THE FEDERAL LOW-INCOME HOUSING TAX CREDIT AND HISTORIC REHABILITATION TAX CREDIT

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1 THE FEDERAL LOW-INCOME HOUSING TAX CREDIT AND HISTORIC REHABILITATION TAX CREDIT This outline provides an overview of the federal low-income housing tax credit and historic rehabilitation tax credit. I. LOW-INCOME HOUSING TAX CREDIT A. Generally. The federal low-income housing tax credit is an indirect federal subsidy to support investment in the development and operation of affordable multi-family rental housing for lower-income people. The credit is a dollar-for-dollar credit against federal income tax due. Initially established under the Tax Reform Act of 1986, it is now one of the longestrunning federal housing programs. The credit is provided for in Section 42 of the Internal Revenue Code. 1 B. Amount of Credit. Generally, the amount of tax credit for a taxable year is equal to the applicable percentage of the qualified basis of a qualified low-income building. The low-income housing tax credit may generally be claimed annually over a ten-year period (the Credit Period ) beginning with the year that a building is placed in service or, at the election of the taxpayer/owner of the building, the year thereafter. An averaging convention applies to the first year of the Credit Period pursuant to which a certain portion of the tax credits that would otherwise be allowable in that year are deferred until the first year following the end of the Credit Period. 1 Unless otherwise indicated, all Section references are to the Internal Revenue Code of 1986, amended, as in effect on the date hereof.

2 The credit is designed so that, in the case of a new building that is not federally subsidized and that is occupied solely by qualified low-income tenants, the owner of the building will generally receive, in present value terms, tax credits equal to 70 percent of the costs of construction. In the case of a building that is considered to be federally subsidized (generally, building financed with tax-exempt bonds or with below-market loans financed with certain kinds of federal funds), the credit is generally equal, in present value terms, to 30 percent of the cost of construction. The credit is in addition to the other tax benefits associated with the ownership of residential rental property such as depreciation deductions. C. What Buildings Qualify. A qualified low-income building is a building in a qualified low-income project. A qualified low-income project is generally defined as a project for residential rental property that meet the (i) Minimum Set-Aside Test and (ii) the Rent Restriction Test. 1. The Minimum Set-Aside Test. A project must set aside a minimum number of residential units for qualified low-income tenants at restricted rents. A project owner may elect either the Test or the Test. The Test requires that 20 percent or more of the residential units in the project must be both rent-restricted and occupied by individuals whose income is 50 percent or less of area median gross income. The Test requires that 40 percent or more of the residential units in the project must be both rent-restricted and occupied by individuals whose income is 60 percent or less of area median gross income. 2

3 The election, which is made on IRS Form 8609, is irrevocable. The minimum set-aside requirement must be met at all times from the close of the first year of the Credit Period through the end of the 15-year Compliance Period. 2. The Rent-Restriction Test. A residential unit is generally considered to be rent-restricted if the gross rent with respect to such unit does not exceed 30 percent of the imputed income limitation applicable to such unit. The imputed income limitation applicable to a residential unit that is in a project that satisfies the test is generally 60 percent of area median income, adjusted for family size based the following assumptions: (i) in the case of a studio apartment that does not have a separate bedroom, the unit is occupied by one individual, and (ii) in the case of a unit that has one or more rooms, 1.5 individuals occupy the unit for each bedroom. Detailed tenant income certification requirements apply. Gross rent includes the applicable utility allowance, which is generally determined using local public housing authority utility allowances. Thus, the maximum allowable rent must take into account and be reduced by the applicable utility allowance. D. Qualified Basis. The qualified basis of a qualified low-income building for any taxable year is an amount equal to the applicable fraction of the building s eligible basis. The applicable fraction is the smaller of the unit fraction or the floor space fraction and is determined at the close of each taxable year. The unit fraction is a fraction, the numerator of which is the number of low-income units in the building and the denominator of which is the number of residential rental units in the building. The floor space fraction is a fraction the numerator of which is the total floor space of low-income units in the building and the denominator of which is the total floor space of the residential rental units in the building. 3

4 1. Eligible Basis. The eligible basis of a new building is generally its adjusted basis for federal income tax purposes (including the adjusted basis of depreciable property used in common areas or provided as comparable amenities to all residential rental units in the building but excluding the adjusted basis of any portion of the property that is not considered residential rental property ) as of the close of the first taxable year for which lowincome housing credits are claimed with respect to the building. The adjusted basis of commercial space is not included in eligible basis. a. 30 Percent Basis Step-Up for Projects in Qualified Census Tracts and Difficult Development Areas. In the case of a new building located in a qualified census tract or a difficult development area, the eligible basis of the building will be 130 percent of what it would otherwise be. A qualified census tract is a census tract designated as such by Secretary of Housing and Urban Development and is generally a census tract with a concentration of low-income households. A difficult development area is generally any area designated by the Secretary of Housing and Urban Development as an area which has high construction, land or utility costs relative to area median gross income. b. Federal Grants Excluded from Eligible Basis. If, during any year of the 15-year Compliance Period, a grant is made with respect to any building or the operation thereof and any portion of the grant is funded with federal funds, the eligible basis of the building for such taxable year and all succeeding taxable years shall be reduced by the portion of the grant so funded. 4

