The 4 percent low-income housing tax credit program is a critical but underutilized source of federal financing for affordable homes. A rental development automatically qualifies for the 4 percent LIHTC if it receives at least 50 percent of its financing through tax-exempt private-activity bonds and meets either of the following income criteria:
- 40 percent of the units are rented at an affordable rate to families making 60 percent or less of area median income, or
- 20 percent of the units are rented at an affordable rate to families making 50 percent or less of area median income.
While some additional subsidy is usually necessary to make a project work, the equity generated through 4 percent tax credits is a significant asset that contributes substantially to the costs of providing affordable rental homes. Policymakers interested in maximizing the availability of federal funding for affordable housing in their community may wish to consider strategies for expanding their use of this valuable tool when feasible under stable market conditions.
Types of 4 Percent Credit Projects
Because 4 percent tax credits generate less capital than 9 percent credits, they are often used for rehabilitation of older rental homes (whether or not they were originally subsidized) and the preservation of subsidized rental developments—activities that tend to have lower development costs than new construction. Accordingly, areas where the affordable multifamily rental stock is aging may find 4 percent tax credits particularly useful.
Four percent tax credits can also be used for new construction, particularly if a state or locality is willing and able to commit matching funds to make the project work. By matching 4 percent credits with available federal funds or with state and local matching funds, 4 percent credits can be used in almost any market under stable market conditions.
Although the 4 percent tax credit is worth only about half as much as the 9 percent credit, it can generate significant equity. For example, in one transaction involving the preservation and renovation of an older, 94-unit, federally insured complex whose owner had prepaid its mortgage, the equity from 4 percent tax credits contributed $3.1 million toward total project costs of $8.2 million. Operating income during renovation, deferred developer fees, and the original development’s replacement reserve contributed another $1 million, with the balance financed through tax-exempt bonds. Aside from the tax-exempt bonds, no state or locally controlled funds were needed to make this deal work.
How have States and Localities Leveraged the 4 percent Low-Income Housing Tax Credit?
In some cases, state and locally controlled funds have been needed to make 4 percent tax credit deals financially viable. For example, in the rehabilitation of ParcView Apartments by Wesley Housing Development Corporation in Alexandria, Va., the city contributed $9 million (in the form of a deferred loan) toward project costs of $31.6 million. Other financing included $14.7 million in tax-exempt bonds, $6.2 million in 4 percent tax credit equity, and deferred developer fees.
Many states prioritize use of the 4 percent tax credit to finance affordable rental homes by dedicating significant shares of bond authority to affordable housing development. In Texas, for example, approximately 22 percent of the state’s tax-exempt bond authority has been allocated to multifamily homes in recent years, financing the construction of nearly 100 new multifamily developments and the acquisition and rehabilitation of some 14 multifamily developments in the three-year period from 2004 through 2006. These developments included more than 24,000 homes and leveraged more than $70 million in 4 percent tax credits.
Other federal funding streams have also been effectively combined with 4 percent tax credits. In particular, 4 percent tax credit deals have worked well as part of the preservation of project-based Section 8 properties through HUD’s Mark-to-Market program. Other contexts in which 4 percent tax credits have worked well with minimal commitment of state or local dollars include the revitalization of distressed public housing developments through HOPE VI or capital fund financing and Section 202 developments for the elderly (however, no new Section 202 developments have been funded since 2012). More recently, Choice Neighborhoods projects have been able to utilize the 4 percent tax credits in cities throughout the U.S.
Why Should States and Localities Expand Their Use of the 4 percent Low-Income Housing Tax Credit?
A major advantage of the 4 percent tax credit is that 4 percent credits are not subject to the same caps that apply to the 9 percent credits. Because the federal government limits the supply of 9 percent tax credits each state can allocate each year, not all qualifying projects receive assistance during strong housing markets when demand for tax credits is often high.
By contrast, there is no limit to the number of 4 percent tax credits that states may allocate. So to the extent that communities can increase their use of the 4 percent LIHTC, they can increase the amount of federal funds for affordable housing they bring into the community. The one condition is that 4 percent tax credits can be used only for projects financed with federal funds, which generally come from tax-exempt private-activity bonds.
Tax-exempt private activity bonds used for rental housing are charged against each state’s total private-activity bond cap, so tax-exempt financing for rental homes may have to compete with other uses, including mortgage revenue bonds (which states use to offer mortgages at below-market rates), bonds issued for certain types of eligible industrial facilities, bonds used to finance student loans and certain other uses.
