Acquisition Rehab The Missing Manual

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1 Acquisition Rehab The Missing Manual Erik Whitton Spectrum Enterprises May 18, 2015 PURPOSE Spectrum staff is often asked to provide guidance to individuals with questions about acquisition rehab LIHTC deals. This article will attempt to answer some of the fundamental questions that arise when a housing professional is responsible for an acquisition/rehab deal for the first time. The article will also address resyndication scenarios where an existing LIHTC project receives a subsequent allocation (after the initial 15 year compliance period ends). INTRODUCTION Before getting started on this article I will say that most problems arise due to a lack of planning or communication between all parties. The issues we see most frequently do not necessarily result in noncompliance reported by the HFA to the IRS, instead we see a lot of issues where the property has not met the terms of the partnership agreement with the investor. It is critical that all parties communicate in the early stages to clearly identify the key aspects of acquisition/rehab deals. Primarily these are: Date of acquisition; When will construction begin and end? Will tenants need to relocate due to construction? First credit year; Minimum set aside; How many units were pledged to the HFA as LIHTC units; The credit delivery timeframe promised to the investor; How the project will be defined to the IRS on the 8609 forms (for multiple building properties); For an existing property, how many current tenants will be able to qualify vs. how many cannot qualify due to income/student status ACQUISITION REHAB EXPLAINED Properties may receive Tax Credit funding primarily as either new construction or acquisition rehab. New construction is pretty straightforward (the developer is building something from the ground up). Acquisition rehab is more complicated. An owner can receive tax credits both on the acquisition (purchase) and rehabilitation of an existing building. The building could have existed previously as apartment housing or it could have been something else entirely such as a school or a factory and is now being repurposed for affordable housing.

2 If the building was not formerly apartments (is not currently occupied) the process of certifying tenants is similar to new construction. You are typically looking at a substantial amount of construction work needed to get the building ready for occupancy. Once all construction is completed the manager begins marketing and lease up as if it was new construction. However many acquisition rehab credits are awarded to existing apartment buildings. Since these presumably already have things such as kitchens, bathrooms, and furnaces no major construction is needed. As a result, we see many situations we call in place rehabs. This means the apartments are already occupied. There is no need to market the property and lease it up as a brand new project. Your tenants are already living there. IN PLACE ACQUISITION REHAB This is where a lot of confusion exists. Although you don t need to market the building and fill all the units, you do need to certify your existing tenants. A key date is the date of acquisition. This is the date the new owner purchased the property. Many people get confused here believing the same owner is in place. However, in most cases a new partnership is formed that purchases the building. While it may be the same names and faces there is usually a new ownership entity that is created to purchase the property. A manager needs to know the date of acquisition. This is the date that will be used as the TIC effective date for all of your in place tenants. You have a period of 120 days to fully complete their income certification. This includes meeting with them to get an application or questionnaire filled out; sending out and receiving all income and asset verifications; filling out the TIC form and getting all required paperwork and signatures. As long as you can complete this process within 120 days of the acquisition date, you are protected with the IRS Safe Harbor. (* The following section has additional details about the Safe Harbor) Some useful tips include notifying all tenants about the need to be income certified. Make sure to tell them about the improvements they will experience as a result of the construction work. Make sure to also inform them of the possible noise, dust, and workers that will be at the site. In order to start the process of mass certifying all tenants you might plan a pizza party or BBQ and invite all tenants. Make sure to provide additional staff from other sites managed by your company. This is a good way to start getting questionnaire forms completed and the paperwork started. Do not worry about the fact that your TIC forms will show an effective date that precedes the income/asset verifications, affidavit forms, and TIC signatures. This will not be noted as a problem by a compliance auditor. There is no need to back date anything in this process.

