Why is 55 cents on the dollar a good deal?

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Why is 55 cents on the dollar for State low income housing tax credits a good deal for the State?

  • The 55 cents is an investment:  it isn’t taxed, so it all of it goes into the project and never has to be paid back (it is equity).
  • While the tax credit period is 10 years per building, that period doesn’t start until tax credits have been awarded to a project, the deal has been negotiated, legal agreements signed, construction starts and completes, and 100% of units are occupied by a qualified tenant.  Then a tax return must be filed to claim the previous year’s tax credit.  So, 4 years often goes by before the first full year of tax credits costs the state.
  • Another way to say it is that an investor will often go 4 years before even getting any return of their investment.  This is unlike bonds or other types of loans, where interest starts immediately.  
  • Based on a customary pay-back, an investor won’t make its first dollar of profit (return on investment) until the 10th year of the deal. 

 

Why is 55 cents on the dollar better than a loan from the state (a dollar)?

  • Loans must be repaid and loan payments (even low or no interest) increase rent, defeating the purpose of the program.
  • 100% of the loan cost is booked in the state’s current year budget.  With a tax credit program, after enjoying 3+ years of no cost, the state spreads out its cost over 10 additional budget years.  Given the natural growth of the budget over the project life, this means the state will spend a smaller percentage of its annual budget money on housing, versus doing it now.
  • Unlike a tax credit, where the state takes 0% of the risk, with a loan the state takes 100% risk. Under the current program, if a deal defaults, the investor loses everything going forward, and either never receives any tax credits or owes the state for the recapture of any tax credits already redeemed.  Once the state disburses a loan (which will be in a subordinate position), however, it will be near-impossible for the state to recover anything if the project defaults.

 

Why is 55 cents on the dollar better than a forgivable loan from the state (a dollar)?

  • Loans that are intended to be forgiven are taxed as grants when the loan is made, causing 35% to be lost immediately to taxes.  Only $0.65 on the dollar goes into the project, which does generate 10 more cents per dollar for the project, but… 
  • 100% of the loan cost is booked in the current year’s budget. With a tax credit program, after enjoying 3+ years of no cost, the state spreads out its costs over 10 additional budget years.  Again: given the growth of the budget over the project life, the state will spend a smaller percentage of its annual budget money on housing, versus doing it now.
  • Tax credit = 0% risk to state/Loan = 100% risk to state

 

Why is the 55 cents on the dollar better than a grant from the state?

  • For all the same reasons as forgivable loans.  They are the same.

 

 

Why do we need syndicators?

  • Perhaps contrary to intuition, syndicators get more money into deals than direct investments otherwise would.  Without syndicators, investors who use tax credits received directly as a partnership allocation are not able to deduct state taxes paid with the tax credit from their federal tax return, meaning the tax credits are worth 35% less.  (This explains why pricing was in the 35-45 cent range for so long.)
  • By splitting the tax credits from the underlying investment in the real estate partnership and selling them to buyers with state tax liabilities, syndicators avoid the 35% tax hit and are able to get more money into the projects. (See example below).  
  • Syndicators perform extensive due diligence underwriting deals and developers to make sure they are financially sound. (See accompanying due diligence checklist.) Syndicators also conduct post-closing monthly construction monitoring, regular site visits during both construction and regular operations, initial compliance check of all tenants and ongoing spot checks, quarterly review of project finances, annual review of audit and tax return.
  • Syndicators provide experience in housing oversight that a typical investor lacks. Syndicators also bring free market discipline to projects that government agencies cannot.  This private oversight is why the program has produced far better results than prior government housing programs.
  • If a project faces trouble, syndicators plug gaps rather than face credit recapture and/or foreclosure.  
  • By pooling investments, syndicators match investor tax credit demand to project production and make a market.

 

Example using $1,000,000 in state tax credits:

  • The syndicator creates an equity fund partnership to invest $550,000 in a tax credit project. The equity fund partnership is actually investing in the partnership that owns the real estate.  As a condition of this investment, the state tax credits are allocated to the equity fund partnership.

(Capital invested into a partnership is not taxable as income.  It isn’t taxed at all, and instead simply creates a capital account for the respective partners.  In this case, the state equity fund partnership has a $550,000 capital account, which is only useful in valuing the partnership interest for IRS purposes.)

  • The equity fund partnerships are largely held by tax-exempt or tax-neutral (usually losses or depreciation) entities, with tax credit buyers having a very small interest (1% or less) in the equity fund partnership.
  • The equity fund partnerships split the tax credits from the underlying investment and sell the credits to buyers with state tax liability at a rate equal to 90 cents per tax credit dollar ($900,000).

(The equity fund partnerships make investments and receive the tax credits as a nontaxable allocation of a tax attribute.  They don’t buy the tax credits. So, when the funds sell the tax credits, 100% of the sale proceeds are taxable. This means the entire $900,000 is taxed even though there is only $350,000 net cash ($900,000 minus $550,000).  But, because tax-exempt/tax-neutral entities own 99%+ of the equity fund partnerships, they receive 99%+ of the income and taxes are immaterial.  When the $350,000 real profit is finally paid (in the future) to employees or partners of the tax-exempt/tax-neutral entity, it is fully taxable.) 

  • The buyers pay cash for the tax credits, which are then claimed on buyer’s state tax return.

(Cash is property in tax law.  Because the buyers have exchanged property for the state tax credits, which are used to satisfy state tax liability, they are entitled to deduct $1,000,000 from their state tax liability. They effectively exchanged property for the payment of state taxes.  Note, the buyer will be taxed on their $100,000 profit [$1,000,000 taxes minus $900,000 purchase price]).