Tax Credit Lending part 3: Low-Income Housing Tax Credits

written by Blair Groves

In part one and two we covered the basics of historic rehabilitation projects, what properties qualify and how the tax credit is calculated. Click here to read part one and part two. Low-Income Housing Tax Credits (LIHTC) projects differ from historic rehabilitation projects, in that every year there is an allocated amount of credits that can be awarded.  Each state is allocated from the Federal Government a pool of “per capita” LIHTCs, also known as the state’s 9% credit pool, based on the state’s population.  Sponsors of proposed projects apply, through a very competitive process, for an award of credits.  The state agency awards the tax credits based on their Qualified Allocation Plan for that year.

How is the Tax Credit Calculated?

Calculation of tax credits for LIHTC projects can become somewhat complicated.  Three terms that must be understood are eligible basis, applicable fraction and qualified basis.  Eligible basis are project costs that are eligible to generate tax credits.  These costs must be depreciable and include all “hard” construction costs and most “soft” costs such as developer, engineering and architectural fees, to name a few.  Ineligible costs include land, marketing, partnership organizational costs and off-site improvements. Note that the eligible basis may qualify for a 30% boost if the project is in a Difficult Development Area (DDA) or a Qualified Census Tract (QCT).

State agencies can also choose to award up to a 30% basis boost so that the project may be financially feasible. Once you have the eligible basis calculated you multiply it by the applicable fraction.  The applicable fraction is the percentage of the property that is dedicated to serving low-income housing residents.  You must take the lower of the unit fraction or the floor space fraction.  The unit fraction is the affordable units as a percentage of total units.  The floor space fraction is low-income housing square footage as a percentage of total project square footage.  If all units in a property are used for affordable housing the applicable fraction will be 100%. This then gets you to the qualified basis on which you apply your tax credit percentage to.  As of December 2015 tax law, non-bond-financed deals are able to utilize 9%.  Properties that are financed with tax-exempt bonds will use 4%.  This gives you the annual tax credit amount, which is generated each year for 10 years.  These projects require a 15 year compliance period to avoid potential recapture of the tax credits.

Underwriting Considerations

Underwriting LIHTC projects will differ depending on if you are the construction lender or the permanent lender. Permanent financing amounts are relatively small due to the equity injected by the investors, which can be as much as 50% of the project. If you are the permanent lender, an important thing to review is the credibility of the assumptions used in projecting repayment.  These include, but are not limited to, vacancy, operating expenses, inflation and rents.

Rents must be in-line with the maximum allowed under the LIHTC program, and inflation assumptions applied to those rents in the later years of the project can have a substantial impact on the profitability of the project.  Another thing to look into are financial reserves available to call upon to complete a project, if needed. There are also considerations to take into account regarding appraisals.  Due to the restricted rents of the projects, the typical appraisal method of taking the net operating income and applying a cap rate can result in a low appraisal value.  However, a portion of the appraisal should also give value to the tax credits the project produces, as these stay with the project in the event of a foreclosure and are received over a 10 year time period. This is the final article in this series.

Please contact us if you have any questions about tax credit lending 417-881-0145.