IPEDAFTER THE CLOSING: Maximizing Value and Avoiding Pitfalls

at Tax Credit Properties

Pre-Conference Workshop:Tax Credit Basics

San Diego, CaliforniaApril 25-27, 2007

James F. Duffy – Nixon Peabody LLPThomas A. Giblin – Nixon Peabody LLP

Brad Elphick – Novogradac & Company LLP

Background

• Tax Reform of 1986

• Section 42 of IRC of 1986– Housing Program in the Tax Code– Statute Amended Several Times, Including in 2000

• Objective to Provide Investor Equity

• Credit is a Dollar-for-Dollar Tax Reduction

Structure

Investor LP$$$

Syndicator GP

InvestmentPartnership LP

Local GP

Developer

OperatingPartnership

Key Business Terms

• Projects Generally Owned by Limited Partnership or Limited Liability Company

• Limited Partner Generally Owns 99.99% of Tax Credits, Losses & Profits

• Limited Partner Pays in Capital Contributions in Multiple Installments (generally 3 or 4), Based on Negotiated Benchmarks

• General Partner Guarantees Completion, Amount of Credits and Funding of Deficits

Calculating Credits/Defining Terms

• “Applicable Percentage” times “Qualified Basis” = Annual Credit Amount

• Annual Credit Amount available for 10 years.

Applicable Percentage

• Two Credits:– 70 Percent Present Value Credit (the “9% Credit”)– 30 Percent Present Value Credit (the “4% Credit”)

• Credit Rates– 8.10% (9% Credit) & 3.47% (4% Credit) – April

2007– Lowest rates in July 2003 – 7.78% and 3.33%

Applicable Percentage (cont’d)

• Owner’s election to set the Applicable Percentage either (i) when receiving a binding commitment from the state to allocate credits (or when tax-exempt bonds issued) (a “lock-in election”) OR (ii) when building placed in service

4% New Construction/Substantial Rehabilitation Credit

• “Federally Subsidized” new construction or rehabilitation expenditures– Building Receives Tax-Exempt Bonds or Below Market

Federal Loan• “Below Market Federal Loan”– Interest Rate below the “applicable federal rate”

(the “AFR “) which is approximately 4.81% in April 2007 (for long-term loans compounded annually)

– Funded from federally appropriated dollars

Exceptions From Federally Subsidized Definition

• HOME Loan if 40% at 50% Targeting (in each building)

• Community Development Block Grant (“CDBG”) Loans

• Affordable Housing Program (“AHP”) Loans

• Loan is Subtracted from “Eligible Basis”

• Section 8

• Native American Housing Assistance and Self-Determination Act of 1996 (“NAHASDA”) of 1996 if 40% at 50% Targeting (in each building)

4% Acquisition Credit

• Existing Buildings/Acquisition Costs

• Purchase from “Unrelated Party”

• Ten-Year Rule

• Waiver of Ten-Year Rule from Treasury Department

4% Acquisition Credit (cont’d)

• Certain Placements in Service Ignored– Carryover Basis– Acquired from Decedent– Placement in Service by Governmental Unit or Non-

Profit Entity– Foreclosure

Substantial Rehabilitation Requirement

• Greater of:– $3,000 per Low-Income Unit, or– 10% of Adjusted Basis

• “Separate New Building”

• Can Receive 4% plus 9% Credits

9% New Construction/Substantial Rehabilitation Credit

• If Not Federally Subsidized

Basis Calculations

• Start with “Eligible Basis”, then “Qualified Basis”

“Eligible Basis”

• New Construction = Adjusted Basis (generally, development cost less land)

• Acquisition = Acquisition Cost

• Substantial Rehabilitation = Capitalized Rehabilitation Expenditures (24-month rule)

• Must Subtract Federal Grants

• 130% Increase in Qualified Census Tracts Census (“QCTs”) and Difficult Development Areas (“DDAs”)

“Qualified Basis”

• “Applicable Fraction” times “Eligible Basis” equals “Qualified Basis”

• “Applicable Fraction” is the Lower of:– Number of Occupied “Low-Income Units” divided by

the Total Number of Units, or– “Floor Space Fraction”

“Low Income Units”

• Threshold of Election of:– 20% of Units at 50% of Area Median Income (“AMI”),

or – 40% of Units at 60% of AMI

• Election Upon Placement in Service

• Must Meet Minimum by End of 1st Credit Year

• HUD Publishes Area Income Figures Annually

“Low Income Units” (cont’d)

• Adjustments for Family Size like Section 8– Family of 4 Qualifies at 60% (50%) AMI– Family of 3 Qualifies at 54% (45%) AMI– Family of 2 Qualifies at 48% (40%) AMI– Single Household Qualifies at 42% (35%) AMI

“Rent Restricted”

• Rent (including utilities) cannot exceed 30% of qualifying income for assumed family size; based on bedrooms per unit

• Occupancy Assumptions:– One Person for Studio– 1.5 Persons per Bedroom

Rent Calculation Example

• Median Income = $60,000

• Two Bedroom Unit

• 3 Person (2BR x 1.5) Income Limit = $32,400

• 30% of Income Limit = $9,720

• Monthly Rent (1/12) = $810

Additional Rent Rules

• Rent Limits Change Annually with Publication of New Area Median Incomes

• Rent Will Not Decrease Below Original Floor• Gross Rent Does Not Include Section 8 (or Similar

Rental Subsidies)• Gross Rent Must Include Utility Allowance for

Tenant-Paid Utilities (i.e., Deduct from Rent to Owner)

Example of Tax Credit Calculation

• 100 Unit Project/70 Low-Income Units

• Total Development Costs (Including Land) = $5.5M

• Land Value = $500K

• Eligible Basis = $5.0M

• Qualified Basis = $3.5M ($5.0M x 70%)

