Affordable Housing: LIHTC Accounting Overview. July 30, 2014

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1 Affordable Housing: LIHTC Accounting Overview July 30, 2014

2 Tax Credits 101 TOPIC Welcome and Overview Project Proforma Roles, Motivations and Responsibilities of Developer and Investor 10% Test 50% Test Cost Certification 2

3 Overview of Low Income Housing Tax Credits 3

4 What is a Low-Income Housing Tax Credit? Authorized under Section 42 of the Internal Revenue Code Designed to help fund low-income housing Investors purchase tax credits from developers of low-income housing. The money paid by investors is contributed to the project as equity. 4

5 Types of LIHTCs 9% Credit New construction or substantial rehabilitation awarded through competition 4% Credit New construction or substantial rehabilitation awarded in conjunction with tax-exempt bonds 5

6 How Do You Get Tax Credits? Developer applies to housing credit agency (HCA) for reservation of credits 9% credits are awarded through competition 4% credits are awarded as of right in conjunction with tax exempt bonds 6

7 Role of Housing Credit Agency HCA HCAs are responsible for selecting developments to allocate the Credit, underwriting the Credit (sizing it according to financial needs of the project), reporting Credit activity to the IRS, and monitoring for compliance with federal regulations. 7

8 Qualified Allocation Plan QAP HCA guidelines must be published in annual Qualified Allocation Plans ( QAPs ), which detail selection criteria and compliance monitoring rules. Most HCAs select projects through competitive cycles (at least one per year), with various threshold and scoring criteria. Selection criteria includes project characteristics, owner characteristics, location, market feasibility, energy efficiency, income targeting, and affordability periods. 8

9 Tax Exempt Bonds Tax-Exempt Bond Financed Developments Developments with at least 50% of aggregate basis financed with taxexempt bonds are eligible. Credits are awarded as of right. Projects do not compete. Must meet QAP and underwriting criteria. Applicable Tax Credit Percentage is published monthly by U.S.Treasury, and is a floating rate at or below 4%. August 2014 applicable tax credit percentage is 3.25% Frequently used to finance acquisition and rehabilitation of existing properties (e.g., Preservation deals). Project size usually 100 units or more 9

10 Low Income Use Restriction Minimum Requirement: rent and income restrictions must remain in place for a 15-year Compliance Period, plus an additional 15-year Extended Use Period. Property owners may elect to opt-out of the Extended Use Period with HCA approval under certain circumstances; Qualified Contract. Many QAP s have longer use restrictions and prohibit opting out early. 10

11 Eligible Basis Eligible basis = adjusted basis of building at end of 1st year of credit period Includes common areas 30% boost in QCTs or DDAs Projects located in HUD-designated Qualified Census Tracts or difficult to develop areas receive a 30% increase on eligible basis 11

12 Eligible Basis (cont.) Costs that ARE included: Engineering & architecture Survey Appraisal Construction costs Market study Impact fees/permits Inspections Tenant relocation Accounting & legal Environmental Depreciable land improvement Developer fee Construction period interest, loan fees, insurance, real estate taxes 12

13 Eligible Basis (cont.) Costs that ARE NOT included: Land Permanent loan fees Marketing and lease-up costs Tax credit fees Reserves Syndication fees Commercial or income-producing space 13

14 Community Service Facilities Generally, costs included in basis are limited to space used exclusively for low-income tenants. In qualified census tracts, basis may include costs of providing a community service facility for use primarily by low-income residents of the area. They do not have to be tenants. There are limitations on the percentage of basis that may be eligible for tax credits for community service facilities. Consult your tax credit advisor. 14

15 Rent Rules Rent + utility allowance (gross rent) cannot be >30% of household income Qualifying income based on family size and # of bedrooms Gross rent does not include Section 8 or other subsidies Rent limits change annually when HUD publishes new Area Median Incomes (AMIs) 15

16 Income Limits Minimum set aside: certain % of units restricted for % of AMI 20/50: 20% of units at 50% of AMI 40/60: 40% of units at 60% of AMI NYC only: 25/60: 25% of units at 60% of AMI 16