3 IRS SAFE HARBOR The IRS created this safe harbor to allow owners to use existing tenants as tax credit qualifying households in an event where the household was income eligible when the owner purchased the building but then went over the income limit during the rehab construction period before credits were initiated. See IRS 8823 Audit Guide page 4 25 and Revenue Procedure Example: Owner purchases a building in March The Jones tenant in unit A01 is income qualified and a full certification package is completed. Construction begins in March 2015 and is completed in March Owner will begin taking credits in 2016 however Jones started a new job in December 2015 with enough income that he is over the limit. Because an acquisition certification was completed the owner can include unit A01 in the applicable fraction used to claim credits. However, if the owner waited until 2016 to certify the tenant the unit would not be credit qualified. This safe harbor is not a requirement of the program, instead it is common sense and has largely become an industry standard. In other words, why wouldn t you certify your existing tenants at time of acquisition in order to lock them in as income qualified tenants in case they later go over the limit? Some rehabs take a long period of time between the owner purchasing the property and the start of the credit flow. Anything can happen during this period so it is good to have this safe harbor protection. Here are a few additional thoughts on the safe harbor: 1. The safe harbor protects income only. The household must remain student eligible throughout their tenancy to be considered LIHTC qualified. 2. Owner must keep the unit rent restricted to receive the safe harbor protection. 3. Manager does not need wait until the date of acquisition to begin certifying tenants. If the manager has access to the files before the acquisition date they can begin the process 120 days prior to closing. In a situation where there is no management change and the acquisition date is well communicated (not delayed) you have a period of 240 days to certify all existing tenants. Even at a large community this is plenty of time to complete the process provided you have adequate staffing, communication, and planning. 4. In a situation where the acquisition occurred prior to September 3 and the following year is the 1st credit year you will need to test the income of all tenants between September 3 and December 31. This test is for the purposes of the available unit rule. There is no need to completely re certify all tenants; instead you simply need to contact them to find out if their income has changed. Be sure to note your files. See IRS 8823 Audit Guide pages 4 25 and 4 26.

4 WHAT INCOME AND RENT LIMITS DO I USE? Use the income limits in effect on the date of acquisition for all TICs that you complete within the 120 day window surrounding the date of acquisition. For any TICs completed after 120 days use the income limits that correspond to the TIC effective date (the TIC effective date will match the date all paperwork and signatures were finalized). Your acquisition date might fall in the 45 day grace period after new income limits are announced (but before they become mandatory). In these cases you are free to choose the higher of the 2 available limits. See IRS LIHC Newsletter # 48 In most cases you will use the rent limits that correspond to the income limits (same year). However, it is possible that higher rent limits can be used. The gross rent floor rule allows the owner to charge rents based on the limits in effect at the time the owner received the initial allocation of credit from the state agency. You could have a scenario where the credit allocation was August 2012 and the acquisition date was March If the 2012 limits were higher than 2013 you can charge rents based on 2012 limits. See IRS 8823 Audit Guide page 11 3 WHAT IF AN EXISTING TENANT DOES NOT QUALIFY? You may find that you have existing tenants that have too much income to qualify, or they might be ineligible full time students. Hopefully the owner was aware of this ahead of time and did not structure the property as 100% LIHTC (check the tax credit application and the partnership agreement to see what commitments were made to the state agency and the investor). In that case you would simply treat the household as market rate (i.e. no credits would be claimed). However, owners often believe all of their tenants will qualify so they structure the property as 100% affordable. In that case you could negotiate an incentive with the tenant to voluntarily leave the apartment so you can re rent to a qualified household. It is very important to note that you may not simply evict or not renew leases without good cause. For a detailed explanation of the good cause requirement see IRS 8823 guide chapter 26. Make sure the household chooses to leave in a voluntary manner and be aware that some households may simply choose not to leave despite your best efforts. In those cases the unit is treated as an over income non qualified unit. Tip: talk to over income tenants about home ownership. Work with them to provide tools needed to qualify for a mortgage and choose a realtor. See if your state housing agency provides programs for prospective first time home buyers and set this up at your site. Offer ineligible tenants moving services from local companies, truck rentals, packing boxes, etc. Offer them other apartments in communities you manage they might qualify for. Offer cash in exchange to leaving the site. DO NOT work with them to manipulate their income in order to qualify! Tip: Make sure paperwork is clear in notifying tenants of their right to remain in the unit.

