© 2013 McGladrey LLP. All Rights Reserved. October 8, 2013 Massachusetts CFMA Introduction to Low Income Housing Tax Credits

© 2013 McGladrey LLP. All Rights Reserved. Program Overview  Established by Congress in 1986 to encourage private investment in construction and rehabilitation of affordable rental housing  Codified in Section 42 of the Internal Revenue Code - LIHTC  Since 1987, the program has produced over 3,125,000 units or approximately 125,000 annually  Largest single funding source for affordable housing production in the U.S. 1

© 2013 McGladrey LLP. All Rights Reserved. A Tax Credit is…  A direct dollar –for-dollar tax reduction against federal tax liabilities for investors, individuals and corporations for a 10-year period  But… use of credits in low income housing comes with a mandatory 15 year compliance period during which affordability requirements must be maintained (or else credits can be recaptured) 2

© 2013 McGladrey LLP. All Rights Reserved. Low Income Housing Tax Credits  State Housing Finance Agencies receive from the IRS an annual allocation of credits based on population  Indexed to inflation  For 2013, the annual allocation is $2.25 per capita  The Department of Housing and Community Development (DHCD) is the Comm. of MA allocation agency 3

© 2013 McGladrey LLP. All Rights Reserved. Qualified Allocation Plan  Each state is required to adopt a Qualified Allocation Plan (QAP) and is permitted to establish its own allocation process (subject to certain federal requirements)  QAP must set forth criteria to determine allocation priority – each state is different – crucial to understand your state’s QAP  Competitive application process 4

© 2013 McGladrey LLP. All Rights Reserved Qualified Allocation Plan – DHCD  Priority categories for 2013 funding:  Housing for extremely Low Income persons earning less than 30% of AMI (Area Median Income) - focus is on homeless or risk of homelessness  Investment in distressed and at-risk neighborhoods  Preservation of existing affordable housing  Family housing production in neighborhoods and communities that provide access to opportunities – jobs, transportation, education and public amenities 5

© 2013 McGladrey LLP. All Rights Reserved. How does low income housing come into play?  Encourages the Construction and Rehabilitation of Affordable Rental Housing by providing incentive – Owners and Investors can use the credits to reduce their federal tax liability  LIHTCs are awarded to Owners, who then sell them to investors for a certain price, which then becomes the equity contributed to the project  Receipt of the equity reduces amount of debt needed to finance the Project  Results is lower rents 6

© 2013 McGladrey LLP. All Rights Reserved. How does low income housing come into play  Credit amount to a project is based on construction costs incurred and begins when units are occupied by low income families  No tax credit allocation can be for an amount more than is required for the project to be financially feasible throughout the 10-year credit period (sources & uses, equity attributable to tax credits, development and operating costs) – must be reviewed at application (for MA purposes – One Stop Application), Carryover and issuance of Form 8609  Form 8609: used to obtain a housing credit allocation from the housing credit agency. A separate Form 8609 must be issued for each building; also used to certify certain information 7

© 2013 McGladrey LLP. All Rights Reserved. Types of Tax Credits  Substantial Rehab/New Construction LIHTC- 9% of eligible basis taken over 10 years  Acquisition LIHTC – 4% of eligible basis taken over 10 years – only with substantial rehab –  Substantial rehabilitation - greater of $6,000 per unit or 20% of adjusted basis of building being rehabilitated  LIHTC awarded with Tax Exempt Bonds- must finance over 50% of project – automatic 4% credit taken over 10 years  Historic Rehab Credit – 20% of basis taken in first year only – different IRS section 8

© 2013 McGladrey LLP. All Rights Reserved. Calculating Tax Credits  Housing Credit Terms - Eligible Basis - Credit Rate - Applicable Fraction - Qualified Basis - Basis Boost 9

© 2013 McGladrey LLP. All Rights Reserved. Calculating Tax Credits  What is Eligible Basis?  Eligible Basis is the value of the costs incurred by a taxpayer to make a residential property ready for its intended use. For new construction, it is all the costs associated by building the property; for renovation, it is all the costs associated with the repair of the building.  An estimate of Eligible Basis anticipated to be incurred during your project’s development period will be performed in order to apply for tax credits. 10

© 2013 McGladrey LLP. All Rights Reserved. Calculating Tax Credits  What Costs count as “basis”? - Construction costs Including construction period costs such as loan interest, real estate taxes, water and sewer charges, and insurance - Architect’s fees - Environmental surveys - Relocation expenses - Title and recording fees - Appraisals 11

