Low Income Housing Tax Credit 201

Low Income Housing Tax Credit 201
Glenn Graff Becca Hartstein Kim Lawson 2019 Applegate & Thorne-Thomsen Developer Boot Camp, April 2, 2019

LIHTC 101 Summary Ownership Structures Tax Credits vs. Tax Deductions
Types of Credits – 9% and 4% Computing LIHTC Applicable Percentage – the Credit rate Qualified Basis – Eligible basis x Applicable Fraction Eligible Basis Basis Boost – QCT, DDA and Discretionary Boost Compliance, Definitions and Procedural Issues Qualified Low-Income Buildings and Qualified Low-Income Projects Next Available Unit Rule & Vacant Unit Rule 15-Year Compliance Period Extended Use Agreement Allocation Process

LIHTC 201 Outline Acquisition Credits
Section 42 Non-Profit Right of First Refusal Original Issue Discount Tax-Exempt Use Bonus Depreciation Section 163(j) and Interest Limitations True Debt Issues Capital Accounts

4% Credits - Recap “30% Present Value Credit” or the “4% Credit” - The 30% Present Value Credit is a percentage which will yield over the 10-year Credit Period a Credit with a present value equal to 30% of the Qualified Basis of a building. It is used in two situations: Credits for Existing Buildings Federally Subsidized Building LIHTC - buildings financed directly or indirectly by loans funded with the proceeds of tax-exempt financing. Below market federal loans (such as HOME, CDBG, AHP, etc.) no longer constitute a federal subsidy for purposes of determining whether a building is “Federally Subsidized”. 4% Credit Rate - Has fluctuated over time between 3% and 4%, generally between 3.2% and 3.5%. The March 2019 rate is 3.27%.

4% Acquisition Credit – 4 Requirements
No Placements In Service in Last 10 Years or meet an exception Acquire Building by “Purchase” from an unrelated party Building Not Previously Placed in Service by a Related Person Minimum Rehab Requirement will be met

4% Acquisition Credit – 10 Year Rule
Practice Note: Establishing Transfers Did Not Place in Service No Prior Use - Was building used for any purpose after a transfer in the last 10 years? Even small uses can disqualify a building from acquisition credits. Code Violations - If building was in violation of codes or otherwise not allowed to be occupied when transferred, then no PIS? Pictures/Evidence of building physical condition – documentation showing could not be used when transferred. Examples - holes in roof, major systems not working. 4% Acquisition Credit – 10 Year Rule No Placements In Service in Last 10 Years or meet an exception Placement in Service (“PIS”) – When a building is ready for its intended use Building Transfers – Transfers generally place a building in service. Due Diligence Item - 10-Year Tract Search – review title for property transfers. Out of Service Building Exception – Transfers of buildings that are not capable of being used at that time are not considered a placement in service and won’t disrupt the 10 year no PIS rule.

4% Acquisition Credit – 10 Year Rule (cont’d)
Exceptions to No Placements in Service During Prior 10 Year Rule When can a prior placement in service be ignored? Federally or State Assisted Building Exception – Federally Assisted - any building which is substantially assisted, financed, or operated under section 8 of the United States Housing Act of 1937, section 221(d)(3), 221(d)(4), or 236 of the National Housing Act, section 515 of the Housing Act of 1949, or any other housing program administered by the Department of Housing and Urban Development or by the Rural Housing Service of the Department of Agriculture. State-Assisted Building - any building which is substantially assisted, financed, or operated under any State law similar in purposes to any of the federal laws referred to above. Lack of IRS Guidance – Proceed with Caution – Without IRS Guidance, the industry is cautious on this exception due to the all or nothing nature of acquisition credits. Units with Assistance- Given lack of IRS guidance, generally want at least 50% of units to be subsidized with Section 8 or Section 9 funds or similar funds. What Is Substantial Federal Financing – any FHA, HUD or RD financing should work. There is a lack of clarity on how to determined what is substantial. Timing Requirements? – Must assistance/financing/operation be in place prior to acquisition? Most investors would require existence prior to acquisition, but there are some investors and tax counsel who in some situations may allow the federal/state characteristic to come on at closing.

