extend its national footprint, increase its services, and strengthen its position as industry specialists.
Beth Mullen is a principal of the Reznick Group’s Real Estate Consulting Group in Sacramento, California.
How does house bonding work?
Bondholders are protected by mortgage bonds that are backed by a valued real asset or a collection of assets. In the event that the borrower defaults, the mortgage bondholders have the right to sell the collateral assets in order to recover the principal.
The contract provisions dictate when and how bondholders can sell assets, as well as how the proceeds of the sale are allocated. Mortgage bonds often have lower interest rates than standard corporate bonds that are not secured by real assets due to a lower level of risk.
A corporation, for example, borrowed $1 million from a bank and pledged its equipment as security. The bank owns a claim on the company’s equipment and holds the mortgage bond. Through monthly coupon payments, the corporation repays the bank with interest and principle.
If the corporation makes all of the payments on time, it will be able to keep the equipment. If it is unable to repay the bank in full, the bank has the right to sell the equipment to recoup the funds lent.
Pros and Cons of Mortgage Bonds
Mortgage bonds offer borrowers and lenders a number of benefits. Because these bonds are secured by real assets, their lenders are exposed to fewer potential losses in the event of default. Mortgage bonds can enable less creditworthy customers to borrow larger sums of money at reduced interest rates.
Mortgage bonds can be securitized into financial derivatives and sold to investors, increasing capital market liquidity and allowing risk transfer.
The danger of losing the collateral if the borrowers default on their payments is one of the disadvantages of mortgage bonds. Despite the fact that the lender acquires ownership of the property,
What is the purpose of mortgage bonds?
Definition of a Mortgage Bond Mortgage bonds are sold by lenders to real estate investors who get interest payments on the loans until they are paid off. In the event of a default, an investor has a claim on the assets put up as collateral, such as a house, and can take possession of them.
Are tax credits beneficial?
Tax credits are often preferred over tax deductions since they reduce the amount of tax you owe directly. Your marginal tax bracket determines the impact of a tax deduction on your tax liability. For example, if you’re in the 10% tax bracket, a $1,000 deduction will only lower your taxable income by $100 (0.10 x $1,000 = $100).
Even so, if you’re eligible for both a tax credit and a deduction for the same expenses, calculating the numbers can help you figure out which would save you the most money come tax season.
What does the tax credit directly benefit owners?
Amounts that businesses can deduct from their taxes payable to the government are known as business tax credits. Unlike a deduction, which is used to lower taxable income, business tax credits are used against the taxes payable. When businesses file their annual tax returns, they apply the tax credits. The Internal Revenue Service (IRS) in the United States regulates the administration of business tax credits, which are used to reduce a company’s financial obligation to the federal government.
Is a tax credit the same as a refund?
The term “refundable” refers to the fact that if you qualify for a refundable credit and the credit amount exceeds the amount of tax you owe, you will receive a refund for the difference.
- If you owe $800 in taxes and are eligible for a $1,000 refundable credit, you will get a $200 refund.
- Refundable tax credits, like payroll withholding, are considered tax payments. This implies that, much like the amount of tax withdrawn from your salary, the amount of a refundable tax credit is deducted from the amount of taxes payable.
- The amount of your refund might be substantial with some of the larger refundable credits, such as the Earned Income Tax Credit. Refundable credits are thus one of the most valuable components of your tax return.
Even with zero tax liability, you may still qualify
Some taxpayers may discover that they owe no taxes due to nonrefundable credits, deductions, or other conditions. Even if no taxes are owing, taxpayers can apply for any refundable credits they are eligible for and receive a refund for the amount of the credit or credits.
- If you have no taxes due and are eligible for a $2,000 refundable tax credit, for example, you will receive the entire $2,000 as a refund.
- As a result, after accounting for all nonrefundable credits, deductions, and tax payments, consider computing any refundable tax credits.
What is the LIHTC ten percent test?
The Reznick Group has over 25 years of expertise providing accounting, tax, and business advising services to clients all around the United States. The firm’s capabilities are diverse, spanning from real estate and management consulting to auditing and tax preparation. Reznick Group, which is ranked among the top 20 public accounting firms in the country, is on the rise, expanding its services and solidifying its position as an industry leader.
