The Low-Income Housing Tax Credit

Wespath Benefits and Investments (Wespath)—through its Positive Social Purpose (PSP) Lending Program—has invested in loans to support affordable housing and community development since 1990. The PSP Lending Program has consistently provided market returns commensurate with risk throughout this period. Many of the loans that comprise the PSP Lending Program are backed by properties financed under the Low Income Housing Tax Credit (LIHTC) program, which was created under the Tax Reform Act of 1986. The LIHTC program has become a key source of capital for the construction of new affordable housing and the preservation of existing affordable housing across the United States. This article provides an overview of the LIHTC program which has been instrumental in the success of the PSP Lending Program.

What It Is

The LIHTC program is a Federal tax credit program administered by the Internal Revenue Service under Section 42 and Section 142 of IRS Code. The LIHTC program is a public-private partnership between state and federal government, large corporations and developers that provides affordable housing for low and moderate income individuals and families. The LIHTC program meets the housing needs across the social strata, including working families, veterans, seniors, disabled persons and formerly homeless individuals.

How It Works

In its simplest form, the LIHTC is a dollar-for-dollar reduction of a taxpayer’s annual tax liability and may be used for the first 10 operating years of a development. Each year, all 50 states receive an allocation of affordable housing tax credits. The amount received is determined by the state’s population. Upon receipt of the tax credit allocation, it becomes the job of the state allocating agencies to select affordable housing developments. This occurs via a competitive process that is outlined in detail in each state’s Qualified Application Plan. This plan includes general mandates from the Federal government for all tax credit developments as well as state specific guidelines.

The demand from investors (or developers) for an allocation of LIHTC’s almost always exceeds the allocation of LIHTC’s available each year. Competition is high, and often requires that a project wait for several years to receive an allocation of tax credits. To be eligible for tax credits, a development must set aside at least 20 percent of the development’s units for individuals or families earning up to 50 percent of the area median income (AMI) or 40 percent of units for individuals or families earning up to 60 percent of AMI. Most LIHTC developments, however, set aside the majority or even all their units for low to moderate income individuals and families.

Once a development is allocated tax credits, the developer can either use the credit to offset their own tax liability or, as is more often the case, sell the rights to the tax credits to another entity. Developers typically sell the rights to the tax credits as their own tax liability is small compared to the amount of tax credits for which the project is entitled. Currently, large corporations and financial institutions are the primary purchasers of LIHTCs. The proceeds from the tax credit sale are then used to build the affordable housing development. Development costs that exceed the amount of funds received from the tax credit sale are funded by permanent mortgages, local grants, subsidies, and the equity invested by the developer. Upon completion of the project the developer certifies all costs are true and accurate and commences leasing the newly created units to low-income individuals and families.

Any property built using LIHTCs is subject to a compliance period during which it must remain affordable. The minimum compliance period is 30 years, divided into two 15 year periods. The first period is called the compliance period and the second is called the extended use period. The development is subject to recapture during the compliance period. During the recapture period, the federal government can reclaim LIHTCs previously applied to investor tax returns and prevent the development from using the tax credit in future years. The extended use period can be greater than 30 years depending on the locality of the development.

PSP Lending Program—Investing in LIHTC-Backed Assets

The PSP lending program invests in loans on properties supported by LIHTCs for three primary reasons. First, LIHTC property values are generally much higher than the value of the loans against them. This minimizes the lender’s losses if the developer fails to pay the mortgage because the property can be sold for more than the remaining balance on the loan.

Second, the likelihood of a default on a LIHTC development during the initial compliance period is reduced due to LIHTC recapture provisions, which force the owner to restate previous years’ tax returns as if the development had not received the tax credit benefits. This could create a significant tax liability for the LIHTC investors and the tax consequences provide strong incentive for these investors to monitor and ensure that mortgage loans for these developments are current.

Finally, affordable housing is in high demand in the United States, which increases the likelihood of apartments in LIHTC developments remaining occupied at high rates, thus generating revenue to support the mortgage of the development.

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