80/20 program a useful tool for residential development

Real Estate Weekly, April 10, 2002 by Christopher M. Cotter

New York City is going to experience a wave of new construction projects over the next decade that is probably unprecedented in its history. While Downtown needs to replace the commercial space that was lost on Sept 11, 2001, the city's residential community - in all five boroughs - has never stopped growing and over the next several years will continue to decentralize.

Few programs are as beneficial to residential developers - and to the community as a whole, for that matter - as the 80/20 program. This program allows developers to enjoy substantial economic advantages by developing a project under the umbrella of federal, state and local government incentives designed to stimulate affordable housing. By setting aside 20% of a project's apartments for low-income tenants, benefits can be obtained which apply to the entire development. While renting to low-income tenants would normally make a project unfeasible, this powerful combination of incentives allows the developers to achieve equal or better returns than 100% market rate rentals. Because these programs exist for the public's benefit there are many requirements and qualifications to fulfill. It is critical that developers have the help of experienced consultants to maximize these benefits.

It should be noted that the program does not in any way lessen the appeal or value of the final project. In fact, some very high-profile new buildings in many of the city's most gilded neighborhoods have benefited from 80/20 tax incentives, and since the affordable apartments are scattered randomly throughout the building, the tenants paying market rents do not know who the beneficiaries are, so there is no stigma.

The 80/20 program actually consists of a bundling of several incentives which, when combined, help the builders and the community. One such benefit comes from tax-exempt bonds issued under Internal Revenue Code (IRC) Section 142 (d). Residential developments with a minimum set-aside of affordable housing may qualify to receive an allocation of tax- exempt bonds, which have a maturity of 30 to 33 years. The bonds' long-term nature eliminates the need for costly refinancings every 5 to 15 years, shielding developers from the possible jeopardy of unfavorable market conditions and higher financing costs down the road.

The tax -exempt bonds can have fixed or floating interest rates. Although issued by a state or local agency under authority of the federal government, a form of credit enhancement is required to back the bonds. However, even with the additional expense of credit enhancement, tax-exempt bonds offer a 1.5- to 2% lower interest rate than conventional mortgages.

The credit enhancement can be in the form of a letter of credit, mortgage insurance such as Fannie Mae or Freddie Mac, or bond insurance. If this does not cover the full amount of the bonds, additional or back-up credit enhancement will be needed (In fact, it is common to have one form during the construction phase and another upon stabilization.) Takeouts of the construction credit provider can save up to an additional one percent over conventional mortgages.

The other bonus from tax-exempt bonds is that the development generally qualifies as-of- right for low-income housing tax credits (LIHTQ;) under IRC Section 42. These credits, received over 10 years, are designed to get a developer back 30 percent of the cost of the affordable units on a present value basis.

Since LIHTCs are usually generated by passive activities through the work of nonreal estate professionals, the LIHTQ; can be used to offset taxes only on passive income. In no case can the credits be used to reduce liability below either the alternative minimum tax -or 75% of the net liability if above $25,000. They may, however, be used to offset taxes from non-passive income if a taxpayer -in the form of either a closely held C corporation or an individual -satisfies the eligibility requirements as a real estate professional. Otherwise, the general exception allows for a deduction of up to $25,000 against non-passive income. This translates into a maximum credit of approximately $9,775 (in this case, 39.1% of $25,000) per individual.

A taxpayer is also subject to an alternative minimum tax. Tax credits cannot be used to lower an individual's tax liability below the alternative minimum tax. Excess amounts of tax credits may be carried backward one year or forward 20 years.

If this taxpayer cannot meet the eligibility standards for the LIHTCs -i.e. if he is considered a real estate professional as defined by law -he can still minimize his equity investment by selling the tax credits to an outside investor, who becomes a part of the LLC or limited partnership that is the project's developer. It becomes a case where the taxpayer who owns just one percent of the project is the general partner while the investor, who now owns 99% of the company, is a limited member.

How it works is the investor will typically put in between 60 and 80 cents per dollar of tax credits -depending, naturally, on the details of the individual project, such as the guarantees granted by the developer and the depreciation allocated to the investor.