Magazine article Journal of Property Management

Tax-Credit Essentials

Magazine article Journal of Property Management

Tax-Credit Essentials

Article excerpt

Low-income housing tax credits were created by Congress in 1986 to facilitate the rehabilitation and construction of multifamily residential property. Tax credits are spawning an entire sub-industry - structuring them, underwriting them, brokering them, managing tax-credit projects, ... and much more.

From 1986 to 1995, tax credits were used to build or rehab almost 750,000 residential units in the United States. (Figure 1) Although there was less funding available in 1995 than there was for 1994 ($385 million as opposed to $495 million a year earlier), projections for 1995 are that credits will have been used to finance about one-third of all multifamily construction in this country, or roughly 90,000 to 100,000 units. Thus, for anyone working in the real estate industry today, a knowledge of tax-credit financing is essential.

What Is a Tax Credit?

A Section 42 tax credit (so named because it is defined in Section 42 of the IRS code) offers a dollar for dollar deduction against the tax liability of an individual or corporation. The primary purchasers of tax credits today are corporations, accounting for approximately 75 percent of all tax-credit sales in 1994. With a few exceptions, tax credits may be applied to offset tax liabilities for 10 years in the future and may be carried back for three years. Section 42 credits do not affect the basis of a property, so there is no recapture. However, investors may receive some residual value from the sale or refinancing of the property at the end of the hold period.

Properties receiving tax credits must comply with resident requirements for a minimum of 15 years, but the trend in many states is to look for developers willing to extend that compliance for up to 30 years.

The tax-credit program was created by Congress but is administered by the state housing authorities. States have tremendous latitude in determining what projects receive credits, and every state's approach is different.

The positive aspect of state-based administration is that the states can allocate their credits to the areas where they see the greatest need. If there is a shortage of senior housing, more credits can be allocated there; if family housing is most in demand, those projects can receive priority. Currently, many states seem to be increasingly interested in seniors housing projects. However, the majority of credits nationally are still allocated to family projects.

State housing authorities allocate tax credits to projects - or more specifically to the limited partnerships that own the projects. Most typically, the general partner in these limited partnerships is either the developer or a non-profit sponsor that hires the developer. The general partner is responsible for the management of the completed project and generally receives the cash flow and, by law, at least 1 percent of the tax credits. Today, an increasing number of general partners are non-profit - state and local housing authorities, religious groups, and social service organizations.

The limited partners in the partnership are typically corporations, but may be pools of individual investors. These partners provide a substantial portion of the money needed to construct the project. In turn, they receive 99 percent of the tax credits, depreciation losses, mortgage interest deductions, and in some cases, a portion of the project's cash flow. The greater the perceived risk of the project, the more likely the limited partner is to demand a portion of the cash flow. Limited partners may own any percentage of the project, but the tax credits and the profit and loss (depreciation and interest deductions) must be allocated in the same ratio as ownership interest.

Because of an increased awareness and demand for tax credits, prices have risen from an average of $.37 in 1989 to $.55 today per dollar of credit. Interest rate fluctuations during 1994 affected yields, but have now largely stabilized. …

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