© 2013 McGladrey LLP. All Rights Reserved. Calculating Tax Credits  What doesn’t count in “basis”? - Land acquisition - Reserves - up front operating, replacement (or rent-up reserve and escrow accounts) - Permanent mortgage fees - Partner organization costs (legal) - Marketing expenses - Syndication costs 12

© 2013 McGladrey LLP. All Rights Reserved. Low Income Housing Tax Credits  Credit Rate - Published monthly by the IRS – fluctuates with changes in interest rates - October 2013: 4% credits = 3.27%, 9% credits = 7.63% - Tax Act of 2008 – floor of 9% on new construction PIS before – no change in 4% credits - Tax Act of 2012 – extended 9% floor for credit allocations made before Rates are multiplied by the adjusted qualified basis to determine the annual LIHTC amount for which the project is eligible 13

© 2013 McGladrey LLP. All Rights Reserved. Low Income Housing Tax Credits  Applicable Fraction - Building by building computation measured on both the # of residential units and square footage - Determines the total # of units in each building that will be low-income - Owners awarded tax credits based on eligible costs multiplied by the Applicable Fraction - Only an issue if project contains buildings that are NOT 100% tax credit units - Must maintain the same Applicable Fraction throughout the compliance period 14

© 2013 McGladrey LLP. All Rights Reserved. Low Income Housing Tax Credits  Qualified Basis is the amount of eligible basis (less any federal financing) that is attributable to the low income units  Qualified Basis = adjusted eligible basis X the Applicable Fraction – (the lesser of): - The percentage of low income units in the building – or – - The percentage of floor area attributable to low income units in the building 15

© 2013 McGladrey LLP. All Rights Reserved. Sample LIHTC Calculation 16 TDC $ 5,000,000 minus $ 1,050,000ineligible costs equals $ 3,950,000eligible basis times100%applicable fraction equals $ 3,950,000qualified basis times9%credit rate equals $ 355,500annual credit amount for ten years

© 2013 McGladrey LLP. All Rights Reserved. Low Income Housing Tax Credits  Basis Boost – You can increase your qualified basis by up to 130% if your project is located in: - A qualified census tract (more than 50% of the residents earn less than 50% of the median income) – or – - A difficult to develop area (where costs are far above the national average)  HUD publishes a list of QCTs and DDAs eligible for basis boost annually 17

© 2013 McGladrey LLP. All Rights Reserved. Sample LIHTC Calculation using Basis Boost 18 TDC $ 5,000,000 minus $ 1,050,000ineligible costs equals $ 3,950,000eligible basis times100%applicable fraction Times130%basis boost equals $ 5,135,000qualified basis times9%credit rate equals $ 462,150annual credit amount for ten years

© 2013 McGladrey LLP. All Rights Reserved. Use of Federal Funds with LIHTCs  Any federal funds used for construction must be subtracted from eligible basis. This is to avoid double federal subsidy: - Tax exempt bonds are included as federal financing - HOME and CDBG do not function as federal funds  Rather than subtracting federal dollars, you can take 4% credit on entire eligible basis 19

© 2013 McGladrey LLP. All Rights Reserved. General Program Requirements  Rent and Income Restrictions for Qualified Building  Minimum Set –Aside Test – Minimum % of units must be rented to low income tenants  At least 20% of units in Project must be rented to tenants with income at or below 50% of AMI or  At least 40% of units in Project must be rented to tenants with income at or below 60% of AMI (area median income)  AMI figures are published annually by HUD in same manner as used in Section 8 Program 20

© 2013 McGladrey LLP. All Rights Reserved. General Program Requirements  Rent Restriction Test – Maximum rents limited for LIHTC units  Gross rent (including utilities) cannot exceed 30% of applicable AMI  Gross rent does not include Section 8 or similar rental subsidies  Gross rent must include utility allowance for tenant paid utilities – you must deduct this amount from rent charged to tenant 21

© 2013 McGladrey LLP. All Rights Reserved. General Program Requirements  Minimum 30-Year Affordability Commitment  15 year Compliance Period – 3 tests must be met continuously for 15 years or risk credit recapture - Minimum Set- Aside - Applicable Fraction by building - Rent and income restrictions  15 year Extended Use Period – Owner must agree to extended low income housing use of at least 15 years – agreement is binding on project owner and successors, is deed restricted and enforceable by tenants 22

