investment tools-ira weinstein-tn economic development finance course

W h a t A r e T o d a y ’ s G o a l s ?

N u m b e r 1 i s “ n o t t o o v e r l o a d y o u r b r a i n w i t h t o o m u c h

i n f o r m a t i o n ”

B a c k g r o u n d

• Part of 1986 Tax Reform to encourage the construction and rehabilitation of low-income rental housing

• Contained in Section 42 of the Internal Revenue Code• Emphasis on private sector involvement (i.e. developing and managing

properties)• Objective: provide investor equity to lower debt service which decreases

rents to tenants

W h a t i s t h e L I H T C ?

• Credit is a dollar-for-dollar Federal tax reduction• Credit amount based on the cost of constructing or rehabilitating rental housing

developments• Credits available over 10 year credit period• Credits are the primary incentive/return for the equity investor

T y p e s o f L I H T C s

9% Credit• New construction or substantial rehabilitation – awarded through

competition

4% Credit New construction or substantial rehabilitation awarded in conjunction with

tax-exempt bonds

H o w D o Y o u G e t T a x C r e d i t s ?

• Developer applies to housing credit agency (HCA) for reservation of credits• 9% credits are awarded through competition• 4% credits are awarded “as of right” in conjunction with tax exempt bonds

R o l e o f H o u s i n g C r e d i t A g e n c y“ H C A ”

HCAs are responsible for selecting developments to allocate the Credit, “underwriting” the Credit (sizing it according to financial needs of the project), reporting Credit activity to the IRS, and monitoring for compliance with federal regulations.

Q u a l i f i e d A l l o c a t i o n P l a n “ Q A P ”

HCA guidelines must be published in annual Qualified Allocation Plans (“QAPs”), which detail selection criteria and compliance monitoring rules. Most HCAs select projects through competitive cycles (at least one per year), with various threshold and scoring criteria.

Selection criteria includes project characteristics, owner characteristics, location, market feasibility, energy efficiency, income targeting, and affordability periods.

T a x E x e m p t B o n d s

Tax-Exempt Bond Financed Developments

• Developments with at least 50% of aggregate basis financed with tax-exempt bonds are eligible.

• Credits are awarded “as of right.”• Projects do not compete. Must meet QAP and underwriting criteria.• Applicable Tax Credit Percentage is published monthly by U.S.Treasury, and is a

“floating” rate at or below 4%.– August 2013 applicable tax credit percentage is 3.24%

• Frequently used to finance acquisition and rehabilitation of existing properties (e.g., “Preservation” deals).

• Project size usually 100 units or more

L o w I n c o m e U s e R e s t r i c t i o n

• Minimum Requirement: rent and income restrictions must remain in place for a 15-year Compliance Period, plus an additional 15-year Extended Use Period.

• Property owners may elect to “opt-out” of the Extended Use Period with HCA approval under certain circumstances; Qualified Contract.

• Many QAP’s have longer use restrictions and prohibit opting out early.

E l i g i b l e B a s i s

• Eligible basis = adjusted basis of building at end of 1st year of credit period• Includes common areas• 30% boost in QCTs or DDAs

• Projects located in HUD-designated Qualified Census Tracts or difficult to develop areas receive a 30% increase on eligible basis

R e n t R u l e s

• Rent + utility allowance (gross rent) cannot be >30% of household income• Qualifying income based on family size and # of bedrooms• Gross rent does not include Section 8 or other subsidies• Rent limits change annually when HUD publishes new Area Median Incomes

(AMIs)

I n c o m e L i m i t s

Minimum set aside: certain % of units restricted for % of AMI• 20/50: 20% of units at 50% of AMI• 40/60: 40% of units at 60% of AMI

NYC only: 25/60: 25% of units at 60% of AMI

R e c a p t u r e f o r N o n - C o m p l i a n c e

• Decrease in qualified basis• Not meeting minimum set-aside• Low-income occupancy decreases• Sale or foreclosure• Eminent domain• Damaged building out of service (e.g. Sandy casualty losses)

T y p i c a l O w n e r s h i p S t r u c t u r e

General Partner Tax C redit Investor

N om inal 1% Credits, 99% Credits, $$ EquityEquity Investm ent P rofits & Losses P rofits & Losses

O perating Partnership

D evelopm entFee Rent

D eveloper M ortgage Tenant Group

P r o j e c t S u m m a r y & A s s u m p t i o n s

Construction start & placed in service dates Occupancy (lease-up) Debt & equity Operating income & expenses Development budget (sources & uses) Tax credit assumptions (4%-9%, 30% basis boost, tax credit pricing)