17 Recapture for Non-Compliance Decrease in qualified basis Not meeting minimum set-aside Low-income occupancy decreases Sale or foreclosure Eminent domain Damaged building out of service (e.g. Sandy casualty losses) 17

18 Role of the Investor Purchases tax credits and tax benefits Current price is approximately $.90 for $1.00 of tax credits Investors may pay more for credits in areas eligible for CRA credit Investors may pay less for credits in areas deemed higher risk Becomes 99.99% limited partner in project ownership entity 18

19 Typical Ownership Structure General Partner Tax Credit Investor Nominal 1% Credits, 99% Credits, $$ Equity Equity Investment Profits & Losses Profits & Losses Operating Partnership Development Fee Rent Developer Mortgage Tenant Group 19

20 Financial Model 20

21 Project Summary & Assumptions Construction start & placed in service dates Occupancy (lease-up) Debt & equity Operating income & expenses Development budget (sources & uses) Tax credit assumptions (4%-9%, 30% basis boost, tax credit pricing) 21

22 Project Income Unit mix Bedrooms Number of units Target median income % LIHTC rent limits Proposed rents Cannot exceed LIHTC rent limits Market study Vacancy allowance Tenant paid utilities 22

23 Project Expenses Administrative Management fees (% of effective gross income) Monitoring fees Annual audit/tax Utilities Operating expenses Realistic per unit cost Replacement reserves Typically $250 - $300 per unit per year 23

24 Operating Pro Forma Income Trend 2% Expense Trend 3% Vacancy Allowance 7% Management Fee 5% Income Year 1 Year 2 Year 3 Year 4 Year 5 Gross Project Income 874, , , , ,912 Vacancy Allowance (61,236) (62,461) (63,710) (64,984) (66,284) Effective Gross Income 813, , , , ,628 Expenses Total Expenses 540, , , , ,118 Net Operating Income 272, , , , ,510 Debt Service Financing Private Loan 238, , , , ,647 Cash Flow 33,944 34,393 34,701 34,860 34,863 Debt Coverage Ratio Cash Flow Financing HOME 16,972 17,196 17,350 17,430 17,432 Remaining Cash Flow 16,972 17,196 17,350 17,430 17,432 Def Dev Fee Balance 691, , , , ,296 Def Dev Fee Payment (16,972) (17,196) (17,350) (17,430) (17,432) Def Dev Fee Balance 674, , , , ,864 24

25 Development Budget - Uses Acquisition costs Land Existing building (rehab) Construction costs (hard costs) General requirements Builder s profit & overhead Hard cost contingency Soft costs Development related Financing (construction/perm) 25

26 Development Budget Uses (cont.) Soft costs Syndication Tax credit related Developer fee Max developer fee limits (state) Reserves Operating Rent-up Escrows 26

27 Development Budget - Sources Construction financing Construction Permanent Debt Permanent debt Cash flow financing Grants Equity LIHTC equity State tax credit equity Deferred developer fee 27

28 Tax Credit Equity Eligible Costs 14,405,812 QCT/DDA Boost (130%) x 100% Eligible Basis 14,405,812 Applicable Fraction x 100% Qualified Basis 14,405,812 Applicable Percentage x 9.0% Annual LIHTC Eligible 1,296, years x 10 Total LIHTCs Over Period 12,965,231 Investor Ownership % x 99.99% Total Investor LIHTCs 12,963,934 Tax Credit Price x.95 Tax Credit Equity 12,315,738 28

29 Investor Metrics Investor IRR Schedule of benefits o Losses Depreciation o Tax credits Distributions (cash flow) Capital contributions o Quarterly compounding Capital account Minimum gain 29

30 The 10% Test 30

31 Why Conduct a 10% Test? If a project is not placed in service in the year of credit allocation, the project must apply for a Carryover of the Allocation. This process is specific only to competitive LIHTCs. LIHTCs in conjunction with tax exempt bonds are exempt. The 10% Test is part of the Carryover Allocation Application to demonstrate progress toward project completion. Typically, the HCA requires an Independent Accountant s Report. The form of report is dictated by the HCA and may vary from state to state. 31