4% Acquisition Credit – 10 Year Rule (cont’d)
Practice Note: Sometimes 10 Years Isn’t Enough QNP/Gov’t Exception or Foreclosure Exception only apply if there was a good 10-years at the time of the transfer to the QNP/Gov’t/Lender. Example 7/1/ (c)(3) entity buys operating building 1/1/ (c)(3) transfers to LIHTC Partnership. Analysis – Exception to 10-year rule only applies if there were no placements in service from 6/30/2006 through 6/30/2016, more than 12 years ago. 4% Acquisition Credit – 10 Year Rule (cont’d) Additional Exceptions to Placements in Service During Prior 10 Year Rule When can a prior placement in service be ignored? Carryover Basis Exception – If a building was previously transferred by capital contribution or other situation where the basis was determined based on the basis of the transferor Property Acquired by Inheritance Exception Qualified Nonprofit Organization or Governmental Unit Exception – if 10-year requirement was met at the time transferred to such entities. Property Acquired by Foreclosure – if 10-year requirement was met at that time and the building was reconveyed within 12 months of placement in service Single Family Residences- if transferred by the owner and occupier

4% Acquisition Credit – Purchase Requirement
Practice Note: Aggregating Common Parties Interests Seller GP - $100 capital, 90% cash flow & back-end, 1% LIHTC Bank 1 – $1,000,000 capital, 1% cash flow & backend, 9.99% LIHTC Bank 2 – $9,000,000 capital, 5% cash flow & backend, 90% LIHTC Buyer GP - $100 capital, 49% cash flow & backend Bank 1 – $10,000,000 capital, 99% credits, 51% cash flow & sale/refinance Analysis No Acq. Credits because GP + Bank 1 have more than 50% in Seller and Buyer 4% Acquisition Credit – Purchase Requirement Building Must Be Acquired by Section 179 Purchase Building Must Be Bought – No capital contributions, gifts/donations, like-kind exchanges No Related Seller - Seller Must Not Be Related to Purchaser Common Parties Cannot Own More than 50% of Seller and Buyer Partners - measure by more than 50% of profits or capital Related 501(c)(3)s – measure is control Related by Family - brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants How to Solve Related Party Issue If common GP, limit GP of Buyer to less than 50% of cash flow (including incentive management fee) and sale/refinance and have no common investors. Balance of economics can go to another unrelated party, an unrelated nonprofit or the Investor Often no impact on economics - due to seller financing, related party loans, deferred developer fee and low cash flow deals

Building Not Previously Placed in Service by a Related Person
PIS Rule –the building cannot have previously been placed in service by the taxpayer or by any related person Similar to Purchase Requirement where buyer and seller can’t be related No Time Limit On Lookback Example Bank purchased building in 1960 and operating it until 1970 when building was sold. 2019 – LIHTC partnership buys building and Bank is 99% LIHTC Investor Project fails acquisition credit requirement because bank placed building in service in and bank owns more than 50% of LIHTC Partnership

4% Acquisition Credit – Minimum Rehab Requirement
Practice Note: Rehab Placement In Service Rule Can Solve Carryover 2-Year Timing Carryover allocations require a building be placed in service by the end of the 2nd calendar year after the allocation is issued. Many buildings may not be fully rented up by the end of the 2nd calendar year or the rehabilitation might not even be completed. There is a method to nuance this issue. If the minimum rehab test has been met, then the Project can be placed in service in that 2nd calendar year, but defer the start of the credit period to the next year. That will allow the Project to complete construction and rent-up in the third year. 4% Acquisition Credit – Minimum Rehab Requirement Building Rehabilitation Expenditures Must Meet the Minimum Rehabilitation Requirements An Inflation Indexed Amount – currently $7,000/low-income unit for 2019 20% of the Adjusted Basis – of the building in question at the start of a 24- month measuring period picked by the taxpayer, but ending in the year of placement in service