5 2. Low-Income Unit. A low-income unit generally means a residential rental unit that (a) meets the income and rent restrictions of the applicable minimum set-aside test; (b) is suitable for occupancy (complies with local health, safety and building codes) and (c) is used on other than a transient basis. Generally, a unit is considered to be leased on other than a transient basis if the term of the initial lease is at least six months. E. Applicable Percentage. For property placed in service in 1988 and thereafter, the applicable percentage is adjusted monthly by the Internal Revenue Service. The percentages are to be adjusted to reflect the present values of 70 percent or 30 percent, respectively, determined on a discounted after-tax basis based on the average of the annual applicable federal rates for mid-term and long-term obligations for the month. The applicable percentage varies depending on whether the building is a new building and whether the building is federally subsidized. In the case of a new building which has never been previously placed in service, the 70 percent rate applies unless the building is federally subsidized for the taxable year. The 30 percent rate applies to existing buildings that qualify for the credit and to new buildings that are considered to be federally subsidized for the taxable year. A new building is treated as federally subsidized for any taxable year if, at any time during such taxable year or any prior taxable year, there is or was outstanding any obligation, the interest on which is tax-exempt or any below-market federal loan, the proceeds of which are or were used (directly or indirectly) with respect to such building or operation thereof. A below-market federal loan generally means any loan funded, in whole or in part, with federal funds if the interest rate payable on such loan is less than the applicable federal rate in effect under Section 1274(d)(1) as of the date on which the loan was made. 5

6 The applicable percentage is generally the percentage determined for the month in which the building is placed in service. However, the taxpayer may elect to use the applicable percentage as of the time the housing agency enters into a binding agreement to allocate credits to the building rather than the applicable percentage that is in effect as of the time the building is later placed in service. The applicable percentage for July 2001 for new buildings receiving no federal subsidy was 8.28 percent. The applicable percentage for July 2001 for buildings that are considered to be federally-subsidized was 3.55 percent. F. Compliance Period. A project is generally required to be operating in compliance with the requirements of Section 42 for a period of 15 years beginning with the first year of the Credit Period. This 15-year period is referred to as the Compliance Period. Failure to comply with the requirements of Section 42 throughout the Compliance Period may result in a disallowance of credits, the ineligibility of the Project for tax credits in future years, or the recapture of a portion of the credits claimed. G. Extended Low-Income Housing Commitment. Generally, no tax credits under Section 42 are allowable with respect to a building for a taxable year unless an extended lowincome housing commitment is in effect with respect to that building as of the end of that taxable year. An extended low-income housing commitment is an agreement between the taxpayer/owner of the project and the applicable state agency that meets the requirements of Section 42(h)(6)(B). The commitment must be recorded pursuant to state law as a restrictive covenant on the property by no later than the end of the first year of the Project s Credit Period. The amount of credit allowed in any taxable year may not exceed the amount necessary to support the applicable fraction specified in the low-income housing commitment for such 6

7 building. However, in the case of a building financed with volume cap bonds, the low-income housing commitment may be amended to increase the applicable fraction. H. Tax Credit Allocations. 1. Projects That Are Not More Than 50 Percent Financed With Tax-Exempt Bonds Require a Tax Credit Allocation. Generally, in order for a building to be eligible for low-income housing tax credit, the building must receive an allocation of the housing credit dollar amount from the state or local agency in whose jurisdiction the project is located. In Oregon, the allocating agency is the Oregon Housing and Community Services Department. The amount of low-income housing tax credit that may be claimed with respect to any building in any taxable year may not exceed the housing credit dollar amount allocated to the building. The aggregate amount of credits that may be allocated within any state is limited by the state's annual low-income housing credit authority limitation. The credit allocations which may be made by the applicable agency for each state are generally limited to $1.75 ($1.50 for 2001) for each resident of the state, as determined by the most recent estimate of the state's population released by the Census Bureau before the beginning of the year to which the limitation applies. For years after 2002, the state tax credit ceiling will be increased by a cost-of-living adjustment factor. 2. Nonprofit Set-Aside. Ten percent of a state's housing credit ceiling for any calendar year is reserved for projects involving qualified nonprofit organizations. A qualified nonprofit organization generally means an organization exempt from federal income taxation under Section 501(c)(3) or (4) of the Internal Revenue Code, one of the exempt purposes of which includes fostering low-income housing and which is determined by the state 7

