The Low-Income Housing Tax Credit (LIHTC) Program makes federal tax credits available to community banks that own affordable rental properties. The credits owe their existence to the Tax Reform Act of 1986 and are intended to facilitate the development of low-income rental property. Since its inception, the program has been instrumental in the construction or rehabilitation of more than 1.7 million affordable housing units that otherwise might not have been built.

How Banks Benefit from LIHTCs

The chief economic benefit derived from an LIHTC investment is the opportunity to claim a federal tax credit. The credit is earned over a 15-year period but is claimed over an accelerated 10-year time frame, beginning in the year the property is placed in service and as units are occupied. Because qualifying investments result in decreased tax liability, the economic return is not subject to state or federal taxation. Thus, the tax credits they generate are inherently more valuable than the same dollar amount of taxable income earned from an alternative investment.

Owners of LIHTC properties are also able to shelter otherwise taxable income from both federal and state taxation through deductions for depreciation. Additional state housing tax credits may be available in the states in which LIHTC properties are located, further enhancing investment returns. And regulated depository institutions, which are subject to the requirements of the Community Reinvestment Act (CRA), may receive consideration for LIHTC investments in the determination of their CRA ratings.

Owners of LIHTC properties must maintain the properties’ low-income designation for at least 15 years for the tax credits to be fully earned. A 15-year extended compliance period is effective for all projects that received an allocation of credits after 1989; however, once the initial 15-year compliance period is over, the Internal Revenue Service (IRS) may not recapture the tax credits, and bank investors may exit the partnership. Investors may exit the properties at any point without facing recapture as long as the properties continue to operate as affordable housing through the end of year 15. If investors exit the properties during the initial 10-year credit period, they cannot claim any credits remaining for the balance of the 10-year credit period.

How LIHTC Investing Works

Banks seeking LIHTCs may purchase interests in entities (e.g. limited partnerships and limited liability companies) that provide bank investors with a stream of tax credits and losses generated by an underlying affordable rental property. LIHTC entities are structured as real estate partnerships under the Internal Revenue Code (26 UCS 704(a)), which allows banks to be considered passive investors/limited partners and to receive distributive shares of the tax credits and other passive losses. Investments can be made either directly or through funds offered by syndicators, which comprise limited partnerships or limited liability companies (LLC) that invest in numerous LIHTC properties. Both options allow for various degrees of investment size, asset diversification, compliance monitoring, and investment screening.

A direct investment is generally made by taking an ownership interest in a limited partnership or limited liability company that owns an LIHTC property. An investor must assume responsibility for all underwriting and compliance monitoring activities. An investor may have less flexibility in the amount of capital it must commit than if it were to invest in a diversified pool of properties, so this approach can be challenging for a community bank that wants to enter the LIHTC arena.

An alternative to direct investing is investing in a fund established by a syndicator. Unlike direct investing, in which a bank has to perform all due diligence itself, the syndicator generally offers to screen potential investments and monitor ongoing compliance. Many syndicators offer multi-investor funds, allowing investors to purchase a slice of the fund; this approach offers banks greater flexibility in determining how much capital to invest. Most funds purchase partnership interests that own affordable rental properties in many geographic areas, which diversifies investors’ risk across several rental markets.

In a syndicated fund, the syndicator sets the minimum investment. Many state and local syndicators allow investments of $1 million or less. The amount of capital required for a direct investment in an LIHTC property depends on the size of the project and the amount of credits generated.

Some syndicators offer guaranteed funds, in which guarantors assure a minimum yield to investors. If funds do not provide the promised yields, the guarantors compensate investors for the difference. Thus, guaranteed funds shift investment risks to the guarantors, with banks’ risk being tied to the creditworthiness and experience of the guarantors. With nonguaranteed funds, no performance guarantees are provided, and the banks bear the investment risk. As would be expected, guaranteed funds generally offer lower yields than nonguaranteed funds.