4% Acquisition Credit – Purchase Price
Exclude Land Value – No acquisition credits for land. Due Diligence Item - Have appraisal value land separately. Apply pro rata to purchase price. Building Purchase Price – eligible basis of acquired building includes cash paid plus debt assumed including seller financing Commercial Space – must exclude allocable portion of purchase price related to any commercial space Due Diligence Item – have appraisal separately value commercial space. Assuming and Modifying Debt – if debt is modified and assumed, then Original Issue Discount (“OID”) Rules can apply. AFR solves this issue. See later discussion of OID rules. Seller Financing – OID rules require seller financing to carry AFR otherwise the full amount of the seller financing may not be respected. See later discussion of OID rules.

Acquisition Credits Eligible Basis — 4% Example Acquisition Credit Computation
$12,000,000 Acquisition Cost ($2,000,000) Less Land and Commercial Space $10,000,000 Eligible Basis (pre-boost) 100% No Basis Boost on Acq. Eligible Basis x 75% Applicable Fraction $7,500,000 Qualified Basis x 3.27% Applicable Percentage $245,250 Annual Acq. Credits x 10 10 Years $3,188,250 Total Acquisition Credits over 10 Years

Acquisition Credits Eligible Basis — 4% Example
Rehabilitation Credit Computation $5,000,000 Rehabilitation Costs ($100,000) Less Commercial Space Rehab $4,900,000 Eligible Basis (pre-boost) 130% Basis Boost $6,370,000 Eligible Basis x 75% Applicable Fraction $4,777,500 Qualified Basis x 3.27% Applicable Percentage $156,224 Annual Credits x 10 10 Years $1,562,242 Total Credits over 10 Years Equity Computation $3,188,250 Acquisition Credits $1,562,242 Rehab Credits $4,750,492 Total Credits $0.93 Credit Pricing $4,417,958 Total Equity

Section 42 Right of First Refusal
General Rule About Right to Upside - The right to upside on an investment isa critical piece of determining who owns property for tax purposes No Below-Market Purchase Options – General Partners or other parties generally cannot have a right to purchase a project for less than fair market value. Otherwise the tax ownership and who can claim Credits may be called into question Section 42 Right of First Refusal (“ROFR”) – Special Section 42 rule - tenants, governmental entities, and Qualified Nonprofit Organizations can have a right to buy a building for no less than debt plus taxes. The ROFR can reduce or eliminate the impact of a tax-exempt partner agreeing to qualified allocations because they can exercise the ROFR and thus benefit from all the residual value.

Other Issues – OID Types
Seller Financing Must be at least AFR for month of sale, compounding at least annually If No AFR - determine present value of all payments using AFR to determine deemed loan principal amount. Result is reduced purchase price and lower acquisition credit eligible basis and lower depreciable basis. Simple Interest Simple interest not paid currently creates OID issue Determine equivalent compounding rate Simple Interest and Seller Financing Convert simple interest to equivalent compounding rate If less than AFR, apply Seller Financing Rules Modification of Debt Must be at least AFR for month of modification, compounding at least annually If No AFR - debt is present valued to determine principal amount. Can trigger discharge of indebtedness income and/or lower acquisition/depreciable basis

OID – Impact on Project Impact of OID:
Acquisition Credits and Seller Financing - Lost credits and depreciation Minimum gain impact Depreciable Property and Seller Financing (No Acquisition Credits) Loss of depreciation Lower interest deductions Land and Seller Financing No depreciation or credit impact Debt Modification – Difference between previous principal amount and new deemed principal amount is ordinary income to the borrower. Can trigger reduction of purchase price and lower acquisition eligible basis and depreciable basis for buyer. Materiality – where no acquisition credits, impact might not be material.