T a x C r e d i t E q u i t y

Eligible Costs 14,405,812

QCT/DDA Boost (130%) x 100%

Eligible Basis 14,405,812

Applicable Fraction x 100%

Qualified Basis 14,405,812

Applicable Percentage x 9.0%

Annual LIHTC Eligible 1,296,523

10 years x 10

Total LIHTCs Over Period 12,965,231

Investor Ownership % x 99.99%

Total Investor LIHTCs 12,963,934

Tax Credit Price x .95

Tax Credit Equity 12,315,738

I n v e s t o r M e t r i c s

Investor IRR– Schedule of benefits Losses

» Depreciation Tax credits

– Distributions (cash flow)– Capital contributions Quarterly compounding

Capital Account– Minimum gain

D e v e l o p e r s ’ P e r s p e c t i v e

• Developer Fee• Control property management and management fee• Control majority of any positive cash flow from operations and residuals• Highest equity price• Fastest equity pay-in• Retain control of property at end of 15 year compliance period• Least exposure under investor deal guarantees

I n v e s t o r ’ s P e r s p e c t i v e

• Looking for reasonable certainty with respect to amount of losses and credits - Investor Benefits

• Looking for reasonable certainty with respect to timing of Investor Benefits• LP Agreements written attempting to “manage” the Investor Benefits Flow• Rarely do LIHTC projects generate substantial positive NOI/cash flow• If there is positive cash flow, GP/developer is generally entitled to as much as

90% as an Incentive Management Fee (tax deduction)• If there is negative cash flow, GP/developer is generally obligated to fund

Operating Deficits (with a special allocation of non-depreciation operating deductions equal to the amount funder)

I n v e s t o r ’ s P e r s p e c t i v e

• If a project’s NOI/Cash Flow is close to zero, depreciation, amortization, and accruing interest on soft debt will result in a net annual tax loss

• LIHTC follow the depreciation deductions• Generally, LIHTCs, Depreciation & Amortization and Accruing Interest

deductions are reasonably quantifiable in the deal projection process• Investors price deals based on projections and strength of GP/developer

guarantees

W h a t i s a 1 0 % T e s t ?

A 10% Test supports Accumulated Basis* in a project. Accumulated Basis must be at least 10% of the Reasonably Expected Basis* of the project on a specific date.

*Accumulated Basis: Total costs incurred to date which represent project’s depreciable basis plus land.

*Reasonably Expected Basis: Project’s depreciable basis plus land costs. This amount is generally stipulated by the Owner as part of the Carryover Allocation.

* Note: terminology varies by HCA

W h y C o n d u c t a 1 0 % T e s t ?

If a project is not placed in service in the year of credit allocation, the project must apply for a Carryover of the Allocation. This process is specific only to competitive LIHTCs. LIHTCs in conjunction with tax exempt bonds are exempt.

The 10% Test is part of the Carryover Allocation Application to demonstrate progress toward project completion.

Typically, the HCA requires an Independent Accountant’s Report. The form of report is dictated by the HCA and may vary from state to state.

B a c k g r o u n d o n B o n d F i n a n c i n g

• HCAs allocate competitive LIHTCs to projects based on their annual LIHTC volume cap allocation received from the U.S. Treasury.

• An exception to this rule relates to projects financed with Tax-Exempt Bonds. LIHTCs awarded as of right to projects financed with Tax-Exempt Bonds do not count against the HCAs’ LIHTC volume cap allocation.

• As of right 4% LIHTCs are non-competitive. Projects must only meet requirements under the State’s QAP and tax exempt bond rules.

W h a t i s t h e 5 0 % T e s t ?

The 50% test is calculated by dividing the Bond Proceeds by the Aggregate Basis of the Project. For these purposes:

• Bond Proceeds: Include only the amount of bonds used to finance the acquisition, hard construction and soft costs of the project. Generally this will equal the mortgage amount. Bond Proceeds do include interest earned on the bonds or bond reserve funds.

• Aggregate Basis: Includes the Project’s depreciable basis and land costs.

W h a t i s a C o s t C e r t i f i c a t i o n ?

• CPA’s audit of project costs. Required by HCA’s to certify eligibility for LIHTCs.

• Each HCA has specific information required to be included. Typically required: schedules of total and eligible costs by project and building, calculation of credits, sources and uses of funds, gap analysis and project proformas.

• Upon final issuance of the cost certification, as a part of the final application package, which usually includes additional materials, forms 8609 will be issued to the owner.

N e w C o n s t r u c t i o n v s .A c q u i s i t i o n R e h a b

• New Construction: Involves construction of a project “from the ground up.” In these circumstances, there was either vacant land with no existing building, or all existing structures were demolished and a new structure constructed.