© 2013 McGladrey LLP. All Rights Reserved. General Program Requirements  Federal Placement in Service Deadlines  Project must be PIS (Placed in Service) in the year LIHTC’s are allocated to Project Owner  Exception : Carryover  10% Test – Cost Certification of 10% of Reasonably Expected basis must be incurred by a certain time  If credits are carried over – project must be PIS by the end of the second calendar year after year Carryover is made 23

© 2013 McGladrey LLP. All Rights Reserved. General Program Requirements  Reasonably Expected Basis = Adjusted Basis of Land and Depreciable Property  If 10% test is failed, Project will not be eligible for ANY tax credits  No carryover allocation requirement for automatic allocation of 4% tax credits for bond-financed projects 24

© 2013 McGladrey LLP. All Rights Reserved. Low Income Housing Tax Credit Structure Investor “Fund” Partnership G.P. Manager State Housing Agency Section 42 “Operating Partnerships” Equity Credits Nominal Equity Credits L.P. Investor Losses Cash Flow Credits Equity 25

© 2013 McGladrey LLP. All Rights Reserved. Low Income Housing Tax Credit Structure  Sponsor acts as General Partner (GP) - GP oversees development team and construction, obtains funding, applies for LIHTCs, coordinates supportive services, maintains LIHTC compliance  Syndicator acts as Limited Partner (LP) - LP forms a partnership with the GP and provides equity in exchange for a 99.99% interest in the LIHTCs and the operational losses that flow from a given project  Investor - Investor (primarily corporations) forms a partnership with the LP and provides equity in exchange for a 99.99% interest in the LP. The LIHTCs and operational losses flow through the LP to the Investor. 26

© 2013 McGladrey LLP. All Rights Reserved. The relationship with Investors  Expectations of rate of return through credits, losses and cash payments  Investors should expect guarantees for: - Completion - Credit compliance - Operations  End of 15 years – sale, donation, abandonment or a combination 27

© 2013 McGladrey LLP. All Rights Reserved. Example of Investor Equity for LIHTC 28 Annual Credit$ 355,500 Years 10 Total Credits $ 3,555,000 Equity % interest99.99%Assuming direct investor Investor credits $ 3,554,645Allocated to investor Price per credit $.88 Equity contributed$ 3,128,087

© 2013 McGladrey LLP. All Rights Reserved. Low Income Housing Tax Credit Timeline Allocation Carryover Placed In Service ConstructionCredit Period – 15y 12/31/1312/31/15 29

© 2013 McGladrey LLP. All Rights Reserved. Developer Benefits  New housing – tangible results; mission  Serving selected target populations  Choose housing type and design  Earn development fees  Potential for management fees  Potential cash flow  Potential ownership of project in 15 years  Publicity/ enhance reputation in community 30

© 2013 McGladrey LLP. All Rights Reserved. Risks to Developer RisksRisk Mitigation Loss of start-up moneyLimit up-front cash expenditures; spread the risk Public opposition/NIMBYSite selection that is good but not too good; knowledge and skill with local politics Project runs over budget (construction risk) Select strong builder, architect; monitor progress and quality; Bond or Letter of Credit? Tax Credits delivered late (“Credit adjuster”) Select strong builder; realistic timing assumptions! Project loses money operating (Operating deficit guarantees) Realistic budget and RESERVES! Tenant problems, marketingExperienced manager; good package of site, design, amenities, market and price 31

© 2013 McGladrey LLP. All Rights Reserved. Critical Diligence Points for Developers  Developer - Awarding of tax credits is not enough - Need hard equity commitment to purchase the credits - Developer guarantees tax credit delivery- in amount and timing  States have cost caps that cannot be exceeded (or funded with credit dollars)  Credits start flowing when project is “leased – up” – timely completion is critical and penalty provisions against the developer can be costly if project is delayed 32

© 2013 McGladrey LLP. All Rights Reserved. Critical Diligence Points for Developers  Sources of funds are highly dependent on construction costs  More costs mean more credits – but not necessarily the ability to fund additional debt  If project is under budget, then the amount of credits promised is not delivered and can negatively impact the developer fee allowed by the state - Developers will then react by finding more costs to put into the budget (i.e. playgrounds, etc.)  Due to the complexity and interaction with the sources of funds -> The best developed projects come in exactly on budget and exactly on time – no more; no less 33

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