Other Issues –Tax-Exempt Use
Certain type of involvement of tax-exempt entities can create tax-exempt use where Congress has chosen to reduce tax benefits to avoid games being played. Tax-Exempt Entities include governmental entities, entities exempt from tax such as 501(c)(3) organizations, foreign entities, Indian Tribal Governments 2 Types of Tax-Exempt Use Disqualified Leases to Tax-Exempt Entity - Leases to tax exempt entities (or related parties) that: Were involved in tax-exempt bond financing for the building, Have a fixed or determinable purchase price/option, Have a lease term of more than 20 years, or Involve a sale and lease back by the tax-exempt entity 35% De Minimis Rule for Disqualified Leases – based on floorspace of lease

Other Issues –Tax-Exempt Use (cont’d)
Practice Note: Structuring with Public Housing Authorities Problem - PHAs generally cannot use the 168 election because the taxable subsidiary would generally be deemed a government instrumentality. Solution – If the PHA has a 501(c)(3) affiliate, have the 501(c)(3) own the taxable corporation that makes the 168 election. Other Issues –Tax-Exempt Use (cont’d) Partnerships with Tax-Exempt Members or Tax-Exempt Controlled Entities – creates tax-exempt use unless: Qualified Allocation OK – tax-exempt entity has same share of all items forever No flips or disproportionate sharing of cash flow or sale refinance proceeds 168 Election – tax-exempt entity does not own a direct interest in Partnership, but owns a corporation that is a partner Corporate partner must not be tax-exempt Corporate partner must make election to be taxed on distributions from partnership or sale of partnership interest Generally doesn’t work where tax-exempt entity is a Government entity because the taxable subsidiary usually is a Government instrumentality 501(c)(3) Taxable Corp. with 168 election LIHTC Investor 99.99% LIHTC Partnership

Other Issues –Tax-Exempt Use (cont’d)
Impact of Tax-Exempt Use (i.e., if not otherwise “cured”) Recovery Period – no accelerated depreciation 5 year accelerated personal property  9 year straight-line 15-year accelerated site improvements  20 year straight-line 27.5-year straight-line building  30 year straight-line No impact if 163(j) election Loss of Bonus Depreciation Equal to Percentage Tax-Exempt Use Loss of Historic or Energy Credits Equal to Percentage Tax-Exempt Use

Bonus Depreciation 100% Bonus Depreciation allowed if following rules met: New and Used Property with a Life of 20 years or Less Personal Property (including energy property) and Site Improvements Placed in service Before 2024 Bonus depreciation goes down 20% per year starting in 2024 with no bonus depreciation after 2027 Bonus depreciation not available if property used in trade or business of selling electricity or certain other activities Used Property if placed in service before 2027 and meets same rules as for acquisition credits “Purchase” requirement. Caution with Bonus Depreciation on Used Property – may lead to reduction in credits if used property is disposed of as part of rehabilitation. Cost Segregation Studies – more investors (but not all) are becoming comfortable with using cost segregation studies to identify more bonus depreciation property and improve yield and pricing. No Impact from Section 163(j) 30% interest rules.

Interest Limitations - 163(j) Election
Business Interest Deduction Limitation Generally “Business Interest” deductions are now limited to the sum of (a) business interest income + (b) 30% of taxpayer’s adjusted taxable income. This limitation is applied at the partnership level. Partnerships owning LIHTC properties typically have little or no taxable income or business interest income and are likely to lose significant interest deductions. Section 163(j) Election Out Election available to entities that operate a real property trade or business Impact of making a 163(j) election No 30% business interest deduction limitation, but then is subject to the alternative depreciation system for residential buildings (for buildings placed in service after 2017, results in 30 year depreciation instead of years)