• Acquisition / Rehabilitation: Involves acquiring an existing project and rehabilitating the structure. This can involve rehabilitation around tenants, tenants do not vacate units, or vacate units on a daily basis; or units can be taken out of service, tenants are relocated during rehabilitation.

The nature of the construction/rehabilitation has direct effects on the ability to capitalize costs as eligible as well as the method for determining credit rates.

T h e R e h a b i l i t a t i o n T a x C r e d i t sI n t e r n a l R e v e n u e C o d e S e c t i o n 4 7

T w o T y p e s o f R e h a b i l i t a t i o n T a x C r e d i t s

Older (pre-1936), non-historic and non-residential buildings: 10 percentof qualified rehabilitated expenditures

• 10% credit buildings aren’t certified historic structures, just (pre-1936) old. Don’t overlook these buildings, often the 10% credit can be combined with other incentives like New Market Tax Credits

• Note the non-residential aspect of the 10% credit

Historic buildings: 20 percent of qualified rehabilitation expenditures

I m p o r t a n t D a t e s i n t h e H i s t o r y o f t h e R e h a b i l i t a t i o n T a x C r e d i t s

• 1976: First federal tax incentives for historic preservation (accelerated depreciation/ amortization).

• 1978: First federal tax credit for rehab of historic buildings (10%).

• 1981: Three tiered tax credit (25%, 20% and 15%), including first credit for rehab of older, non-historic buildings.

• 1986: Current two tiered structure; passive loss limitations imposed.

T h e 2 0 % R e h a b i l i t a t i o n T a x C r e d i t F u n d a m e n t a l s

• Preservation aspects jointly administered by NPS and State Historic Pres. Offices (SHPOs).

• Tax Aspects Administered by the IRS.• RTC is the most important (in dollar volume) federal preservation program.

T h e 2 0 % R e h a b i l i t a t i o n T a x C r e d i t S t a t i s t i c s

• 1,020 proposed projects approved by NPS in 2012 *• In 2012, 47% of HTC projects provided housing 1/3 of which were

affordable units; 21% office and 16% commercial uses*• Of the 91% of Projects that used other incentives or publicly supported

financing, 43.5% used state historic tax credits *• Top states ranked by Part 3 approvals: MO (89), VA (87), LA (72), PA (53)

OH and NY (36 each)*• Average Cost of Projects Certified in 2012: $3.155 million, producing on

average about $631,000 in credits *• More than $3.472 billion in private investment leveraged by up to $694

million in tax credits*– Federal HTCs leverage $5 of private investment for every $1 of public expenditure

*Source: Annual Report for Fiscal Year 2012: Federal Tax Incentives for Rehabilitating Historic Buildings National Park Service

T h e N P S R u l e s : P a r t s 1 , 2 , a n d 3

Historic Preservation Certification Application Part 1 – Evaluation of Significance Part 2 -- Description of Rehabilitation Part 3 -- Request for Certification of Completed Work

W h a t T y p e s o f B u i l d i n g s Q u a l i f y ?T h e I R S R u l e s : D e p r e c i a b l e B u i l d i n g R e q u i r e m e n t

• Must be a “building”. Building is defined as a structure or edifice enclosing a space within its wall and usually covered by a roof.

• Building must be depreciable. Depreciable buildings are generally those used for nonresidential (i.e. commercial) or residential rental purposes. (See Section 168(e))

B e S u r e Y o u P a s s “ T h e T e s t ”

Standard Rehabilitation Test

• Look back from placed in service date to basis in building 24 months prior or beginning of project, whichever is later

• QREs must exceed prior basis or $5,000, whichever is greater

• Rolling 24-month window

Phased Rehabilitation Test

• Must be evidence that project will take longer than 24 months to complete prior to commencing rehab

• 60-month window• Otherwise similar rules

W h a t T y p e s o f R e h a b i l i t a t i o n s Q u a l i f y ? D e f i n i t i o n o f Q R E s

• “Qualified Rehabilitation Expenditures” (QREs) is the tax term given to those development costs on which rehabilitation tax credits can be claimed.

• QREs are any amounts chargeable to a capital account made in connection with the renovation, restoration or reconstruction of a qualified rehabilitated building (including its structural components), except as provided by law.