32 What is a 10% Test? A 10% Test supports Accumulated Basis* in a project. Accumulated Basis must be at least 10% of the Reasonably Expected Basis* of the project on a specific date. *Accumulated Basis: Total costs incurred to date which represent project s depreciable basis plus land. *Reasonably Expected Basis: Project s depreciable basis plus land costs. This amount is generally stipulated by the Owner as part of the Carryover Allocation. * Note: terminology varies by HCA 32

33 The 10% Calculation dl 10% < Accumulated Basis (land + depreciable basis) Reasonably Expected Basis (total expected land + depreciable basis) 33

34 What is involved in a 10% Test? The Independent Accountant will test, on a sample basis, costs presented by the Owner as Accumulated Basis. Testing could include: Sampling of invoices or other documentation. Confirmation of costs incurred with third party vendors. Recalculation of fees to determine inclusion in accordance with terms. Relevant project documents will be obtained, reviewed and retained as part of the engagement documentation. Additional specific procedures required by the HCA, if applicable. 34

35 50% Test: Projects Financed with Tax Exempt Bonds 35

36 Background on Bond Financing HCAs allocate competitive LIHTCs to projects based on their annual LIHTC volume cap allocation received from the U.S. Treasury. An exception to this rule relates to projects financed with Tax-Exempt Bonds. LIHTCs awarded as of right to projects financed with Tax-Exempt Bonds do not count against the HCAs LIHTC volume cap allocation. As of right 4% LIHTCs are non-competitive. Projects must only meet requirements under the State s QAP and tax exempt bond rules. 36

37 What is the 50% Test? The 50% test is calculated by dividing the Bond Proceeds by the Aggregate Basis of the Project. For these purposes: Bond Proceeds: Include only the amount of bonds used to finance the acquisition, hard construction and soft costs of the project. Generally this will equal the mortgage amount. Bond Proceeds do include interest earned on the bonds or bond reserve funds. Aggregate Basis: Includes the Project s depreciable basis and land costs. 37

38 The 50% Test Bond Proceeds 50% < Aggregate Basis (of building and land) 38

39 Other Bond Nuances For a bond financed project to obtain LIHTCs the bonds must be volume cap bonds, a separate application and allocation process from an issuing agency. Tax exempt bond volume cap is allocated annually by the U.S. Treasury to issuing agencies. The Project must meet the 95/5 Test. This test is often called the good cost / bad cost test and is typically performed by an Independent Accountant. For these purposes some examples are: Good Costs: Building and land, common space, resident recreation and parking facilities related to the rental residential units. Bad Costs: Commercial space, financing fees, bond issuance costs, some costs incurred prior to bond inducement. 39

40 Meeting the 50% Test If the Project meets the 50% Test, the Project may claim 100% of the 4% credits on the total amount of eligible basis. Example: Volume Cap Bonds 10,000,000 Aggregate Basis 19,900,000 50% Test Ratio % Land in Aggregate Basis 2,000,000 Eligible Basis 17,900,000 Eligible under 50% Test % Final Eligible Basis 17,900,000 40

41 What Happens if a 50% Test Fails? If the Project does not meet the 50% Test the Project is limited to 4% credits on the amount of eligible basis times the final ratio. This has a severe impact on the available credits! Example: Volume Cap Bonds 10,000,000 Aggregate Basis 20,100,000 50% Test Ratio % Land in Aggregate Basis 2,000,000 Eligible Basis 18,100,000 Eligible under 50% Test % Final Eligible Basis 9,004,975 41

42 To prevent failing 50% Test Alternative methods for calculating capitalization of project costs; i.e., construction interest capitalization, 266ii election, etc.. This is typically the first alternative evaluated. Reduction of Aggregate Basis costs via funding at General Partner level through GP guarantees of maximum project costs for construction. Obtain an additional allocation of volume cap bonds to increase the numerator in the calculation. These bonds would be used to pay qualified costs and typically repaid with permanent sources such as equity or other debt. Reduction of developer fee until the 50% ratio is met -- typically the last resort! 42

