Industry Insights

With tightening credit markets, developers have had to use innovative strategies to finance their real estate projects. Some have turned to alternative financing sources such as investment tax credits for affordable housing and historic rehabilitation projects.

Both of these tax credits were prescribed by Congress with the intent to provide special incentives for certain community-related objectives. The objective of the Low Income Housing Tax Credit (LIHTC) is to provide affordable housing for people earning less than a county’s median income. The objective of the Historic Rehabilitation Tax Credit (HRTC) is the preservation of buildings and structures deemed as historic landmarks by the National Park Service (NPS). Furthermore, as part of the economic stimulus programs of 2008, Congress amended some Internal Revenue Code (IRC) provisions to enhance the usability of these credits.

The Mechanics

The mechanics of the LIHTC basically involve an investor receiving a credit based on a percentage of his investment in the rehabilitation or new construction of housing units (typically apartment complexes). The project must set aside a portion of its units to be rented solely to qualified tenants. To be eligible as qualified tenants, residents earn less than a county's median income. The IRC generally specifies that either 40 percent of the project’s total units must be rented to tenants who earn less than 60 percent of the county's median income, or 20 percent must be rented to tenants earning less than 50 percent of the county’s median income. Furthermore, set-aside units cannot charge more than a prescribed, below-market amount as rent.

The HRTC is similar to LIHTC; however, it has some additional nuances due to the involvement of the NPS. An investor receives a credit of 20 percent of eligible costs based on his investment in the rehabilitation of a structure listed on the National Register of Historic Places. The rehabilitation, however, must be conducted with approval from the NPS, whose responsibility it is to maintain the structure's historic character.

Use as a Financing Source

The way that either tax credit is used as a financing source is essentially the same. A developer would invite an investor looking for tax credits to invest in the project to receive the credits. The investor makes a capital contribution, and the developer can then use the monies to pay for construction-related activity. Once work is complete and the building is placed in service, tax laws require the investor to remain a partner/member for a fixed amount of time (five years for the HRTC and 15 years for the LIHTC). However, once that mandatory period is complete, the investor typically exits the partnership or limited liability company.

Tax credits are purchased as a fraction of each dollar of credit received by the investor. Prices throughout the years have ranged from 60 cents of capital contribution per $1 of credit to $1 or more per credit dollar. Furthermore, most deals that qualify for federal investment tax credits also may qualify for various state investment tax credits, which may enhance the economics of the overall transaction.

Win-Win Situation

The benefits for developers using tax credits as a financing vehicle are multifold. Primarily, it reduces the cost of debt from projects, and moreover, it lessens constant and mandatory debt payments as a cash outflow. Even if investors request a return on their capital, the money is paid out of operational cash flows. In addition, lending institutions typically will offer better financing terms or often require, as a part of the loan, certain debt-to-equity ratios. Since the investor’s money counts as equity rather than debt, it enhances the project’s analytics. Furthermore, there is the intangible benefit of being able to give back to the community by developing public interest buildings.

The benefits of tax credit financing for investors also are numerous. Investors, like developers, can experience the intangible benefits of contributing to community service projects. Investors benefit financially from tax credits because the credits reduce a taxpayer’s tax liability dollar for dollar, compared with tax deductions, which only reduce taxable income. So while a $1,000 tax deduction for a corporation with an average federal tax rate of 35 percent results in cash savings of $350, a $1,000 tax credit results in cash savings of $1,000. In other words, a tax credit of $1,000 can offset the equivalent of up to $2,850 of taxable income from income taxes (assuming an average corporate income tax rate of 35 percent). Moreover, investors may be entitled to preferential returns on their investments. Also, in certain situations, investors can negotiate to participate in the appreciation of the underlying building upon their exit.

Risks

No real estate project is without risk. The regular risks associated with real estate development and ownership, such as high debt obligations, inability to achieve full or breakeven occupancy and property devaluation, are always present. Tax-credit-specific risks generally revolve around the possibility the project could lose its tax credits and, worse yet, be subject to a recapture of the tax credits (where the investor has to pay back the government for the tax credits he has claimed). This can happen in a situation where the project is not kept in compliance with tax credit laws. For example, an LIHTC project may become subject to tax credit recapture if it is not renting the prescribed number of units to eligible tenants. However, regular monitoring of the project to ensure its compliance usually prevents such a situation from happening. Furthermore, special attention should be given to the deal structure to ensure there is no adverse tax consequence to any party involved in the project.

Remember, no two deals are ever the same and each tax credit equity financing business deal should be carefully planned and scrutinized. Please consult your BKD advisor for more information on this topic.