A Look at Year 15 Events for Tax Credit Sites
The Low-Income Housing Tax Credit (LIHTC) program has been a significant source of new multifamily housing for more than 25 years. Since the program began, state housing agencies have financed over 2.6 million affordable units of rental housing, according to data compiled from the National Council of State Housing Agencies. During the period from 1987, when the program began, to 2012, agencies have allocated nearly $13.4 billion in housing credits from their annual state ceilings.
As sites financed with these tax credits mature, they approach the time when they may become eligible to end the program’s rent and income restrictions. Sites have an initial, 15-year compliance period. Then they move into the second 15-year phase, known as the extended use period (EUP). The EUP began nationally for sites with tax credit allocations in 1990 or later, as required by the Revenue Reconciliation Act.
We’ll go over three possible outcomes for tax credit sites that are linked to events that happen at Year 15 and that affect the likelihood that a site will continue to serve as affordable housing in the years to come. These outcomes include whether the property’s use restrictions change, whether the property is sold to a new ownership entity, and whether the property became financially or physically distressed before Year 15.
Reviewing the Basics
First, we’ll review the fundamentals of the program, which form the basis for potential changes during the EUP.
Compliance period. At the outset of the tax credit program, the owner of your site signed a contract with your state agency, committing to an extended use period of at least 30 years: an initial compliance period of 15 years with the IRS, and an EUP of 15 additional years under state regulations.
The initial compliance period begins the year the site first claims tax credits, which could be the “placed in service” (PIS) year or the following year. The PIS date is the first date on which the first unit in a building is ready and available for its intended use. Generally, the PIS date is the same for all tax credit units in a particular building; different buildings in a multibuilding property can have different PIS dates. Usually, the PIS date is the same date as on the Certificate of Occupancy.
The initial compliance period—for IRS purposes—is 15 years, including the PIS year or the next year. For example, if your PIS date was 2001, the end of the first 15-year compliance period would be 2015. You would count 2001 as the first year because, regardless of the precise PIS date in 2001, the compliance period was effective beginning Jan. 1, 2001. If the owner had chosen to defer his credits to 2002, the compliance period would have begun on Jan. 1, 2002, and would end on Dec. 31, 2016.
Compliance period versus credit period. Sites can take their tax credits over a 10-year credit period. But each site must remain in compliance with IRS regulations for 15 years. For example, if your site’s PIS date was 2001, your owner could have taken all of its tax credits during the first 10 years—that is, by 2010. But if the site were to go out of compliance during the remaining five years of the initial compliance period, the IRS could recapture some of those tax credits.
Deferring the credit period. Under the program, owners have the option of deferring the credit period to the year following the PIS date. One reason you might defer is that you didn’t fill all of your tax credit units with eligible households by the end of the PIS year. This is where the “two-thirds rule” comes into play: If you elected to begin the credit period in 2001, but didn’t qualify all of the low-income units by year’s end, units that had not been qualified would have to claim credits over the compliance period rather than the credit period. Thus, units qualified in 2002 would claim credits over the remaining 14 years of the compliance period. This effectively reduces the annual credit to two-thirds of the 10-year credit amount for the affected units. Rather than face this reduction, the owner could have elected to start the credit period in 2003.
Release from IRS code after 15-year compliance period. Upon completion of the initial 15-year compliance period, sites are freed from almost all of the regulations under the IRS code. From that point on—that is, during EUP—only the EUP contract governs; the IRS code no longer applies. In other words, if the site goes out of compliance after the initial 15-year period, the IRS can’t recapture tax credits that the owner took during the 10-year credit period. But during EUP, state agencies will monitor sites and will penalize owners for noncompliance.
Possible Year 15 Events
Which of the three outcomes will be realized is linked to events that happen at Year 15 and that affect the likelihood that a property will continue to serve as affordable housing. The following events may occur at or around Year 15.
Change in use restriction. During the first 15 years of a LIHTC site’s compliance period, owners must report annually on compliance with LIHTC leasing requirements to both the IRS and the state monitoring agency. After 15 years, the obligation to report to the IRS on compliance issues ends, and owners are no longer at risk for tax credit recapture. Owners then may seek to withdraw from the program during the EUP.
Sites subject to an extended LIHTC use restriction may seek to have that restriction removed. The legislation that extended LIHTC use restrictions from 15 to 30 years also established a Qualified Contract (QC) process under which owners may request regulatory relief from use requirements any time after Year 15.
An owner has two possible ways to withdraw from the program during EUP: either by foreclosure on the site or by the state Housing Finance Authority (HFA) finding a buyer, known as a “qualified contract purchaser.” The sale to a qualified contract purchaser requires a state agency to find a buyer for the site within 12 months of the owner’s giving the state the necessary information for the sale. If the state is unsuccessful in finding a buyer, then the owner is entitled to be relieved of LIHTC affordability restrictions as long as it agrees to protect existing low-income tenants from lease termination or eviction without cause, and those restrictions phase out over three years.
And if the state HFA finds a qualified purchaser, but for some reason the sale doesn’t close, the current owner is locked into the full term of the EUP. If the site owner, itself, finds a buyer, the state’s HFA must approve that buyer as a “qualified contract purchaser.” Any time an owner sells a tax credit site, the buyer must agree to take on the extended use agreement, which remains in effect for the rest of the term.
In practice, each state agency can define its own regulations for implementing the QC. The process ranges from relatively simple and straightforward to very complex. Furthermore, some states either require or persuade developers seeking tax credits to waive their right to use the QC process in the future. In these states, no QC applications are likely to be submitted.
Change in ownership. When a tax credit site begins, a developer (a corporation, nonprofit, or individual) will usually enter into a limited partnership with investors (generally a corporation or individual) so that it can sell the tax credits to the investors in exchange for cash. The investors, usually the limited partners, benefit from the tax credits while the developer, usually the general partner (GP), benefits from the cash infusion it receives from selling the credits to the investors.
A change in ownership for an LIHTC property can happen at any time. However, the ownership change is most likely to take place around Year 15, because it’s in the interest of limited partners to end their ownership role quickly after the compliance period ends. They have used up the tax credits by Year 10, and after Year 15 they no longer are at risk of IRS penalties for failure to comply with program rules.
Generally, limited partners will sell their interests in the property to the GP and for the GP to continue to own and operate the property. The minority of GPs who end their ownership interest at Year 15 almost always do so by selling the property.
Financial distress and capital needs. While most sites operate successfully through at least the first 15 years after they are placed in service under the tax credit program, some sites fall into financial distress by the time they reach Year 15 for a host of reasons: Poor property or asset management practices; poor physical condition of the property; and/or a soft rental market.
Sites are usually required to fund replacement reserves annually, out of operating income, to pay for capital repairs and renovations. But these reserves may be insufficient after 15 years to cover current needs for renovation and upgrading.
Market conditions may also affect property conditions over time. Properties in strong housing markets that can be rented at or near the maximum LIHTC rents are more likely to have high occupancy rates and to generate more operating funds that can be used for maintenance and repairs than can be obtained from housing in a weaker market, and thus enter Year 15 with fewer deferred repair and maintenance needs.
The extent and nature of a site’s financial and physical distress will affect its Year 15 choices. For example, owners may be more likely to seek a new allocation of tax credits or other major financial assistance to rescue a site with major capital needs. If a property is continuing to operate at tax credit rents, it may have to compete for tenants with new tax credit sites, and the site in better physical condition is likely to win out.