5 Please refer to HUD Memo: Occupancy Protections for HUD Assisted Households in Properties with Low Income Housing Tax Credits WHAT IF I CAN T GET EVERYONE CERTIFIED WITHIN 120 DAYS? For a variety of reasons you may not be able to get everyone certified within 120 days. There s no need to panic here or worry about lost credits or noncompliance. This simply means you no longer have the protection offered with the safe harbor. Instead of using the acquisition date as your TIC effective date, you should instead use the date that you fully completed the file after obtaining all verifications and signatures. The balance of credits not claimed in year 1 can be claimed in year 11. Be sure to check your partnership agreement to see the credit delivery committed to the investor. A downward adjuster is possible depending on how aggressively this was structured. TENANT RELOCATION In some cases a rehab may be completed without the tenant leaving their unit. In other situations however you may need tenants to relocate. The relocation may be done off site or on site. Refer to the following possible scenarios: OFFSITE RELOCATION For tenants relocated offsite the owner must pay all moving expenses. Tenants cannot pay more than than the restricted rent they would be paying while on site. The IRS has provided informal guidance that offsite relocation may not last more than 6 months (check with your HFA if you are relocating tenants off site). ONSITE RELOCATION It is more common to see tenants relocated to units at the same property. This can either be a temporary relocation where the tenant will return to their original unit or a permanent relocation where the tenant will stay in the new unit. ONSITE TEMPORARY RELOCATION If the tenant will temporarily move out of their apartment to another unit in the same project while their unit is rehabbed the manager does not need to complete any additional certification paperwork. Example: The Smith household in unit 101 is temporarily moved to unit 105 while contractors replace the carpeting, windows, and kitchen cabinets. This work is completed within 2 weeks and the household then moves back into unit 101.

6 ONSITE PERMANENT RELOCATION If a tenant is going to permanently relocate to a different unit in the same project their TIC and lease status move with them. Owners will usually do a rolling rehab where a portion of units are empty upon acquisition. For example a building might have tenants in all first floor units but the units in the 2nd floor are empty when the building is purchased. Construction crews will rehab the 2nd floor units first. After this work is done the 1st floor tenants are transferred to 2nd floor units and then the construction crews begin work on the 1st floor units. Example: an owner purchases a building on May 1, 2014 and certifies the Jones household in unit 1 1 (an un rehabbed first floor unit). During June, July, and August the owner completes all rehab work for the empty 2nd floor units and the Jones household moves into unit 2 1 on September 1. There is no need to conduct a full income certification for Jones at this time. However, a new TIC form should be printed and marked Other Unit Transfer to note the move. In this example unit 1 1 is qualified for the months of May/June/July/August. Starting in September the unit becomes empty never qualified because it swaps status with 2 1. After construction is completed and an eligible tenant moves into 1 1 it becomes qualified again. Unit 2 1 is empty never qualified for each month until September. Starting in September the unit becomes qualified with the Jones household living there. With all tenant relocation during rehab it is critical to keep a record showing the status of each unit during each month. You need to record who resides in the unit each month; whether they are a qualified household (income/student status/rent); and whether the unit is suitable for occupancy. Keep track of qualified vacant units as well. Keep track of all tenant relocations from one unit to another. This is required in order to compute the first year applicable fraction which determines the credit amount. For an in depth explanation of this and to see an example of a chart you may use please see IRS 8823 Audit Guide pages 4 28 through We often see poor record keeping in this regard. On a final note regarding tenant relocation the management team must be aware of the special rules used by the IRS to define a project. This only occurs where a property has multiple buildings so if you just have a single building you can ignore this. With a multiple building site the owner makes an election on their IRS 8609 forms whether to treat all buildings as a single project; or to treat each building as a separate standalone project; or something in between. For instance, you could have a 10 building project purchased in 2013 where buildings 1 4 are rehabbed by the end of the year. The owner could designate these as Project A while choosing to treat buildings 5 10 as Project B due to being rehabbed the following year. In this situation a tenant may not simply transfer from a unit in Project A to another unit in a Project B building. Instead, the manager must treat this as a move out and a