True Debt Analysis Purpose of Analysis – Need to establish that soft debt will be respected as debt and not a grant or an ownership interest Must Use Reasonable Assumptions – common to use 3/3/5 rather than 2/3/7. Test Date – generally earliest maturity of soft debt Assume Market Rate Loan Refinancing for early maturing debt? Vacancy Rate – never lower than market study. 5% is commonly accepted. Debt Term – Best to have soft debt mature no earlier than end of Extended Use Period. This allows Project to go market rate and refinance/sell. Market Rents – look to market study and trend forward Cap Rate – Capped NOI is commonly used. Look to cap rate in appraisal Need to include optional expenses? Create Debt Reserve Diligence Items -– appraisal, market studies, all regulatory agreements

Capital Accounts - Generally
Represents a partner’s investment in the Partnership Increases in capital account: Capital contributions Share of Partnership income allocated to partner Decreases in capital account: Partnership distributions Share of Partnership losses allocated to partner

Capital Accounts - Generally
Treatment of Certain Items: Reasonable fees should not be treated as “distribution” that would reduce capital account LIHTCs do not reduce Capital Accounts State Credits do not reduce Capital Accounts Federal HTCs and Energy Credits do reduce Capital Accounts HTC – Reduce Capital Account and basis by amount of HTC Energy Credits - Reduce Capital Account and basis by 50% of Energy Credits

Capital Accounts – Problems
Zero capital account – cannot be allocated further losses or LIHTC unless: Deficit Restoration Obligation (“DRO”) Minimum Gain Delay negative capital account Zero Capital Account After Credit Delivered- Yield issue, but can be lived with

Capital Accounts – Projections Example
LIHTC Delivered Capital Account is positive until after all LIHTC delivered in 2029 – Numbers Work!

Capital Accounts - Solutions
What if capital account runs out before all LIHTC delivered? Slowing Depreciation Doesn’t Help Much Anymore- Prior 168(g) Alternative Depreciation election or forced tax-exempt use no longer effective! Bonus Depreciation – opt out (by asset class) Generally not recommended for personal property as it rarely helps Forced categorization as commercial property by failing 80% test? Reduce Interest Rate or Fees Reduce interest rate on loans (soft debt) Reduce or eliminate Fees Accruing Fees DRO “Bridge” capital contributions – DRO capped and extinguished once contributions are made

Capital Accounts – Solutions (cont’d).
Loss Flip Don’t Solve Credit Reallocations Loss Flips Must occur after Credit Period so won’t help avoid Credit reallocation Special Allocation of Losses – specially allocate non-depreciation losses to the General Partner. General Partner may need a deficit restoration obligation Special Allocations to Nonprofit Tax-Exempt Entities can create Tax-Exempt Use Touchy Issue for Syndicators – generally used as last resort Create Minimum Gain – See next page

Capital Accounts – Minimum Gain
Minimum Gain Definition - the difference between the secured nonrecourse debt on the Project and the adjusted basis of the Project. Explanation - To the extent that the debt exceeds the Project’s value, there is gain that must be eventually recognized. Even if the partnership gave the property to the lender for nothing, the partnership would be considered to have exchanged the property for the amount of the debt. Because the debt is higher than the property’s basis, there will be gain equal to the difference. Because this gain is unavoidable, the IRS will allow a partner to go negative to the extent that it has minimum gain. Recourse Debt – does not make minimum gain if it is the most junior debt. Stacked Debt Adds Complicates Tax Analysis – if recourse debt is stacked between other debt, needs to be reviewed with tax counsel – “Stacking Rules”. Deferred Developer Fee Is Usually Not Nonrecourse – Most Deferred Developer Fee is structured as unsecured recourse debt. As such, typical Deferred Developer Fee would not create minimum gain. But see the discussions below for alternative approaches. Minimum Gain Example – Unrelated Debt Unrelated Nonrecourse Debt $11,000,000 Net Assets (adjusted Basis) ($10,000,000) Partnership Minimum Gain $ 1,000,000 Investor Capital Account can go negative up to $1,000,000