The availability of tax-exempt private-activity bond financing, and by extension the 4 percent tax credit, also depends on the investor demand for these bonds. In a weak financial market, bond investor demand is often low, limiting the feasibility of bond-financed projects.
Obstacles to the Expanded Use of 4 Percent Low-Income Housing Tax Credits
Although the 4 percent tax credit program has many unique advantages, there are also several factors that can present obstacles to realizing the full potential of 4 percent tax credits.
Additional funding needed to make 4 percent Low-Income Housing Tax Credit deals work
One commonly cited obstacle to expanding the use of 4 percent tax credits is that tax-exempt bond financing and the equity from tax credits are insufficient to fund a development without additional public contributions. This is generally true, although in some cases rental housing preservation projects requiring only moderate rehabilitation can be financed through 4 percent credits alone.
There are a number of creative ways to address this obstacle. For example, states and localities can reduce a development’s financing costs by donating publicly owned land, by using money from a housing trust fund to offer a grant or loan to the project or by purchasing units that have been produced through an inclusionary zoning program and thus are available at below-market prices. Federal funds also can be used to contribute to project costs.
Competition for private-activity bond cap
Another obstacle to expanding use of the 4 percent LIHTC is that accessing the credits depends on the availability of bond cap under the state’s allocation of private-activity bonds. While many states do not fully utilize their bond cap, some do reach the maximum. Even when competition for tax-exempt bonds is intense, it is worthwhile to consider allocating more bond cap to affordable rental housing because the automatic qualification for 4 percent tax credits vastly increases the value of the tax-exempt bond authority.
Expense and complication of tax-exempt bond issues
Another factor limiting the use of 4 percent credits is that tax-exempt bond issues are complicated and expensive, making them impractical for small-scale projects. One way housing finance agencies can address this problem is by pooling bond issues for several small projects into a single, larger bond issue. This strategy is particularly important in low-population areas with little demand for large-scale rental housing development.
Too few applications for 4 percent tax credits
The lack of applications from developers for 4 percent tax credits also prevents jurisdictions from expanding their use of the credits. States and localities can encourage applications for 4 percent tax credits by making it clear they are open to applications for multifamily bond issuances focused on particular priorities. According to the National Housing Trust, a majority of states set aside a portion of their private activity bond cap for rental housing preservation, thereby facilitating the drawdown of 4 percent low-income housing tax credits.
In some states, such as Alabama and Delaware, certain types of housing preservation activities automatically qualify for private activity bonds and 4 percent credits, eliminating the need for a competitive application process for the bonds. States may also wish to consider developing a process for steering less-expensive projects originally proposed for 9 percent tax credits to 4 percent tax credits, freeing up 9 percent tax credits for projects that really need the extra equity.
How Much More Valuable is Tax-Exempt Bond Cap When Used to Leverage the LIHTC?
Private activity tax-exempt bonds are a key element to the financing of residential projects that use 4 percent tax credits. However, rental housing is only one of several competing uses of private activity tax-exempt bonds. Other uses include financing of infrastructure, manufacturing, redevelopment, student loans and home mortgage loans. While these other uses are all important activities that merit public support, it is important for states to understand that a single dollar of private activity bond cap is much more valuable when used for rental housing for families with incomes below 60 percent of the area median than for any other use, because this application automatically leverages 4 percent Low-Income Housing Tax Credits.
Without 4 percent LIHTCs, the only financial benefit from tax-exempt bond authority is the marginal reduction in the costs of funds relative to taxable financing (net of the increased costs of tax-exempt financing).
When the interest rate reduction inherent in tax-exempt financing is combined with the equity derived from 4 percent tax credits, however, the value of private activity bond authority can increase significantly during strong markets when demand for tax credits is often high. A 2006 analysis by David Smith and Ethan Handelman of Recap Advisors found that private-activity bond cap was worth 3.5 times more when used for rental homes than when used for other activities. The interest-rate savings from tax-exempt bonds was worth approximately 17 cents per dollar of bond cap, as compared with 43 cents per dollar of bond cap from 4 percent tax credit equity.
The key conclusion here is that states interested in expanding the availability of affordable homes would be well advised to make available as much bond cap as they can possibly use for rental homes. Ideally, this would be done through the use of excess bond cap, but if states have already reached their cap they may wish to consider shifting bond cap from other uses in order to draw down extra 4 percent tax credits. In some cases, this shift could be accomplished by finding other types of tax-exempt bonds to apply to these other uses, such as 501(c)(3) bonds.