43 Reporting for 50% Tests 50% Tests are reported in different ways depending on the HCA. Reports are generally required to be prepared by an Independent Accountant. Two options are typical: Report as part of the final 8609 cost certification: In this option there is a separate provision in the HCA s reporting format which includes a calculation and report on the 50% status. Report in a separate letter: In this option there is a separate report stipulated by the HCA which specifically addresses the 50% test. 43

44 The Independent Accountant s Report Report typically in form of an Agreed Upon Procedures (AUP) report performed by an Independent Accountant Specific procedures required by the HCA are reported upon by the Independent Accountant 44

45 8609 Cost Certification 45

46 What is a Cost Certification? CPA s audit of project costs. Required by HCA s to certify eligibility for LIHTCs. Each HCA has specific information required to be included. Typically required: schedules of total and eligible costs by project and building, calculation of credits, sources and uses of funds, gap analysis and project proformas. Upon final issuance of the cost certification, as a part of the final application package, which usually includes additional materials, forms 8609 will be issued to the owner. 46

47 New Construction vs. Acquisition Rehab New Construction: Involves construction of a project from the ground up. In these circumstances, there was either vacant land with no existing building, or all existing structures were demolished and a new structure constructed. Acquisition / Rehabilitation: Involves acquiring an existing project and rehabilitating the structure. This can involve rehabilitation around tenants, tenants do not vacate units, or vacate units on a daily basis; or units can be taken out of service, tenants are relocated during rehabilitation. The nature of the construction/rehabilitation has direct effects on the ability to capitalize costs as eligible as well as the method for determining credit rates. 47

48 Acquisition Rehab Additional Considerations Minimum Rehab Test: Rehabilitation of the Project must meet minimum requirements: $6,200 per unit or 20% of adjusted acquisition basis, or whatever is stipulated in the relevant QAP Purchase from an unrelated party: Acquisition of the Project must be from an unrelated party for tax purposes. 10 Year Rule: The project must not have been placed in service within 10 years previous to acquisition (certain exceptions apply). 48

49 Eligible Costs (Refresher) Costs that ARE included (wholly eligible): Engineering & architecture Survey Appraisal Market study Impact fees/permits Depreciable land improvement Tenant relocation Inspections 49

50 Acquisition Analysis New Construction: Generally limited to ineligible land costs Acquisition/Rehab: Must create or obtain a purchase price analysis to establish basis in acquired assets: In most cases an independent appraisal is used to support allocation of acquisition cost to land and building (potentially furniture & fixtures and existing leases, etc.) In complex transactions involving commercial space, long term tenants, or related parties, a 3 rd party specialist may need to perform a purchase price allocation Basis related to acquired building is eligible for 4% acquisition credits. 50

51 Construction Costs Construction costs related to residential rental units, common space, tenant amenities (non-commercial) and depreciable land improvements are eligible. Construction costs related to demolition (non-rehab), commercial space, permanent land improvements are not eligible. Contractor fees for overhead, general requirements and profit are limited subject to specific limits prescribed by the HCAs. See QAP for year of allocation. Related party contractors require additional documentation for testing purposes to support costs (job costs, etc.). 51

52 Developer Fees Developer Fees are eligible to the extent of underlying developer activity, which can be determined via review of the developer agreement and direct inquiry. Developer Fee may be allocated to: Acquisition / Rehab and Commercial / Residential Development and construction related services: eligible Financing related activity (acquisition of debt/equity): partially eligible (equity related = ineligible) Developer fees are also subject to specific limits prescribed by the HCA. 52

53 Legal Fees Similar to Developer Fees, legal fees are eligible to be capitalized based on the underlying characteristics for which they were rendered. Fees are treated similarly to those underlying costs. For example, if related to organizational/partnership or syndication costs, legal fees are 100% ineligible. Financing fees are amortized over the life of the related financing instrument. 53

54 Monthly Capitalization (for periodic costs) The amount of a specific cost to be capitalized for a specific month; i.e., eligible, can be determined by the proration of the project which is out of service. New Construction: This scenario is straight forward, at inception, 100% of units are out of service, decreasing to 0% as the Project is completed. Rehabilitation: Capitalization is determined by units out of service at the beginning of each month. Factors such as whether the project has in place tenants at acquisition, rehabs around tenants, etc. all factor in to capitalization determination Note: out of service indicates that the unit is NOT ready and available for its intended use 54

