The Low Income Housing Tax Credit (LIHTC) is a tax credit created under the Tax Reform Act of 1986 that gives incentives for the utilization of private equity in the development of affordable housing aimed at low-income Americans. The credits are also commonly called Section 42 credits in reference to the applicable section of the Internal Revenue Code. The tax credits are more attractive than tax deductions as they provide a dollar-for-dollar reduction in a taxpayer's federal income tax, whereas a tax deduction only provides a reduction in taxable income.

How It Works

The LIHTC provides funding for the development costs of low-income housing by allowing a taxpayer (usually the partners of a partnership that owns the housing) to take a federal tax credit equal to a large percentage of the cost incurred for development of the low-income units in a rental housing project.

Development capital is raised by syndicating the credit to an investor or, more commonly, a group of investors. To take advantage of the LIHTC, a developer will typically propose a project to a state agency, seek and win a competitive allocation of tax credits, complete the project, certify its cost, and rent-up the project to low income tenants. Simultaneously, an investor will be found that will make a capital contribution to the partnership or limited liability company that owns the project in exchange for being allocated the entity's LIHTCs over a ten year period. The amount of the credit will be based on;

1. the amount of credits awarded to the project in the competition,
2. the actual cost of the project,
3. the tax credit rate announced by the IRS, and
4. the percentage of the project's units that are rented to low income tenants.

Failure to comply with the applicable rules, or a sale of the project or an ownership interest before the end of at least a 15-year period, can lead to recapture of credits previously taken, as well as the inability to take future credits.

Application Process

The first step in the process is for a project owner to submit an application to a state authority, which will consider the application competitively. The application will include estimates of the expected cost of the project and a commitment to comply with either the 40/60 election of 20/50 election.

• 20/50 Election-At least 20% or more of the residential units in the development are both rent restricted and occupied by individuals whose income is 50% or less of the area median gross income.
• 40/60 Election-At least 40% or more of the residential units in the development are both rent restricted and occupied by individuals whose income is 60% or less of the area median gross income.

Typically, the project owner will agree to a higher percentage of low income usage than these minimums, generally up to 100%. Low income tenants can be charged a maximum rent of 30% of threshold income. There are no limits on the rents that can be charged to tenants who are not low income but live in the same project.

Low Income Housing Tax Credit Terms and Conditions

The project owner must agree to comply with Section 42 and maintain an agreed percentage of low income units in a "Land Use Restriction Agreement" (LURA) which is recorded. Under the LURA, the project is required to meet the particular project's low income requirements for a 15-year initial compliance period. The credits are subject to recapture if the project fails to comply with the requirements of Section 42 of the Tax Code during the 15-year compliance period.

Syndication and Partnerships

As mentioned above, the credit is used to generate private equity, often prior to, or during, the construction of the project. Developers typically sell the credits by entering into limited partnerships with an investor, with 99.99% of the profits, losses, depreciation, and tax credits being allocated to the investor as a partner in the partnership. The developer serves as the general partner/managing member, and receives a majority of the cash flow through the payment of developer fees.

The following table summarizes the relationship between the developer and outside investors.