Capital Accounts – Minimum Gain (cont’d)
Allocation of Minimum Gain – The allocation of Minimum Gain is determined by the nature of the debt. (“Bad”) Partner Nonrecourse Debt – If a partner (or a party related to a partner) bears the risk of loss on the debt, then the debt is allocated to that partner. This is called “Partner Nonrecourse Debt”. (“Good”) Partnership Nonrecourse Debt – If no partner bears the risk of loss, then the debt is considered “Partnership Nonrecourse Debt” and can be allocated among the partners through the partnership agreement. The partnership agreement will then allocate 99.99% to the limited partner. Minimum Gain Example – Related Party Debt Nonrecourse Debt - Related $11,000,000 Loan from GP Net Assets (adjusted Basis) ($10,000,000) Partner Minimum Gain $ 1,000,000 All minimum gain allocated to GP. Investor cannot have a negative capital account

Related Party Debt Example The below makes “Bad” Partner Minimum Gain 99.99% Interest 10% Cash Flow & Back-End 0.01% Interest 90% Cash Flow & Back-End Syndication Partnership Apartment Building Investor Fund LLC Sponsor/ Lender Loan General Partner

Minimum Gain Cure – 79/21 - If the Project lender owns less than 80% of a partner in the Partnership, then it will not be considered a related party. This will allow the debt to be treated as (“Good”) Partnership Nonrecourse Debt. Must Be a Corporate Partner – The entity that is a partner in the Partnership must be a corporation or an LLC that elects to be taxed as a corporation on IRS Form Only 79% Ownership Must Be Real – Must have 79% of GP’s Vote and Value. Make everything pro rata. Nonprofits and Relatedness – A nonprofit entity is deemed related to another entity if that entity controls it. This is usually measured based on a majority interest in the Board of Directors. If Developer controls 3 out of 5 Board members, then it would be deemed to control the nonprofit.

79/21 Org Chart – Creating “Good” Partner Nonrecourse Debt 99.99% Interest 10% Cash Flow & Back-End 0.01% Interest 90% Cash Flow & Back-End 79% 21% Apartment Building Investor Fund LLC Sponsor/Lender Loan General Partner Corporation Unrelated Party Syndication Partnership

Minimum Gain Cure – 10% De Minimis Rule -If the Project lender is a governmental entity (or an entity that regularly engages in the business of lending) and the lenders direct or indirect interest in the partnership is less than 10%, then the debt will be considered unrelated debt. Must limit everything below 10% - Incentive management fees and residual interests must be capped at less than 10%. General partner fees or any other distributions to partners or related parties must be closely scrutinized. Two General Partners – If there are 2 General Partners, but one is not related to the lender, then the other general partner can pick up the excess cash flow above 10%. Cash Flow Strategies Loan Payments– Often cash flow will be absorbed for the 15-year period paying off the Deferred Developer Fee and applying 90% of cash flow to the related party debt. Section 42 Right of First Refusal (“ROFR”) – If the Sponsor is a Qualified Nonprofit, then it can control the back-end with the Right of First Refusal price of debt + taxes.

10% De Minimis Org. Chart – Creating “Good” Partner Nonrecourse Debt 99.99% Interest > 90%10% Cash Flow & Back-End 0.01% Interest < 10% Cash Flow & Back-End Loan 100% Syndication Partnership Apartment Building Investor Fund LLC General Partner Corporation Sponsor /Lender

Capital Accounts – Minimizing Exit Taxes
Exit Taxes – Using the above techniques, an Investor can often be allocated minimum gain and thus would be allowed to go negative in its capital account and be able to receive 99.99% of LIHTC. Downside is creation of exit taxes for the Investor when it gets out of the Partnership sometime after Year 15. Because a General Partner’s right to buy out an Investor is at a price that is no less than the amount of exit taxes, this often becomes an issue for the General Partner. Loss Flip – A not uncommon tactic to avoid or reduce exit taxes is to provide that after all LIHTC have been delivered, as much as 80%-90% of losses (including depreciation) can be allocated to the General Partner. This will reduce the later- year losses to the Investor and avoid negative capital accounts or at least slow down how far its capital account goes negative.

Low Income Housing Tax Credit 201

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