Low income housing tax credit: Benefits for community banks

Community banks can benefit significantly from the Low Income Housing Tax Credit (LIHTC) program. Both as investor and lender, banks are a key source of financing to the housing developments targeted by the program. Community banks facing a significant federal tax burden can participate in the program through long-established and well-documented procedures as both an equity investor and as a lender. As a 26 year-old federal tax incentive, the program is well-supported by state, local and federal governments as well as a specialized private sector industry of professionals, developers and development or funding agencies.

Program overview

The LIHTC was created by Congress in 1986 as part of the Tax Reform Act. Approximately $8 billion of federal tax income tax credits is available to 50 states on a population-based formula. State Housing Finance Agencies (HFAs) administer the program and are responsible for awarding the LIHTCs to developers. The HFA also oversees compliance with the program during the 15-year period during which some of the LIHTCs are subject to recapture.

For developers, the LIHTC is used to reduce the amount of debt financing, which in turn allows rents to be charged at lower than market rates. Debt sources can include government grants and low-interest rate loans, traditional bank loans and tax-exempt bonds. Developers then sell the LIHTCs to raise equity from investors. Equity is invested either directly into the entity or through a tax-credit syndicator, which acts as an intermediary between the developer and the investor. The developer then constructs and operates buildings in compliance with program requirements.

Why banks invest

The primary reason for banks to invest in LIHTCs is to lower their effective tax rate. Current after tax yields of 6 percent equate to almost a 10 percent pre-tax IRR. LIHTC investments are often underwritten to operate at slightly above breakeven cash flow. However, reserves and guarantees protect investors from foreclosure, and as long as they remain in compliance with program requirements, the LIHTC will continue flowing to the tax credit investor. Overall, the LIHTC program has a solid track record of delivering the expected tax benefits, with industry surveys showing a foreclosure rate below 1percent.

In addition to the tax benefits, LIHTC investments allow banks to earn positive consideration toward their regulatory ratings under the Community Reinvestment Act (CRA). Pursuant to the 1977 CRA, depository institutions are required to meet the credit needs of the entire community they serve, including low income neighborhoods. One way they can meet this requirement is through the LIHTC program.

Eligibility for the LIHTC and for satisfying CRA requirements are subject to certain size, ownership entity and organization-specific financial conditions. However, established tax credit industry procedures and specialized services assist investors in managing the regulatory requirements and risks inherent in a government-regulated, real estate-based and tax advantaged-investment. Established and experienced industry professionals are needed by investors to identify issues, assist in structuring transactions to mitigate risk and provide guidance for limited partners willing to invest in affordable housing funds.

Investment considerations for banks
Banks have the option of direct investment or investing through a tax credit syndicator. Both options require important considerations. Direct investing usually realizes a higher yield, but exposes the bank to much higher risk. Investing through a skilled and experienced tax credit syndicator will reduce yield but will still offer attractive tax benefits. State and local syndicators began forming equity funds during the 1990s to pool investment capital and match it with LIHTC housing developments in their service areas. These funds help spread the risk among many different investors and place the primary responsibility for monitoring the portfolio with the syndicator. For banks that have limited experience with LIHTC investments, investing with a syndicator may be the best approach.

In the event of loss, pre-tax losses equal to the original investment amount will generally be recorded during the 10-year LIHTC delivery period. However tax savings will offset the pre-tax losses and should increase bottom line earnings.

The chart below provides a summary of the LIHTC investment options with a brief commentary on alternative costs and benefits based on investment option chosen.

How the tax credit works

The example below shows how the amount of tax credit is calculated and how that translates into equity for the partnership:

Sources and Uses
Tax credit equity - $2,700,000
Hard debt - $500,000
Soft debt - $700,000
Other financing - $100,000
Total sources - $4,000,000

Land - $200,000
Depreciable costs - $3,450,000
Expensed costs - $100,000

Credit calculation
Depreciable basis - $3,450,000
Percentage low-income - 100%
Credit rate - 9%
Annual allocation - $310,500
Multiplied by 10 years - $3,105,000

Price paid for $ of tax credit - $0.870
Tax credit equity - $2,700,000

For more information
For more information about the low income housing tax credit and how it can benefit your bank, please contact Douglas Koch, national director, National Affordable Housing Practice, McGladrey LLP, 617.241.1173, or Colin McPherson, national director, Affordable Housing Consulting, 617.241.4658.