Low-Income Housing Tax Credit

What is the Low-Income Housing Tax Credit (LIHTC)?

The Low-Income Housing Tax Credit (LIHTC) is the principal federal program for encouraging the investment of private equity in the development and rehabilitation of affordable rental housing. Enacted as part of the Tax Reform Act of 1986, LIHTC is not a direct subsidy but rather a dollar-for-dollar reduction in federal income tax liability for investors. This mechanism effectively lowers the cost of equity for developers, making otherwise financially unfeasible affordable housing projects viable. The program has been instrumental in creating and preserving millions of affordable housing units across the United States, representing the largest source of affordable housing capital in the nation.

Unlike traditional tax deductions that reduce taxable income, tax credits directly reduce the amount of tax owed. This makes LIHTC highly attractive to corporate and individual investors with substantial tax liabilities, as it provides a predictable, long-term return in the form of tax savings. The credits are allocated to states, which then distribute them to developers through a competitive application process based on their Qualified Allocation Plan (QAP).

Mechanics of LIHTC: How It Works

The core principle of LIHTC involves the federal government providing tax credits to state and local housing finance agencies. These agencies then award the credits to eligible developers of affordable rental housing projects. Developers, in turn, typically sell these credits to private investors (often corporations or high-net-worth individuals) in exchange for equity financing. This equity infusion significantly reduces the amount of debt a project needs, thereby making the rents more affordable for low-income tenants.

Key Components and Terminology

• Qualified Basis: This is the portion of a project's eligible development costs attributable to low-income units. It excludes land costs and certain other expenses. The amount of tax credits a project generates is directly tied to its qualified basis.
• Applicable Percentage: This is the rate at which the qualified basis is multiplied to determine the annual credit amount. It is fixed monthly by the IRS and is approximately 9% or 4%, depending on the project type and financing structure.
• Credit Period: LIHTC credits are claimed annually over a 10-year period. This period begins in the year the building is placed in service or, at the election of the developer, the succeeding taxable year.
• Compliance Period: Projects receiving LIHTC must remain affordable and comply with program rules for a minimum of 15 years. Many states require an extended use period, often 30 years or more, to ensure long-term affordability.
• Basis Boosters: Certain projects can receive an increase in their qualified basis, typically 30%, if located in a Difficult Development Area (DDA), a Qualified Census Tract (QCT), or if receiving certain state or local subsidies. This increases the total credits generated.
• Recapture: If a project fails to comply with LIHTC requirements during the 15-year compliance period, a portion of the previously claimed tax credits may be 'recaptured' by the IRS, meaning investors would owe back taxes.
• Passive Activity Loss (PAL) Rules: LIHTC credits are generally exempt from the passive activity loss limitations, making them particularly valuable for investors who might otherwise be unable to utilize passive losses.

Types of LIHTC Credits and Allocation

There are two primary types of LIHTC credits, each with distinct allocation methods and project characteristics:

1. The 9% Competitive Credit (New Construction/Substantial Rehabilitation)

• Allocation: These credits are highly competitive and are allocated by state housing agencies based on a rigorous application process outlined in their Qualified Allocation Plan (QAP). States receive an annual per capita allocation from the federal government.
• Applicable Percentage: Historically, this credit was designed to subsidize approximately 70% of the present value of the qualified basis for new construction or substantial rehabilitation projects without federal subsidies. The actual rate floats monthly but is capped at 9% for calculation purposes, hence the common nomenclature.
• Project Types: Typically used for ground-up new construction or major rehabilitation of existing properties where significant capital investment is required.

2. The 4% Non-Competitive Credit (Acquisition/Tax-Exempt Bond Financed)

• Allocation: These credits are non-competitive and are automatically available for projects that are financed with at least 50% tax-exempt private activity bonds. States do not have a separate cap for 4% credits; rather, they are tied to the state's volume cap for tax-exempt bonds.
• Applicable Percentage: This credit is designed to subsidize approximately 30% of the present value of the qualified basis. The actual rate floats monthly but is capped at 4% for calculation purposes. It applies to the acquisition costs of existing buildings and new construction/rehabilitation costs when paired with tax-exempt bonds.
• Project Types: Often used for the acquisition and moderate rehabilitation of existing affordable housing properties, or for larger new construction projects that can leverage tax-exempt bond financing.

Eligibility Criteria and Compliance Requirements

To qualify for and maintain LIHTC, projects must adhere to strict eligibility and compliance standards designed to ensure long-term affordability and quality housing.