55 Monthly Capitalization New Construction Example Example: Uniform units. 100 Units out of service

56 Monthly Capitalization Rehabilitation Example Example: Uniform units with existing tenants in place, units taken offline. 100 Units out of service

57 Monthly Capitalization Rehabilitation (cont.) Project is vacant at acquisition: monthly capitalization will work like New Construction. Rehab around tenants: monthly periodic costs will not be eligible. 57

58 Periodic Costs Costs which attach to specific periods of time such as insurance, real estate taxes, etc. These costs are allocated across the relevant period and are eligible in the percentage that the related month is out of service see monthly capitalization. Construction loan costs and costs of issuance including title & recording on loans are periodic costs. This is an often confused concept. 58

59 Interest Capitalization Interest is also a periodic cost, but varies from the previous costs in that capitalization is typically done on a quarterly basis on the first day of each quarter. Monthly capitalization is an option for acquisition rehab projects with a irregular pattern for quarterly capitalization. Interest capitalization can be a complex calculation. 59

60 Interest Cap Example Traditional Financing Interest Charges Out of Service Capitalized January $ 8, % $ 8,000 February $ 9,000 75% $ 6,750 March $ 10,000 50% $ 5,000 $ 27,000 $ 19,750 60

61 Interest Cap Example Tax- Exempt Bond Financing Total Bond Issue $ 3,000,000 A B C D = (C / A) E = (B x (1 - D)) F = (B - E) G F x G Interest Charges Bonds Drawn for Construction Construction Fraction Investment Interest Expense Construction Interest Expense Out of Service Capitalized Quarter 1 $ 10,000 $ 1,000,000 33% $ 6,667 $ 3, % $ 3,333 Quarter 2 $ 10,000 $ 1,750,000 58% $ 4,167 $ 5,833 75% $ 4,375 Quarter 3 $ 10,000 $ 2,250,000 75% $ 2,500 $ 7,500 50% $ 3,750 $ 30,000 $ 13,334 $ 16,666 $ 11,458 * Note = 266ii election can be made to capitalize investment interest expense rather than deducting the amounts. This results in no offset to any income earned on bond reserves, which will be recognized as revenue. 61

62 Avoided Interest Avoided interest relates to the cost of interest which has been avoided through the use of equity for financing the Project. Avoided interest is calculated on non-traced debt as the weighted average interest rate for the period. 62

63 Determining the Applicable Percentage New Construction 63

64 Determining the Applicable Percentage - Acquisition 64

65 Determining the Applicable Percentage - Rehabilitation 65

66 Definitions 30% Boost : Properties located in a federally-designated Qualified Census Tract, or Difficult Development Area, are eligible for 30% increase in eligible basis in calculating the credit for new construction and rehabilitation costs (acquisition portion not eligible). Aggregate Basis: Land + depreciable basis; relevant for calculating tax exempt bond 50% test. Annual Credit Amount: Product of Qualified Basis and Applicable Credit Percentage Fraction. 66

67 Definitions (cont.) Applicable Fraction: The lesser of the unit fraction or floor space fraction. Must meet for each BIN in project. Applicable Tax Credit Percentage: Rate published monthly by Treasury to determine credit amount based on Qualified Basis. Fixed at 9% for most new construction and rehabilitation expenses for projects receiving allocations until December 31, Floating rate at or below 4% for acquisition and construction/rehab costs financed with tax-exempt bonds. 67

68 Definitions (cont.) Eligible Basis: Development costs related to acquisition, rehabilitation, or construction of a new building that are depreciable to that building. Floor Space Fraction: S. F. low income units S.F. total units Qualified Basis: Product of Eligible Basis and Applicable Fraction. Unit fraction: low income units total units 68

69 QUESTIONS? 69

70 Presenter Marshall Phillips Principal CohnReznick, LLP 525 North Tryon Street, Suite 1000 Charlotte, NC

71 Presenter Marshall Phillips Principal 525 N. Tryon Street, Suite 1000 Charlotte, NC