W h a t T y p e s o f R e h a b i l i t a t i o n s Q u a l i f y ? D e f i n i t i o n o f Q R E s

• QREs include costs related to:• walls, partitions, floors, ceilings;• permanent coverings such as paneling or

tiling;• windows and doors;• air conditioning or heating systems,

plumbing and plumbing fixtures;• chimneys, stairs, elevators, sprinkling

systems, fire escapes;

W h a t T y p e s o f R e h a b i l i t a t i o n s Q u a l i f y ? D e f i n i t i o n o f Q R E s

• QREs include costs related to:• construction period interest and

taxes;• architect fees, engineering fees,

construction management costs;• reasonable developer fees

W h a t T y p e s o f R e h a b i l i t a t i o n s Q u a l i f y ? D e f i n i t i o n o f Q R E s

Costs EXCLUDED from QREs: Land and building acquisition; Enlargements that expand total volume (cf.

remodeling that increases FMR); Personal property (furniture

and appliances, cabinets andmovable partitions, tacked carpeting);

New building construction; Sitework (demolition, fencing,

parking lots, sidewalks, landscaping)

T a x - E x e m p t s a n d H i s t o r i c T a x C r e d i t s :

• Be aware of tax exempt use issues with Historic Tax Credits• A tax exempt entity as an owner of or tenant in a historic building can cause

a loss of Historic Tax Credits—structure carefully.• Grants/donations to the owner of a historic building can also cause tax issues

and potential reduction of Historic Tax Credits if not handled appropriately.

T a x - E x e m p t s a n d H i s t o r i c T a x C r e d i t s :

Tax Exempt Ownership: Who is a Tax Exempt entity?*

– Governmental/State entities– Any organization exempt from income taxes (such as a 501(c)(3))– Any foreign person or entity– Any Indian tribal government

Can the Tax Exempt (or its sub-entity) make a 168(h) election to be taxed as a for-profit entity?

Will the same Tax Exempt be the end-user of the Building?

*IRC Section 168(h)(2)(A)

T a x - E x e m p t s a n d H i s t o r i c T a x C r e d i t s :

Tax Exempt Use: Specific limitations on Tax Exempt Use by end-user tenants 50% limitation (up from 35%)

What counts towards the limitation? Qualified vs. Disqualified Leases to Tax Exempt Entities

– Did the tax exempt participate in the financing?– Is there a fixed purchase price/option to buy under the Lease?– Is the Lease term in excess of 20 years?– Has there been a “sale/leaseback” with the Tax Exempt

W h a t T r i g g e r s t h e C r e d i t ?

Placement in Service (provided sub rehab test is met) CO or TCO is Evidence of Placement in Service

Is the building readyfor occupancy?

T h e 2 0 % R e h a b i l i t a t i o n T a x C r e d i tR e c a p t u r e

• Credit previously allowed is recaptured if any portion of the project which includes QREs is disposed of prior to the fifth anniversary of placement in service.

• Amount subject to recapture decreases by 20% during each year of the five year period.

T h e 2 0 % R e h a b i l i t a t i o n T a x C r e d i tR e c a p t u r e

• Disposition includes any sale, exchange, transfer, gift or casualty. Subsequent rehabs that do not comply with the Secretary’s Standards can trigger recapture.

• Reduction of a partners interest can be deemed a disposition (33% rule).

S i n g l e E n t i t y S t r u c t u r e

Tenants

RentalPayments

Tax Credit Investor LLC

Construction/Perm Lender

Managing Member(Developer Affiliate)

HistoricTax Credit

Equity

99.99% Credits, Profits & Losses and Cash Flow

LoanProceeds

DebtService

Payments

Tax Credit, LLC(Property Owner)

Tax Credit Investor

.01% Credits, Profits & Losses, Fees and

Cash Flow

DeveloperEquity

DeveloperDev.Fee

H i s t o r i c T a x C r e d i t S y n d i c a t i o n T h e C r e d i t P a s s - T h r o u g h S t r u c t u r e

• Landlord LLC owns fee simple, undertakes rehab, enters into Dev. Agreement, and earns the Historic Tax Credit.

• Master Tenant, LLC leases the entire project from the Landlord LLC for a fixed annual rental payment.

H i s t o r i c T a x C r e d i t S y n d i c a t i o n T h e C r e d i t P a s s - T h r o u g h S t r u c t u r e

• Master Tenant, LLC operates the property, subleases to end users and enters into the Property Management Contract.

• Landlord makes special tax election to pass the Historic Tax Credit through to the Master Tenant LLC.