• Tenant Income Limits: A minimum percentage of units must be occupied by tenants whose incomes do not exceed a specified percentage of the Area Median Income (AMI). Developers must choose one of two minimum set-aside tests:
• 20/50 Test: At least 20% of units must be occupied by tenants with incomes at or below 50% of AMI.
• 40/60 Test: At least 40% of units must be occupied by tenants with incomes at or below 60% of AMI.
• Rent Restrictions: Rents for LIHTC units, including utility allowances, cannot exceed 30% of the imputed income for a household at the chosen AMI level (e.g., 30% of 60% AMI for a two-bedroom unit).
• Property Standards: Projects must meet specific health, safety, and habitability standards, including state and local building codes and federal housing quality standards.
• Extended Use Agreement: Beyond the 15-year compliance period, most states require an extended use period, typically 30 years, during which the property must continue to operate as affordable housing. This ensures long-term community benefit.

Advanced LIHTC Credit Calculation Methodology

Calculating the annual LIHTC credit involves several steps, starting with determining the eligible basis and then applying the appropriate percentages and fractions. The general formula for the annual credit is:

Annual Credit = Qualified Basis × Applicable Percentage × Applicable Fraction

Step-by-Step Calculation Process

1. Determine Total Project Costs: Sum all eligible development costs, excluding land and certain other expenses (e.g., commercial space costs).
2. Calculate Eligible Basis: This is the total project costs minus ineligible costs (e.g., land, developer fees above limits, commercial space). For acquisition projects, the acquisition cost of an existing building is also part of the eligible basis, but it must be adjusted if the building was previously placed in service by the same owner or a related party.
3. Apply Basis Boosters (if applicable): If the project is located in a DDA or QCT, or receives certain state/local subsidies, the eligible basis can be increased by 30%. This is a critical factor in maximizing credit generation.
4. Determine Qualified Basis: Multiply the eligible basis (with boosters) by the 'applicable fraction.' The applicable fraction is the lesser of the unit fraction (number of low-income units / total units) or the floor space fraction (square footage of low-income units / total square footage). This ensures credits are only generated for the affordable portion of the project.
5. Identify Applicable Percentage: Use the appropriate 9% or 4% credit rate. For 9% credits, the rate is set monthly by the IRS; for 4% credits, it's also set monthly but is typically lower and applies to projects with tax-exempt bond financing or acquisition costs.
6. Calculate Annual Credit: Multiply the qualified basis by the applicable percentage. This result is the annual federal tax credit amount available for 10 years.

Real-World Example 1: 9% LIHTC New Construction Project

Consider a new construction project for a 50-unit apartment building in a Qualified Census Tract (QCT). The developer aims for 100% low-income units.

• Total Development Costs: $15,000,000
• Land Cost (Ineligible): $1,500,000
• Commercial Space Costs (Ineligible): $500,000
• Low-Income Unit Percentage: 100% (50/50 units)
• Applicable Percentage (approximate): 9% (0.09)
• Location: Qualified Census Tract (QCT) – eligible for 30% basis booster.

1. Calculate Eligible Basis: $15,000,000 (Total Costs) - $1,500,000 (Land) - $500,000 (Commercial) = $13,000,000
2. Apply Basis Booster: $13,000,000 × 1.30 (30% QCT booster) = $16,900,000 (Adjusted Eligible Basis)
3. Determine Qualified Basis: Since 100% of units are low-income, the applicable fraction is 1.0. So, $16,900,000 × 1.0 = $16,900,000
4. Calculate Annual Credit: $16,900,000 (Qualified Basis) × 0.09 (Applicable Percentage) = $1,521,000

This project would generate $1,521,000 in federal tax credits annually for 10 years, totaling $15,210,000 over the credit period. This substantial credit amount provides significant equity for the project, reducing the need for traditional debt.

Real-World Example 2: 4% LIHTC Acquisition and Rehabilitation Project

A developer acquires an existing 80-unit apartment building for rehabilitation, financing the project with tax-exempt bonds. The project is in a Difficult Development Area (DDA).

• Acquisition Cost of Building (Eligible Basis): $10,000,000 (excluding land)
• Rehabilitation Costs (Eligible Basis): $8,000,000
• Low-Income Unit Percentage: 80% (64 of 80 units)
• Applicable Percentage (approximate): 4% (0.04)
• Financing: Over 50% financed with tax-exempt bonds (qualifies for 4% credit).
• Location: Difficult Development Area (DDA) – eligible for 30% basis booster on new construction/rehab costs, but not typically on acquisition basis.

1. Calculate Eligible Basis for Acquisition: $10,000,000
2. Calculate Eligible Basis for Rehabilitation: $8,000,000
3. Apply Basis Booster to Rehabilitation Costs: $8,000,000 × 1.30 (30% DDA booster) = $10,400,000
4. Total Adjusted Eligible Basis: $10,000,000 (Acquisition) + $10,400,000 (Rehab) = $20,400,000
5. Determine Qualified Basis: Applicable fraction is 0.8 (80% low-income units). So, $20,400,000 × 0.8 = $16,320,000
6. Calculate Annual Credit: $16,320,000 (Qualified Basis) × 0.04 (Applicable Percentage) = $652,800

This project would generate $652,800 in federal tax credits annually for 10 years, totaling $6,528,000 over the credit period. While lower than the 9% credit, the 4% credit combined with tax-exempt bond financing provides a powerful tool for preserving and rehabilitating existing affordable housing stock.

