Introduction: In addition to conventional mortgage financing approaches which generally require a significant equity contribution by the developer due to lender loan to value criteria, several tax-exempt and/or low income housing tax credit financing options exist which allow developers/investors to (1) secure lower mortgage interest rates and/or (2) obtain a significant equity contribution to the project thereby reducing the amount of equity that must be funded by the developer. These financing options lend themselves to either new construction multifamily or elderly housing projects or acquisition/rehabilitation projects for existing properties that require updating and remodeling. All of these financing options derive from the federal tax policy of encouraging private enterprise to develop safe, clean and affordable housing for low to moderate income tenants. History has shown that private development does a far better job of providing such housing and avoids the now well known problems associated with many government owned and operated low income housing projects
While involving increased initial legal and closing costs and increased record keeping requirements that make these financing more appropriate for larger projects (e.g., over 75 units), properly structured they can make otherwise uneconomic proposals attractive and allow a developer to proceed with a project with reduced out of pocket equity infusion burdens. These options involve utilizing (1) low income housing tax credits for low to moderate income rental housing projects pursuant to Section 42 of the Internal Revenue Code of 1986, as amended (the "IRC"), (2) tax-exempt multifamily housing revenue bond financing pursuant to Section 142(d) of the IRC, or (3) a combination of low income housing tax credits and tax-exempt housing bonds to meet a particular projects financing needs.
Which option should be utilized depends upon (A) the nature of the proposed project - including the percentage of units to be set aside for low to moderate income tenants and whether or not a Section 501(c)(3) charitable entity will hold an ownership interest in the project - and (B) the financial resources of the developer. Among the key factors to a successful tax credit or tax-exempt bond financed project are (1) a careful and realistic budget for construction or rehabilitation costs, as the case may be, and (B) experienced management that has the experience and resources to compile and annually update tenant income certifications to insure continual low income unit set aside compliance. If a developer lacks such management experience, it is often the wiser course to hire an experienced management company rather than risk the loss of tax credits for a project or to have the bond financing become taxable.
1. Option One - 9% Low Income Housing Tax Credit: This type of financing is available under Section 42 of the IRC and allows projects that are owned either (A) by an entity with joint Section 501(c)(3) entity and private for profit entity ownership, or (B) a private for profit entity. Under Section42 of the IRC, 9% tax credits are available to the developer provided specified rental unit set asides are met for tenants of low to moderate income (i.e., either (1) at least 20% of the units are set aside for tenants with incomes not exceeding 50% of area median income, or (2) at least 40% of the units are set aside for tenants with incomes not exceeding 60% of area median income). If higher low to moderate income set aside levels are maintained, a larger amount of tax credit is available for a given project. Ownership of a Section 42 tax credit project is generally structured in the form of a limited partnership where the project developer holds a small - e.g., one percent (1%) - general partnership interest with the remaining partnership interest in the form of limited partnership interest that is then sold to a tax credit investor that an use the tax credits for a dollar for dollar credit against income derived from other sources. A few examples of such investors are Norfolk Southern Corporation, AIG SunAmerica, Inc., Related Capital Company, and large insurance companies. The last 9% tax credit transaction I handled yielded the developer $0.78 per each $1.00 of tax credit allocation for the project.
The following is an example of how the tax credit is calculated:
Total Development Costs: $5,000,000.00
Less Non-eligible basis (i.e., land) 500,000.00
Eligible Basis 4,500,000.00
Credit Percentage 9%
Total Annual Credits 405,000.00
Tax credit Period 10 Years
Total Tax Credits $4,050,000.00
Credit Sale Price Per $ of Credits $0.75
Equity Infusion $3,037,500.00
A similar calculation is used to determine the cash equity infusion available from 4% low income housing tax credits discussed below.
Section 42 tax credit projects are especially attractive in connection with elderly housing projects since the income certifications required consider only tenant annual income and not assets owned or controlled y a tenant. Hence, a higher caliber of tenants is possible given the fixed incomes of many of today's senior citizens. This financing approach has the following advantages and disadvantages.
Advantages:
A. The sale of 9% tax credits yields the largest infusion of equity into a project and coupled with conventional construction/permanent loan financing allows a developer lacking a significant net worth to develop projects either on their own or with other private ownership participation.
B. The often significant cost and expense of tax exempt bond issuance are avoided.
Disadvantages:
A. Awards of 9% tax credits are made via a highly competitive application and allocation process and pool. In Virginia, the process is administered by the Virginia Housing Development Authority ("VHDA"), with 9% tax credits being awarded to the highest scoring applicants based on VHDA's point system that factors in numerous variables until VHDA has awarded all tax credits available for a given tax year under the IRC. Therefore, there is no guaranty that an applicant will be successful in obtaining an award of 9% tax credits.