Example Tax Credit Calculation (cont’d)

• Applicable Percentage = 8.10% (Not Federally Subsidized)

• Annual Credit = $283,500 ($3.5M x 8.10%)

• 10 Year Credits = $2,835,000

Equity Calculation

• Pricing Primarily Based on Total Amount of 10 Year Credits Available to Investor and Market Conditions

• Expressed as “Cents Per Tax Credit Dollar”• In Above Example, if Investor Will Pay 90 Cents Per

Tax Credit Dollar, Equity Equals $2,551,245 ($2,835,000 x 99.99% x 0.90)

• Equity generally paid in several installments (often 3 or 4 installments) based upon negotiated benchmarks

Equity Calculation (cont’d)

• If Tax-Exempt Bond Financing “4% Credit”, Equity Equals $1,092,941

• ($5,500,000 - $500,000) x 70% x 3.47% x 10 x 0.90 x 99.99% = $1,092,941

Continued Compliance

• 15-Year “Compliance Period”

• Continued Tenant Qualification:– 40% Increase Above Then-Current Eligibility Level is

OK– Vacant Units/Over-Income Units OK if “Next Available

Unit Rule” Followed

Recapture

• Recapture on Non-Compliance:– “Accelerated Portion” of Credit Recaptured (1/3 of

Credit 1st 10 years, Decreasing Through Year 15)– If Minimum Set-Aside Fails, All Accelerated Credits

Recaptured– Otherwise, Unit-by-Unit (Extent of Decrease in

Qualified Basis)

Recapture (cont’d)

• Recapture on Change of More Than 1/3 in Ownership or Sale of Project

• Bond Posting Procedure

• New Owner Steps into Seller’s Shoes Upon Sale of Project

Extended Use

• Recorded “Extended Low-Income Housing Commitment”

• “Extended Use Period”:– At Least 30 Years, May be Longer to Gain Points

• Termination (with three-year vacancy de-control)– Upon Foreclosure– “Qualified Contract”

“Qualified Contract”

• State to Find Buyer If Requested by Owner After 14th Year Pursuant to “Qualified Contract”– Contract Price = Fair Market Value of Any Market Rate

Portion Plus, for the Low-Income Portion, the Applicable Fraction Times:

• Outstanding Debt Plus• “Adjusted Investor Equity” Plus• Other Capital Contributions, Less• Cash Available for Distribution

Qualified Contract (cont’d)

• “Adjusted Investor Equity” = Initial Investor Equity to Project, to the extent reflected in the adjusted basis of the Project, Inflated by COLA (up to 5% per year)

• If No Buyer Found Within One Year, the Extended Use Period ends, Subject to 3-Year Vacancy Decontrol

Compliance Monitoring

• State Credit Agencies Monitor Projects• Owners’ Recordkeeping Requirements:– Number of Low-Income & Total Units– Income Certifications/Annual Re-Certifications & Backup

Verifications– Qualified Basis & Eligible Basis Amounts– Rent Amounts

• Owner Annual Compliance Certifications

$0.00

$0.20

$0.40

$0.60

$0.80

$1.00

$1.20

$1.40

$1.60

$1.80

$2.00

'00 '01 '02 '03 '04 '05 '06 '07

•Congress Raised Cap in 2000 From $1.25 to $1.50 in 2001, $1.75 in 2002, Then Adjusted for Inflation

•$1.95 Per Person for 2007

•$2,275,000 State Minimum in 2007

STATE ALLOCATION VOLUME LIMIT

Volume Limit Rules

• Example:– State With Three Million Population has $5,850,000 in

Credits in 2007• Amount is for One Year of Credit • 10% Non-Profit Set-Aside• 50% Test: Private Activity Tax-Exempt Bonds

Subject to Bond Volume Cap; Tax Credits Do Not Count Against the State’s Limitation of Aggregate Tax Credits

“Qualified Allocation Plans”

• State Must Adopt QAP to Allocate Credits

• QAP Must Set Forth Allocation Priorities

• QAP Must Give Preference to:– Lowest Incomes– Longest Period of Low-Income Use– QCT Projects Contributing to a Concerted

Revitalization Plan

Additional QAP Rules

• QAP Must Provide Procedure for Notifying IRS of Non-Compliance

• Bond Financed Projects Must “Satisfy” QAP

Project Evaluation

• Credit May Not Exceed Amount State Agency Determines Is Necessary For Feasibility and Viability

• Agency Must Consider:– Sources and Uses– Amounts Expected to Be Generated by Tax Benefits– Reasonableness of Development and Operating Costs

Project Evaluation (cont’d)

• Evaluation Occurs at Application, Allocation and Completion

• Owner Must Certify as to Amount of Subsidies

• For Tax-Exempt Bond Financed Projects, Issuer Must Do Similar Evaluation

• Agency Must Require Market Study Paid by Developer

State Allocation Process

• “Carryover Allocation”– 10% of “Reasonably Expected Basis” Must be

Incurred by 12/31 of Allocation Year or 6 Months After Allocation, if Allocation After 6/30

– Building Must be Placed in Service by 12/31 of 2nd Year After Carryover

– Carryover Basis Includes Costs of Land and Depreciable Property

Carryover Allocation Document

• Must be Issued by State Agency by 12/31 of Allocation Year

• 10 Elements Required in Document

• Agency Must Later Issue Forms 8609 After Buildings Complete

• State May Carry Forward Unused Credits for One Year; Then Goes to National Pool

Who Can Use Credits?

• Individuals Limited Under Passive Loss Rules to Approximately $9,900/Year at the 39.6% rate

• C Corporations Can Use Losses and Credits Against Ordinary Income and Taxes

• Cannot Use Credits Against AMT

• Limitations on “Closely-Held” Corporations

10531434