• HUD Issues Final Section 202/811 Mixed Finance Rule
  • November 29, 2005
  • Law Firm: Blank Rome LLP - Philadelphia Office
  • The United States Department of Housing and Urban Development ("HUD") recently issued its final regulations providing for the Mixed Financed development of HUD's Section 202 Supportive Housing Program for the Elderly and HUD's Section 811 Supportive Housing Program for persons with disabilities. The Section 202 program was created in the Housing Act of 1959 to provide funding for supportive housing for the elderly. A companion program was instituted by Section 811 of the National Affordable Housing Act to provide funding for supportive housing for persons with disabilities. The Section 202 and 811 programs have been staples of HUD's financing programs ever since, but their use has been restricted solely to non-profit organizations due to program restrictions in the Section 202 and 811 programs that have previously prohibited the participation of for-profit entities in those developments.

    Under the American Homeownership and Economic Opportunity Act of 2000, Public Law 106-569, the Section 202 and 811 programs were amended to allow for the participation of for-profit limited partnerships and the use of mixed finance development in constructing Section 202 and 811 projects. These changes were intended to allow the financing of Section 202 and 811 developments to include private financing sources such as Low Income Housing Tax Credits ("LIHTCs"), similar to how public housing units may be developed under HUD's Mixed Finance rules for public housing set forth under 24 CFR Part 941 using public housing funds (such as Hope VI or Capital Funds) and LIHTCs. HUD issued a long-awaited interim rule on December 1, 2003 which provided regulations to implement the changes in the 2000 Act to allow the Mixed Finance development of Section 202 and 811 projects. Unfortunately, the 2003 interim rule presented several obstacles towards the successful development of those projects using tax credits, as well as raised a number of issues as to how those transactions would need to be structured. The final rule issued by HUD, which became effective on October 13, 2005, resolved and removed some of the barriers that had been created by the 2003 interim rule, as discussed below; however, there are still a few open issues that will need to be resolved by HUD and by the Internal Revenue Service ("IRS") in order to fully maximize the potential of the mixed finance rules to enable Section 202 or Section 811 financing to be used with LIHTCs (particularly with respect to the 9%, or "70% present value," Low Income Housing Tax Credit).

    The final Section 202 and Section 811 Mixed Finance rule allows the use of for-profit limited partnerships as developer entities that may be the recipient of the HUD Capital Advance that is provided under the Section 202 and 811 programs. Note that HUD specifically indicated that limited liability companies, which are becoming the standard type of entity that is used in LIHTC transactions (except notably in Pennsylvania due to Pennsylvania Capital Stock Tax issues) are specifically not allowed to be used in these mixed finance transactions, so developers will need to use limited partnerships. The for-profit limited partnership must have a sole general partner that is a 501(c)(3) or 501(c)(4) non-profit organization. In addition, HUD indicated that it would not permit a for-profit affiliate of a 501(c)(3) or 501(c)(4) organization to serve as the general partner entity in place of the actual tax-exempt non-profit entity -- this will cause problems in LIHTC transactions due to the inability of the tax credit investor to claim accelerated depreciation of the Section 202 or 811 project over 27.5 years for the entire amount of the building(s)' depreciable basis (due to IRS tax-exempt use rules).

    Under the final Mixed Finance rule, HUD will allow the non-profit sponsor entity which must be a 501(c)(3) or 501(c)(4) entity to transfer the reservation of the Section 202 or 811 funds awarded by HUD directly to the mixed finance owner (i.e. the limited partnership); under the 2003 interim rule, HUD had provided that such a transfer had to occur specifically as a loan from the non-profit entity to the mixed finance owner bearing interest at a specific Section 202 or 811 interest rate. In the recently released final Mixed Finance rule, HUD has removed the specific interest rate provision and indicated that the parties are free to structure the receipt of the HUD 202/811 funds, known as the Capital Advance, in whatever way they deem appropriate in accordance with HUD's mixed finance guidelines. The 2000 Act specifically provided that the Capital Advance funds provided by HUD for Section 202 or 811 development may be treated as amounts not derived from a federal grant, so for purposes of the LIHTC rules the Capital Advance funds are not treated as a federal grant which would reduce the project's LIHTC eligible basis. The Notice of Funding Availability ("NOFA") issued by HUD each year for the Section 202 and 811 programs imposes per-unit Development Costs Limits that determine the amount of Capital Advance that a project may be awarded by HUD.