7 new move in. The household must be fully certified when moving into the new unit. The units would not swap status and the income cert would not follow the household where they transfer to a building in a different project. For more explanation of this refer to IRS LIHC Newsletters #15; #26; #27; #29; and #39. It is important to note that at the time of rehab, the owner has not completed the election on the 8609 (line 8b) that will define the project. Management should confer with the owner to determine what elections will be made prior to moving tenants between buildings. RESYNDICATION The term Resyndication is used to describe an existing LIHTC project that receives a subsequent allocation of credits. This can only happen after the property completes the initial 15 year compliance period. In other words, the owner cannot receive an allocation of credit in year 2008 and again in RESYNDICATION INCOME AND RENT LIMITS One a property receives a 2nd allocation of tax credits it is critical to examine the income and rent limits being used. Often a site has been operating under the first allocation using HERA or HOLD HARMLESS income and rent limits from previous years. These limits could have been established in a given area a few years ago where area limits then began to drop. Upon receiving a subsequent allocation of credit the property may no longer receive the HOLD HARMLESS protection and must use income limits that correspond to the new placed in service date. In some cases the tenant rents being charged will need to be lowered. And, the income limit for admitting new tenants will be lower as well. Finally, the subsequent allocation can still use the gross rent floor as established when the 2nd round of credits are initially allocated to the new owner (if higher than new placed in service amounts). WHAT IF A HOUSEHOLD IS OVER THE INCOME LIMIT? With resyndication there is a concept known as Income Grandfathering. A project might include some units occupied by over income households as of the 2nd credit allocation. As long as the household was previously income qualified when they first occupied a unit (during the initial LIHTC compliance period) they may be used as a qualified household for the new round of credits. Please refer to the discussion on page 4 26 of the IRS 8823 Audit Guide for more explanation of this topic. It is critical that the initial move in file is intact and well documented. Some states allow annual recertification files be used if an initial move in file cannot be used (note: the recert must include full 3rd party income verification).

8 Although previously income qualified households are protected, there is no such protection offered to full time student households or to units charged a gross rent that exceeds the applicable limitation. ARE FULL INCOME CERTIFICATIONS NEEDED? Due to the concept of income grandfathering, a site is not required to complete full income certifications of previously income qualified households to coincide with the new acquisition date. This is true regardless of whether each household is currently within the income limit or above it. Instead of completing full income certification packages, the site may rely on the original move in files under the former credit allocation. In some cases these files can be several years old. Spectrum would urge all owners, managers, and investors to conduct a full review of those files to ensure all paperwork is intact and free of errors/omissions. If resources are available, we would prefer to see all households fully certified to coincide with the new allocation of tax credits. The protection offered to previously income qualified households should only be used where needed with current households that are over the income limit. Before making a decision *not* to certify existing tenants be sure to speak with your state agency and tax credit investor as they might require this. RESYNDICATION STUDENT STATUS After the 15 year compliance period ends, some states allow properties to rent units to full time student households. Upon receiving a subsequent allocation of credits the LIHTC units may not be occupied by non qualified full time student households. Documentation is needed to demonstrate compliance with the full time student rules in conjunction with the new round of tax credits. RESYNDICATION RENT COMPLIANCE Some properties must lower the rent charged to existing households upon receiving a subsequent allocation of credits. It is critical to maintain and provide clear documentation showing when the rent was lowered. If the site is choosing to complete full income certifications this can be recorded on the new TIC form. However, some sites choose not to complete new TIC forms so we have to examine documents such as ledgers to see compliance with this. TIP: if you are planning to resyndicate your property and rents will need to be lowered, we suggest examining ways to use the rehab funds to increase energy efficiency at the site. You may be able to offset the rent reduction by lowering the overall cost of utilities paid by the tenants.

9 Resources: IRS 8823 Audit Guide 4 25 IRS Newsletters Safe Harbor Revenue Procedure HUD Memo Occupancy Protections for HUD Assisted Households in Properties with Low Income Housing Tax Credits