Terence Kimm, CPA, is a principal with Reznick Group and co-head of the Real Estate Consulting Group in Bethesda, Maryland, where he works with developers and syndicators on low-income housing, historic, and New Markets tax credit deals.
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Q: We’ve traditionally created tax-exempt bond arrangements for low-income housing tax credits (LIHTC). We submitted our first 9 percent competitive LIHTC proposal in early 2007. Our application was approved, and we received a letter confirming our reservation. Following that, on December 31, we were given a carryover allocation. Meeting the 10% test by June 30, 2008 was one of the conditions of our carryover allotment. What does the ten percent test entail?
A: A project must qualify for a carryover allocation if it is not completed before the end of the calendar year in which the LIHTC allocation was received. A valid carryover allocation must meet two federal standards. The first is that the basis in the project must meet particular criteria by the later of either six months after the date of the allocation or the end of the calendar year in which the allocation was made. It must be greater than 10% of the project’s “reasonably projected” base by the end of the second calendar year after the year of allocation. The ten percent test is another name for this. The project must subsequently be put into operation by the end of the second calendar year after the year of allocation, according to the second statutory criteria. To be eligible for a carryover allocation, you must have incurred at least 10% of the project’s reasonably estimated basis by June 30, 2008, and the project must be put into operation by December 31, 2009.
Q: What happens if the 10% test isn’t passed by June 30, 2008? Is there any wriggle room?
A: The majority of HFAs will ask you to fill out a carryover allocation application. A certification from an attorney or certified public accountant that the taxpayer has invested more than 10% of its reasonably expected basis in the project will be included in this.
Q: What does “reasonably expected basis” mean, and how does the 10% test work?
The 10% test is a fraction that is calculated as follows. As of the HFA’s measurement date, the numerator is the taxpayer’s adjusted basis in land and depreciable property that is reasonably expected to be part of the project. As of the conclusion of the second year after the year of allocation, the denominator is the taxpayer’s adjusted basis in land and depreciable property that is reasonably expected to be part of the project. It’s worth noting that neither the numerator nor the denominator’s descriptions include eligible basis. As a result, all costs associated with the project’s commercial component might be included in both. Furthermore, any base boost due to the project’s location in a designated census tract or challenging development area is disregarded. Simply put, the numerator is the taxpayer’s current basis in land and depreciable property, and the denominator is the taxpayer’s predicted basis in land and depreciable property at the time of construction completion.
A: It depends on the taxpayer meeting the test’s method of accounting for income tax purposes. All costs included in the numerator must be paid if the taxpayer is a cash basis taxpayer for income tax purposes. If the taxpayer uses the accrual basis for income tax purposes, the laws governing economic performance will determine whether a cost can be lawfully accumulated. The vast majority of LIHTC recipients are accrual basis taxpayers. For accrual basis taxpayers, fees for services rendered are normally deductible charges; however, the services must have been completed. This leads me to one of the most typical issues I’ve encountered while reviewing 10% tests. The taxpayer who receives the carryover allocation must be one who meets the 10% standard. The name of the taxpayer who got the carryover allocation shall appear on all project invoices, contracts, and cancelled checks. If the contracts are not in the taxpayer’s name, an assignment and assumption agreement should be in place to transfer the contracts to that taxpayer. There should be a reimbursement agreement between the payer and the taxpayer who got the carryover allocation if invoices and canceled checks are not in the name of the taxpayer who received the carryover allocation.
A: The following things have occasionally caused 10% test difficulties for various reasons:
- Land acquisition, particularly purchases from connected parties and purchase money notes;
- Certain documents will be required if a portion of the development charge is to be included.
- Fees for financing might be complicated, particularly if you use the same construction and permanent lender.
- Fees paid to government bodies are subject to various economic performance requirements that must be followed; and
- Prior to the start of construction, supplies must be purchased and stored, which will necessitate early planning and documentation.
In conclusion, the planning process for passing the 10% test should begin well before the HFA report’s due date. Providing your accountant with a schedule of the estimated costs incurred and the reasonably expected basis well before the due date will enable them to perform a quick analysis of the incurred costs, provide you with a list of what backup documentation will be required, identify any potential problem areas, and allow for timely completion when due. Now is the moment for surprises, not immediately before the ten percent exam.