M a s t e r L e a s e / C r e d i t P a s s -T h r o u g h S t r u c t u r e

Sub-Tenants/End Users

RentalPayments

Tax Credit Investor LLC

Construction/Perm Lender

Managing Member(Developer Affiliate)

HistoricTax Credit

Equity

99.99% Credits, Profits & Losses, and Cash Flow

LoanProceeds

DebtService

Payments

.01% Credits, Profits & Losses, Fees and

Cash Flow

DeveloperEquity

Master Tenant, LLC(Master Tenant)

Landlord, LLC(Property Owner/Lessor)

90% Profits & Losses, Fees and Cash Flow

Pass-through of Historic Tax Credits & Share of

ResidualLease Payment &Equity Investment

10% Profits, Losses, and Cash Flow

W h a t i s a N M T C U n d e r S e c t i o n 4 5 D

• General Business Credit Under Section 38• Amount of Credit = to 39% of Qualified Equity Invest. (QEI)• Claimed over 7 year compliance period (5% 3yrs and 6% 4yrs)• Who can and cannot use the credit?• Difference between credits and credit allocation• Reported on Form 8874

I n d u s t r y A c r o n y m s

CDFI Community Development Financial Institutions Fund (arm ofUS Treasury that administers program)

CDE Community Development EntityQEI Qualified Equity Investment (investment made in a CDE that

triggers the credit)QALICB Qualified Active Low-Income Community Business (recipient

of NMTC capital)QLICI Qualified Low Income Community Investment (loan/equity

investment from CDE to business/real estate)LIC Low-Income CommunityATS CDFI Fund’s Automated Tracking System (QEI registration

system)CIIS Community Impact Information System (system CDFI uses to

recapture community impact information)

W h a t i s a C D E

• Community Development Entity (for-profit/non-profit)

• What is required to be and maintains status of a CDE?– Mission Test– LIC Accountability Test

• What is a Subsidiary CDE?

• Why would someone want to be a CDE?

W h a t i s a n A l l o c a t i o n A g r e e m e n t

Contract between CDFI Fund and Allocatee CDE

Spells out what they can do with award• Spells out amount awarded• Service Area• Types of Investments• % targeted at high distress tracts• % targeted at non-metro tracts• Flexible product terms• Amount you must invest and dates to invest• Live within the Spirit of Application

W h o a r e T h e P l a y e r s

• Whose on first CDE

• Whose on second Investment Fund

• Whose on shortstop Tax credit Investor

• Whose on third Leveraged Lender(s)

• Who is catching QALICB/Borrower/End User

W h o B e n e f i t s a n d H o w ?

• Everyone at the party recognizes benefits

• Investor thru IRR on credit

• Leveraged Lender thru debt service payments/CRA

• CDE-Fees and further its business/mission

• QALICB/Borrower – Very cost effective capital!

T o d a y ’ s N M T C S t r u c t u r e

Leveraged Lender Investors

CDE

Investment Fund

QALICB

loan

Equity Investment

QEI

loanloan

W h a t D o e s T h e C D E D o ?

• For transaction purposes all CDE’s use “sub-CDE’s” (single purpose entity)

• Receives QEI (triggers credit and locks allowance dates)

• Pays CDE fees

• Originates and makes loans/investments (85%/sub all test)

• Collects debt service

• Pays Expenses

• Distributes cash to Investment Fund

• MM/GP responsible for operations (usually Allocattee)

Q u a l i f i e d C e n s u s T r a c t

• Currently under 2010 Census

• < 80% Median Family Income (distressed 60%)

• > 20% Poverty Rate

• Other high distress indicators (Enterprises zones, Empowerment zones, Non-Metro tracts, Brownfield, Medically underserved, etc.)

W h a t C o n s t i t u t e s a Q L I C I ?

• Loan/Investments “active” “qualified” “low income” community business (loan purchases or other CDE invest.)

• CDE must loan/invest 85% of QEI within 12-mos in business (for 6 yrs and drops to 75% year 7) - “Sub-All-Test”

• Redeployment Rules

W h a t / W h o i s a Q A L I C B

• Any business in qualified tract other than:– Residential Rental Property (80/20 rule)– Business developing, holding, selling or licensing intangibles

• Must meet Activity Tests

• Must be “active” (3 year rule)

• If Real Estate must have substantial improvements

R e c a p t u r e

• Regulatory vs. Program Compliance

• 4 events can trigger recapture

• 6-Month cure period

W h y P r o g r a m W o r k s

Leveraged Lender Investor

Investment Fund

QALICB

Debt ServicePayments

$3 million Equity Investment (owns 100%)

CDE

Tax Credits

$7 mill. Loan @ 5%

Distribute cash $10 million QEI(owns 99.99%)

MM/GPMM/GP

$200,000 Fees

To MM/GP

A-Loan $7 mill Debt servpymnt

B-Loan $2.8 million

7 yr. put option