Low Income Housing Tax Credits

Tax Issue

Many taxpayers are aware of tax benefits of investing in real estate. Taxpayers can create a tax loss be depreciating the property. However, the loss on rental real estate is limited to $25,000 per year ($12,500 for Married Filing Separately). This loss is then phased out for taxpayers with modified AGI of more than $100,000.

The phaseout of the losses can be problematic for taxpayers affected by this. The benefits of investing in real estate are lessened.

Applicable Tax Law

•  The Department of Treasury issues tax credits to the states for low-income housing developments. State agencies then create regulations establishing the criteria for the distribution of the credits to developers of the housing projects.
• The Low-Income Housing Tax Credit is paid annually over a 10-year period beginning in the tax year that the property is placed in service.
• The credit exists for the development of low-income housing. To qualify for the credit, rental income must come from tenants whose income is 60% or less of the median family income for the county in which the housing is developed. The rent for these individuals and families is capped at 30% of the renter’s income.
• Developers claiming the credit must maintain compliance with the rental income requirements or risk losing some or all of the credit.
• Real estate developers use the credit to attract additional investors. The credit is “sold” to investors through a limited partnership in which the individual investor places money with the developer. The developer, through a partnership agreement, promises to pass along the credits and other expenses to the investor. The individual investor then applies the tax credits and deductions to his or her individual tax return.
• The credit passes through to the investor on a non-tax basis. That is, the investor does not have to earn an amount of money, pay tax on that money, and then have the net amount available. A credit of $1,000 passes through on a dollar-for-dollar basis from the partnership to the investor to apply to his or her tax liability.
• The $25,000 allowance for rental real estate applies to Low-Income Housing Tax Credits even if the taxpayer did not actively participate in the activity.

-For property placed in service before 1990, the Low-Income Housing Credit special credit special allowance AGI phaseout begins with modified AGI of $200,000 ($100,000 for Married Filing Separately).

-There is no AGI limitation for property places in service after 1989.

Tax Planning Strategies

Taxpayers considering investing in rental real estate should consider an investment in a Low-Income Housing Tax Credit program. A limited partnership involving Low-Income Housing Tax Credits has many of the benefits of investing in rental property. In addition, the partner receives a tax credit which can be used to offset income taxes due.

Syndicate. A real estate developer will create a syndicate involving a general partner and limited partners. The purpose of the syndicate is to raise capital for the development project. The developer applies to the state housing agency for the Low-Income Housing Credit. The developer will entice limited partners to invest in the syndicate with the promise of future payments to the limited partners in the form of tax credits. The investor collects the investments from the limited partners and uses this money as down payment for the construction of low-income housing. A lender provides the balance of the money needed for the construction.

When construction is complete, the property is rented according to guidelines set up by the state housing agency. The tax credit is paid to the syndicate annually for 10 years. Rent is collected monthly and expenses, including the mortgage, are paid. The investor receives a Form K-1 annually indicating the flow through of deductions and credits. The general partner must follow the rental guide-lines for 15 years in order to maintain the Low-Income Housing Tax Credit.

Examples

Example: Happy Homes, a developer for a low-income housing project, has obtained tax credits in the amount of $90,000 annually for the next 10 years. Happy Homes issues a limited partnership offering to raise the fund needed for the down payment. Through the offering, Happy Homes raises $600,000 of cash. The cash, plus a mortgage obtained from a bank, provides the funds for construction of the housing unit.

Steve invests $60,000, a 10% stake, in the limited partnership offered by Happy Homes. He will receive the flow through of the credit annually for the next 10 years. Steve’s income is subject to the 35% federal tax rate. As a 10% partner, Steve will receive a $9,000 credit annually. However, his credit amount each year will be limited to $8,750 ($25,000 special allowance times 35% tax rate). At the end of the 10 years, Steve will have received $87,500 of tax credits. His net annual return on his investment is 4.95% ($27,500 gain divided by $60,000 investment divided by 10 years). Steve receives the credit on a tax-favored basis. That is, the allowable credit reduces his tax liability on a dollar-for-dollar basis and he does not pay tax on the credit received. Therefore, his equivalent rate of return is 7.05% (4.58% divided by (1.00 minus his tax rate of 35%)).

In addition, Steve will receive flow through of net rental income and rental expenses, such as interest and depreciation. Any losses will generally reduce gains from other passive activities.

Possible Risks

•  An investment in a Low-Income Housing Tax Credit partnership is generally considered illiquid. A secondary market may exist, but and investor selling his or her share of the partnership may incur a loss.
• Credits received through a publicly-traded partnership may be limited by losses and credits from rental real estate activities not owned through a publicly-traded partnership.
• The general partner must maintain strict compliance with the rental requirements or the tax credit could be recaptured.
• Foreclosures, although rare for these housing units, can occur.
• Opportunity costs become a big risk factor for the investor. The initial investment amount is exchanged for an ongoing stream of tax credits. Meanwhile, the initial investment is not available for other opportunities.