Syndication and Investor Participation

The vast majority of LIHTC credits are monetized through a process called syndication. Developers typically do not have sufficient tax liability to utilize the credits themselves. Instead, they partner with syndicators, who are intermediaries that pool capital from institutional investors and allocate the tax credits to them.

Role of Syndicators

• Structuring Partnerships: Syndicators create limited partnerships or limited liability companies (LLCs) where the developer acts as the general partner (GP) and the investors are limited partners (LPs).
• Raising Equity: They solicit and secure equity investments from corporations, banks, and other financial institutions seeking to reduce their tax burden or fulfill Community Reinvestment Act (CRA) obligations.
• Due Diligence and Underwriting: Syndicators perform extensive due diligence on projects to ensure their viability, compliance, and ability to generate the promised tax credits.
• Asset Management: Many syndicators also provide ongoing asset management and compliance oversight to protect investor interests throughout the compliance period.

Investor Motivations

• Tax Liability Offset: The primary driver is the ability to reduce federal income tax liability dollar-for-dollar over a 10-year period, providing a predictable and often superior after-tax return compared to other investments.
• Community Reinvestment Act (CRA) Compliance: Banks and other financial institutions invest in LIHTC projects to meet their CRA obligations, which require them to invest in low- and moderate-income communities.
• Environmental, Social, and Governance (ESG) Goals: LIHTC investments align with ESG initiatives, allowing corporations to demonstrate social responsibility by supporting affordable housing and community development.
• Investment Diversification: LIHTC offers a unique asset class that can diversify an investment portfolio, often providing stable, long-term returns with a social impact.

Benefits and Challenges of LIHTC

Benefits

• Catalyst for Affordable Housing: LIHTC is the most effective tool for creating and preserving affordable housing, leveraging private capital for public good.
• Economic Development: Projects create jobs in construction and property management, stimulate local economies, and revitalize neighborhoods.
• Predictable Investor Returns: Investors receive a stable, long-term stream of tax credits, often with additional benefits like depreciation and potential cash flow.
• Community Impact: Provides safe, decent, and affordable housing, improving quality of life for low-income families and individuals.

Challenges

• Complexity: The program is highly complex, requiring specialized expertise in finance, tax law, and real estate development. The application process is rigorous and competitive.
• Administrative Burden: Developers and property managers face significant ongoing compliance and reporting requirements to state agencies and the IRS.
• Long-Term Commitment: The 15-year compliance period (often extended to 30+ years) requires a long-term commitment to affordable housing, limiting flexibility.
• Market Risks: Despite tax credits, projects are still subject to market risks, including rising operating costs, tenant turnover, and potential changes in AMI.
• Limited Credit Supply: The supply of 9% competitive credits is limited, leading to intense competition among developers and often requiring multiple funding sources.

Strategic Considerations for Developers and Investors

For Developers

• QAP Alignment: Thoroughly understand and align project proposals with the state's Qualified Allocation Plan to maximize competitive scoring.
• Financial Stacking: LIHTC projects often require multiple layers of financing, including conventional debt, subordinate debt, grants, and other public subsidies. Expert financial structuring is crucial.
• Long-Term Compliance: Implement robust property management and compliance systems from the outset to avoid recapture events and maintain project viability.
• Syndicator Relationships: Cultivate strong relationships with experienced LIHTC syndicators to ensure efficient equity raising and project support.

For Investors

• Due Diligence: Conduct comprehensive due diligence on the syndicator, developer, and specific project to assess financial viability, compliance risk, and potential for recapture.
• Risk Assessment: Understand the various risks, including construction delays, cost overruns, market fluctuations, and compliance failures, and ensure appropriate risk mitigation strategies are in place.
• Portfolio Diversification: Integrate LIHTC investments strategically within a broader portfolio to balance tax benefits with other investment goals.
• Exit Strategies: While the primary return is tax credits, understand the potential for residual value at the end of the compliance period and any associated exit strategies for the limited partners.

Current Market Trends and Legislative Outlook

The LIHTC market is dynamic, influenced by economic conditions, interest rates, and legislative actions. Rising interest rates and construction costs have increased the equity gap for many projects, making LIHTC even more critical but also challenging to structure. There is ongoing advocacy for legislative enhancements, such as increasing the state credit allocation, lowering the 50% bond test for 4% credits, and making the 4% credit rate permanently fixed at 4% (rather than floating), to boost the program's effectiveness.

The demand for affordable housing continues to outpace supply, underscoring the enduring importance of LIHTC. Investors are increasingly looking at LIHTC not just for tax benefits but also for its strong ESG alignment, reflecting a broader shift towards impact investing. Navigating this complex landscape requires continuous monitoring of policy changes, market conditions, and innovative financing solutions to maximize the program's potential.