B. Tax Credit projects must be "rent-restricted," with the gross rent applicable to a unit in the project being limited to 30% of the applicable 50% or 60% of area median gross income limitation, whichever set aside test was elected for the project. Gross rent is calculated by assuming one person will occupy a unit with no separate bedroom and that 1.5 persons will occupy each separate bedroom. Gross rent includes a utility allowance, but does not include Section 8 payments or comparable rental assistance program payments, fees for certain supportive services which are paid to the project owner under any government program or by a 501(c)(3) organization, or fees for optional services.
C. The project will be subject to a "Qualified Project Period" that lasts generally 15 years. During this period, the low to moderate income unit set aside requirement will continue to restrict the project.
2. Option Two - Tax Exempt Housing Bonds: This type of financing is available under Section 142(d) of the IRC and allows new construction and acquisition/rehabilitation projects to be financed with tax-exempt bonds provided (A) a bond allocation is obtained from the state allocation authority - in Virginia, this is the Small Business Financing Authority- and (B) the low to moderate income set aside requirements of Section 142 of the IRC are satisfied (i.e., either (1) at least 20% of the units are set aside for tenants with incomes not exceeding 50% of area median income, or (2) at least 40% of the units are set aside for tenants with incomes not exceeding 60% of area median income). As discussed below, this financing approach also can be combined with 4% low income housing tax credits if 50% or more of the Project's basis as defined in Section 2 of the IRC is financed with the proceeds of Section 142 bonds. This structure has the following advantages and disadvantages.
Advantages:
A. While competition for bond allocation has been very intense in some years, securing a bond allocation generally is less difficult than securing an award of 9% low income housing tax credits.
B. 4% low income housing tax credits are usually available.
C. Bonds issued by a state or local municipal bond issuing authority (e.g., a local redevelopment and housing authority) are exempt from registration under the federal securities laws, although offering statements are subject to compliance with securities disclosure requirements.
Disadvantages.
A The Project owner/developer must secure a bond allocation from the State Ceiling under Section 146 of the IRC and the Virginia private activity bond regulations. (Note: These allocations are processed through the Virginia Small Business Financing Authority in a process totally separate and unrelated to the application process for 9% tax credits).
B. $7,500,000 annual cap per project on amount of tax-exempt bonds that can be issued that is imposed by the current Virginia allocation regulations. (NOTE: this bond allocation pool is totally separate and distinct from the competitive application/allocation process and pool that pertains to 9% tax credits.)
C. For acquisition/rehabilitation projects, the buildings within the project must receive rehabilitation expenditures equal to at least fifteen percent (15%) of the acquisition cost of the must be done to the project.
D. Closing and development schedule is controlled by when or whether bond allocation can be secured from the State Ceiling under the Virginia private activity bond regulations (i.e., closing must occur not later than 90 days from the date the bond allocation is awarded).
3. Option Three - Tax Exempt Bonds Combined with 4% Tax Credits: . 4% low income housing tax credits are provided (1) 50% or more of the project's basis is financed with Section 142(d) tax-exempt bonds for which an allocation has been secured from the State Ceiling under the Virginia private activity bond regulations and (2) the project meets VHDA's minimum point score criteria for low-income housing tax credits Generally, the proceeds of the sale of the 4% tax credits will satisfy much, if not all, of any applicable lender imposed equity requirements. This financing approach has the following advantages and disadvantages.
Advantages:
A. The 4% credits are not awarded on a competitive basis and will be available provided a minimum threshold score is achieved under the VHDA application and scoring guide lines (seeVHDA's website at: http://www.vhda.com/).
B. The sale of the 4% tax credits yields a significant infusion of equity into a project and coupled with conventional construction/tax-exempt permanent loan financing allows (1) a developer lacking a significant net worth to develop projects either on their own or with other private ownership participation and (2) a lower interest rate permanent mortgage.
Disadvantages:
A. The Project owner/developer must secure a bond allocation from the State Ceiling under Section 146 of the IRC and the Virginia private activity bond regulations.
B. $7,500,000 annual cap per project on amount of tax-exempt bonds that can be issued that is imposed by the current Virginia allocation regulations.
C. Closing and development schedule is controlled by when or whether bond allocation can be secured from the State Ceiling under the Virginia private activity bond regulations (i.e., closing must occur not later than 90 days from the date the bond allocation is awarded)
D. Closing costs, legal fees, underwriting fees, etc. for a simultaneous closing of a tax-exempt bond issue and a tax credit sale are general significant.
E. As with a 9% tax credit project, the project will be subject to a "Qualified Project Period" that lasts generally 15 years. During this period, the low to moderate income unit set aside requirement will continue to restrict the project.
F. For acquisition/rehabilitation projects, the buildings within the project must receive rehabilitation expenditures equal to at least fifteen percent (15%) of the acquisition cost of the must be done to the project.
Conclusion: The foregoing financing techniques are obviously not right for ever potential project multifamily or elderly housing project. However, when properly structured and with proper due diligence and construction and operation budgeting by a developer, they can provide a powerful too to provide much needed equity in a project and reduced permanent mortgage borrowing costs.
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