Introducing the LIHTC
The Section 42 Low Income Housing Tax Credit (LIHTC) program is a federal tax incentive that encourages private sector investors, developers and lenders to finance, construct and operate affordable housing.
Since the program’s founding in 1986, LIHTC tax credits have been allocated for the construction and rehabilitation of more than three million housing units. About one of every six units of new rental housing built in the United States today is supported with the low income housing tax credit.
How the LIHTC works
A tax credit provides a dollar-for-dollar reduction in tax liability. Accordingly, $1 of tax credit yields substantially greater tax savings than $1 of tax deduction. Click here for a sample comparison of tax credits vs. tax deductions.
The quantity of low income housing tax credits is determined by eligible development costs. The 9% construction and 4% acquisition credits are granted on a competitive basis, while the 4% bond credits provided to recipients of tax-exempt bond financing are awarded through a separate application process.
Competitive credits – A 9% annual credit is provided for eligible construction and “substantial” rehabilitation costs, and a 4% annual credit is applied to the acquisition cost of existing buildings to be rehabilitated.
Tax-exempt bonds – Developments that use private activity bond (tax-exempt bond) financing are limited to a 4% annual credit for all eligible costs, including construction and rehabilitation.
Rents, income limits and Area Median Income (AMI)
LIHTC properties must comply with maximum rent and resident income limits. At least 20% of a property’s units must be dedicated to affordable housing (the “minimum set aside”). Click here for a discussion of the minimum set aside.
Household income limits and maximum rents are based on an “Area Median Income” (AMI) formula as calculated by HUD (US Department of Housing and Urban Development). The AMI is determined annually, is adjusted for family size and varies by location. Click here for a discussion of maximum household income limits and rent limits.
Credit delivery and compliance periods
Section 42 LIHTC properties are subject to an initial 15-year federal compliance period, which is followed by an “extended use agreement” (often referred to as a “LURA” or “land use restriction agreement”) at the state level. The LURA period varies by state, with a minimum length of 15 years. Investors typically seek to exit at some point following the federal compliance period.
Section 42 tax credits are generated for a period of 10 years, with LIHTC delivery commencing as buildings are placed in service. Total tax credits generated over the lifetime of the investment will equal ten times the “annual credit” amount. Click here to learn more about how to calculate the LIHTC.
Affordable housing becomes easier to understand once you have learned its lexicon. For a guide to common industry terminology, click here for our Affordable Housing – LIHTC glossary.
To access our comprehensive database of Fair Market Rents (FMRs) and income limits for the LIHTC, Section 8, Section 235, Section 236 and BMIR programs, click here for Westmont’s Affordable Housing Data Center.
Why LIHTC tax credits?
- Investors earn a highly predictable, competitive return over an extended period (typically ten years), with below-average levels of foreclosure risk in comparison to other real property investments.
- Developers use tax credit equity to reduce the level of mortgage debt or to leverage state-supported financing programs, which improves project cash flow and allows LIHTC properties to be financially viable.
- Lenders benefit from low foreclosure rates, low loan-to-value ratios and the opportunity to use the low income housing tax credit to comply with the Community Reinvestment Act.
- Government agencies use tax credit programs such as the LIHTC program as a tool for outsourcing public policy objectives to the private sector, thereby gaining access to free market capital and professional talent.
- Residents gain access to safe, quality affordable housing with controlled rents.
Profit motivation, private sector leadership, and local control are all defining features of the low income housing tax credit. The LIHTC is designed to encourage institutional investors, banks and industry professionals to provide leadership, capital and expertise, while working in conjunction with state governments to develop projects that are both profitable and tailored to serve community needs. The LIHTC program also strives for flexibility, including provisions for developing properties that combine market-rate and affordable housing units.
The low income housing tax credit program, which is often also referred to as the “Section 42” program, represents a significant departure from earlier approaches to affordable housing. Prior to the LIHTC’s enactment, US affordable housing programs relied upon considerable direct federal participation, including restrictive mortgages, long-term rental subsidy contracts, and management oversight. In contrast, the LIHTC program minimizes direct federal involvement, operating under the theory that the private sector, working in cooperation with state and local governments, is better suited to addressing local requirements and managing the details.
Westmont Advisors is proud to partner with LIHTC compliance experts TheoPRO to offer development compliance services and Section 42 training programs for LIHTC professionals, including property managers, developers, asset managers, syndicators and government agencies. Training and other services are available throughout the United States. Click here to learn more.
Legislative authority, administration and regulation
The low income housing tax credit was initially created by the Tax Reform Act of 1986 (TRA 86). During early years of the Section 42 program, the LIHTC was subject to annual renewal. However, the program’s success led to the LIHTC being made permanent in 1993 as part of the Omnibus Budget Reconciliation Act (OBRA).
Program administration occurs largely at the state or territorial level. The 50 states, District of Columbia, Puerto Rico, US Virgin Islands and Guam each operate a housing credit agency that is responsible for allocating tax credits in their respective jurisdictions, as well as for overseeing most compliance matters. Although federal regulations govern the program, these state housing credit agencies have considerable autonomy in their oversight of the tax credit and management of the LIHTC application process. Each state details its program goals and guidelines in its “Qualified Allocation Plan” (QAP).
States are provided with annual LIHTC allocations for the competitive 9% and 4% tax credits based upon population. Prior to 2001, the amount was fixed at $1.25 per person; this amount was increased to $1.50 for 2001 and $1.75 for 2002. Since 2003, the credit amount has been increased each year by applying a CPI factor to the 2002 amount. As a result of the 2018 Consolidated Appropriations Act, the amount of 9% credits available during 2018-2021 is being increased by an additional 12.5%. As of 2020, each state receives LIHTC equal to approximately $2.8125 per person, with each state receiving a minimum allocation of approximately $3.22 million.
Each state has two years to award its low income housing tax credit allocation. LIHTC that are not awarded in their first year may be carried forward to the following year. LIHTC that a state cannot use over the two-year period are returned to the national pool for re-allocation. If a state awards LIHTC to a development that is not completed, its tax credits can be returned and the state is given an additional two years to award these tax credits to a different project elsewhere in that state.
Tax credits allocated under the tax-exempt bond program are allocated from a separate pool, which is in addition to the competitive LIHTC discussed above.
Section 42 of the Internal Revenue Code is the primary legislation governing the low income housing tax credit. Click here for a link to the statute. The IRS supplements the Code with periodic updates, including “private letter rulings” that apprise taxpayers of agency interpretations of the Code.
A property that receives a competitive (9% or 4% acquisition) credit allocation must be “placed in service” (completed and occupied) in the year that the allocation is received. However, it is commonplace for state agencies to issue “carryover allocations”, which extend the required placed-in-service date to the end of the second calendar year after the allocation was issued. In order to qualify for the carryover allocation, a development must incur at least 10% of its anticipated costs within the calendar year in which the allocation was received or six months after the date of the carryover.
Properties that are developed with the use of the 4% tax-exempt bond credit are not subject to these placed in service rules, and therefore do not require carryover allocations.
Westmont and our partners at TheoPRO can serve your needs throughout the United States. Please do not hesitate to contact us for more information about our consulting and advisory services for real estate acquisition, asset management and tax credits, including the Low Income Housing Tax Credit (LIHTC) and Historic Tax Credit (HTC), as well as other real estate matters. Click here to learn more about our team.
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