8 housing credit agency not to be affiliated with or controlled by a for-profit organization. Furthermore, in order for a project to qualify for the set-aside, the nonprofit organization must materially participate in the development and operation of the project throughout the fifteen-year compliance period. 3. Timing of Tax Credit Allocation. Credits may be allocated only during the calendar year in which the building is placed in service except where: a. credits are claimed on additions to qualified basis; b. credits are allocated in a later year pursuant to an earlier binding commitment made no later than the year in which the building was placed in service; or c. an allocation made with respect to a qualified building which is placed in service not later than the close of the second calendar year following the calendar year in which the allocation is made is timely (a carryover allocation ). The term qualified building means a building which is part of a project in which the taxpayer's basis, as of the later of (i) the date which is six months after the date on which the allocation is made or (ii) the close of the calendar year in which the allocation is made, is more than 10 percent of the taxpayer's reasonably expected basis in the project (as of the close of the second calendar year after the year in which the allocation is made). This requirement is referred to as the 10 percent test. For purposes of the 10 percent test, the taxpayer's basis in the project includes the adjusted basis of land and depreciable property, whether or not such amounts are includible in eligible basis. The cost of construction services is included in the basis of an accrual method taxpayer when the services are performed. 8

9 I. Tax Credit Allocation Must be Made Pursuant to State Qualified Allocation Plan. Under Section 42(m), the housing credit dollar amount allocated with respect to any building shall be zero unless (i) such amount was allocated pursuant to a qualified allocation plan of the housing credit agency which is approved by the governmental unit of which the agency is a part, (ii) the agency notifies the chief executive officer of the local jurisdiction within which the building is located of the project and provides that individual a reasonable opportunity to comment on the project, (iii) a comprehensive market study of the housing needs of low-income individuals in the area to be served by the project is conducted by a disinterested individual at the developer s expense, and (iv) a written explanation is made available to the public for any allocation that is made by the agency that is not in accordance with the established priorities and selection criteria of the agency. A qualified allocation plan is a plan which (i) sets forth selection criteria to be used to determine housing priorities of the housing credit agency which are appropriate to local conditions, (ii) gives preference in allocating housing credit dollar amounts among selected projects to projects serving the lowest income tenants and projects obligated to serve qualified tenants for the longest periods, (iii) projects located in qualified census tracts, the development of which contributes to a concerted community revitalization plan; and (iv) which provides a procedure that the agency will follow in notifying the Internal Revenue Service of noncompliance with the provisions of Section 42 of which the Agency becomes aware. In addition, certain selection criteria are required to be included in a qualified allocation plan. J. Tax Credit Allocation May Not Exceed the Amount Needed for the Project to be Financially Feasible. The housing credit dollar amount allocated to a project may not exceed the amount the housing credit agency determines is necessary for the financial feasibility of the 9

10 project and its viability as a qualified low-income project throughout the credit period. The housing credit agency is required to make this determination as of each of the following times: (i) the application for the housing credit dollar amount, (ii) the allocation of the housing credit dollar amount, and (iii) the date on which the building is placed in service. Thus, the housing tax credit dollar amount ultimately allocated to a building on a Form 8609 may be less than the housing credit dollar amount allocated to such building in a carryover allocation. K. Bond-Financed Projects. A tax credit allocation from the state s credit allocating agency is not required for any portion of a building financed by volume cap bonds. If at least 50 percent of the aggregate basis of a building and land is financed with volume cap bonds, the building is entirely exempt from the allocation requirement. Bond-financed projects are required to satisfy the requirements of the state credit allocating agency s credit allocation plan. Furthermore, the agency issuing the bonds must make a determination that the Tax Credits for the Project do not exceed the amount necessary to assure Project feasibility. In making this determination, the agency must take into account various criteria, such as the reasonableness of the development and operating costs of the project. Furthermore, the agency may use an applicable percentage that is less, but not greater than, the applicable percentage applicable for projects requiring a tax-credit allocation. L. Tax Credit Recapture. Generally, any disposition of a taxpayer s interest in a building or any reduction in a building s qualified basis during the building s Compliance Period may result in tax credit recapture. The recapture amount generally equals the accelerated portion of the credit plus an interest penalty. During the ten-year Credit Period, the accelerated potion of the credit is generally one-third of the credits claimed in each 10

11 year so that if a building is disposed of during the Credit Period, that is the portion of the credit that is subject to recapture. A taxpayer may avoid tax credit recapture upon the disposition of a building or an interest therein during the Compliance Period by posting a bond with the U.S. Treasury that meets certain requirements specified by the Internal Revenue Service. M. Tax Credit Investors. The use of low-income housing tax credits by individuals is strictly limited under the Internal Revenue Code. As a result, in nearly all cases, the tax credits are sold to syndicators of tax credit funds. The syndicators in turn sell the tax credits to large institutional investors. For federal tax purposes, the tax credits follow the ownership of the project. Therefore, projects are typically owned by a limited partnership or limited liability company in which the investor holds a 99.9 or percent interest. Typically, investors make staged investments over the course of a few years. Although last year, investors were often paying over $0.80/tax credit dollar, the price has since dropped due to increased product availability. The yields to tax credit investors are currently between 7 and 9 percent. N. Development Fees. Low-income housing tax credit projects can generate substantial development fees. Typically, a portion of the development fee is deferred for at least a few years with the deferred portion often paid from the later staged investor payments. II. HISTORIC REHABILITATION TAX CREDIT A. Generally. The federal rehabilitation tax credit provides an indirect federal subsidy for the rehabilitation of certain older structures. B. Amount of Credit. 11

12 1. 10 Percent Credit. The credit is equal to 10 percent of the qualified rehabilitation expenditures incurred with respect to any qualified rehabilitated building other than a certified historic structure Percent Credit. The credit is equal to 10 percent of the qualified rehabilitation expenditures incurred with respect to a certified historic structure. C. Eligibility. A qualified rehabilitated building is any building that: 1. has been substantially rehabilitated; 2. was placed in service before the beginning of the rehabilitation; 3. is a structure with respect to which depreciation (or amortization in lieu of depreciation) is allowable; and 4. in the case of a building other than an historic structure, complies with certain requirements regarding the percentage of walls and internal structural framework retained AND the building was placed in service before D. Certified Historic Structure. A certified historic structure is any building that is listed in the National Register or that is located in a registered historic district and certified by the Secretary of the Interior (National Park Service) as being of historic significance to the district E. Substantial Rehabilitation. A building is generally considered to be substantially rehabilitated only if the qualified rehabilitation expenditures during the 24-month period selected by the taxpayer in accordance with the applicable Treasury Regulations and ending with or within the taxable year exceed the greater of (i) the adjusted basis of the building (including structural components) or (ii) $5,000. The adjusted basis of the building (including structural components) is determined as of the beginning of the first day of 12

13 the 24-month period or the holding period of the building, whichever is later. The determination of the beginning of the holding period is made without regard to any reconstruction by the taxpayer in connection with rehabilitation. F. Qualified Rehabilitation Expenditure. The term qualified rehabilitation expenditure generally means any amount properly chargeable to capital account: (i) for property which is depreciable for federal income tax purposes and which is (a) nonresidential real property, (b) real property with a class life of more than 12.5 years, or (c) an addition or improvement to property in one of the above-described classes, and (ii) in connection with the rehabilitation of the qualified rehabilitated building. The term qualified rehabilitation expenditure does not include the cost of acquiring the building, the cost of any enlargements to the building or, in the case of a certified historic structure, any expense unless the rehabilitation is certified by the Secretary of the Interior (National Park Service) as being consistent with the historic structure of the property. The term qualified rehabilitation expenditure also does not include any expenditure in connection with the rehabilitation of a building that is allocable to the portion of the property which is, or may be reasonably expected to be, tax-exempt use property as defined in Section 168(h) of the Internal Revenue Code. Generally, real property may be classified as tax-exempt use property, in whole or in part, either if it is leased to a tax-exempt entity pursuant to a disqualified lease or if it is owned by a partnership composed of both taxable and one or more tax-exempt entities and the partnership s tax allocations are not qualified allocations. G. Timing of Credit. The rehabilitation tax credit can be claimed only in the year in which the rehabilitated property is placed in service. 13

14 H. Depreciable and Low-Income Housing Tax Credit Eligible Basis Reduced by Amount of Rehabilitation Tax Credit Claimed. If a taxpayer claims a rehabilitation tax credit with respect to a building, the depreciable basis of the qualified rehabilitation expenditures incurred with respect to the building is reduced by the amount of the rehabilitation tax credit claimed. The eligible basis of the rehabilitation expenditures is also reduced for purposes of determining the low-income housing tax credit based on those expenditures. I. Recapture. The rehabilitation tax credit is subject to recapture in the event of early disposition (including destruction from casualty or condemnation) of an historic credit property. If, within five years after the date the building is placed in service, the building is disposed of, the owner s tax for the year will be increased by an amount equal to the amount of the rehabilitation tax credit originally allowed, multiplied by a recapture percentage determined on the basis of the holding period of the building. The recapture percentage is 100 percent for a disposition within the first year after the building is placed in service and decreased by 20 percent for each full year that elapses thereafter such that no recapture occurs in the event of a sale occurring more than five years after the building is placed in service. For purposes of determining recapture of the rehabilitation tax credit, a disposition is deemed to occur in any sale exchange, transfer, distribution, involuntary conversion or gift of the building, or the occurrence of any other event which causes the building to cease to qualify for the rehabilitation tax credit. 14