    One notable aspect of Section 202 and 811 transactions that has adversely affected their ability to be used with LIHTCs is the treatment of the Project Rental Assistance Contract ("PRAC") payments, which under the Section 202 and 811 programs is a HUD subsidy that is provided to the owner of the Section 202 or 811 project to pay for monthly operating expenses -- PRAC terms are currently set at five years, with renewals possible subject to the availability of funds from HUD. A question, which is still an open issue in light of the final Mixed Finance rule, is whether the receipt of the PRAC payments by the Section 202/811 mixed finance owner constitutes receipt of a federal grant for purposes of Section 42 of the Internal Revenue Code which governs the LIHTC program -- Section 42 provides that the receipt of a federal grant at any time during the 15 year LIHTC Compliance Period will reduce an LIHTC project's eligible basis by the amount of that grant (and hence result in a loss of tax credits able to be claimed during the LIHTC 10 year tax credit period). Ideally, the PRAC payments would be treated by the Internal Revenue Service as similar to Section 8 Housing Choice Voucher Assistance or HUD Section 9 operating subsidy payments (used for public housing units), which under IRS Treasury Regulation 1.42-9 are specifically allowed to be received by an LIHTC owner without those payments being treated as a federal grant (and therefore those payments do not reduce eligible basis and tax credits for the LIHTC project). In the final rule, HUD has stated its belief that the PRAC payments should not be treated as a federal grant and has indicated that HUD is in the process of discussing this matter with the Internal Revenue Service. Given the significant amount of PRAC payments that are typically received by a Section 202 or 811 project owner during the term of the project's operations, it is fair to say that whether those PRAC payments are treated as a federal grant or not will really decide whether the mixed finance rules will, in practice, enable Section 202 or 811 projects to be financed using Low Income Housing Tax Credits, particularly 9% LIHTC, as was clearly the purpose of the statutory changes made by the American Homeownership and Economic Opportunity Act in 2000.

    A related issue involving the PRAC is whether the receipt of the PRAC payments by the LIHTC project owner constitutes receipt of rent that must be counted towards the rent limitation imposed under the LIHTC rules. Those LIHTC rules prohibit the LIHTC project owner from receiving from a tenant rent that exceeds thirty percent (30%) of the applicable imputed income level for that particular LIHTC unit (which would be either 50% of area median income or 60% of area median income). Note that Section 202 developments are restricted to households whose annual income is at or below 50% of area median income. Rent limits for Section 202 projects are set according to HUD's per-unit operating cost standard, as adjusted for the geographic area where the project is located, and under the Section 202 rules, tenants are required to pay 30% of their adjusted gross income towards monthly rent, with the PRAC payments intended to cover any shortfall in operating expenses. The IRS needs to determine whether the receipt of those PRAC payments constitutes receipt of rent on behalf of the tenant, in which case the actual rent received from the tenant must be reduced so that the total rent from the tenant plus the PRAC payments do not exceed the LIHTC 30% rent limitation. Ideally, the IRS will treat the PRAC payments similar to how Section 8 vouchers and Section 9 operating subsidy payments are received (under Section 42(g) of the Internal Revenue Code), so that a Section 202 or 811 owner using tax credits may receive the PRAC subsidy in addition to receiving from the tenant rent up to the LIHTC 30% rent limitation.

    A significant beneficial change in the final Mixed Finance rule is that HUD has removed the cap, imposed in the 2003 interim rule, on the amount of developer fee that the sponsor may earn in developing the Section 202 or 811 project, which cap was 9% of the project's total replacement cost. The final Mixed Finance rule provides that a developer fee of up to the amount allowed by the state tax credit allocating agency will be permitted, up to a maximum of 15% of the total project replacement cost. Note that this developer fee may not be paid from the Section 202/811 Capital Advance, tenant rents from the Section 202 or 811 units, or from the PRAC payments; as a result, that developer fee would need to be paid from other project sources, such as LIHTC equity generated from the tax credit equity investor.

    The 2003 interim rule had also provided for very detailed closing procedures and documentation requirements that needed to be followed to obtain final HUD approval of these transactions. Under the final Mixed Finance rule, those detailed requirements have for now been deleted; instead, HUD has indicated that it will be issuing additional guidance on the specific closing documents that must be executed for these transactions (similar to what HUD has done for Mixed Finance public housing development). Consequently, until HUD issues such guidance, practitioners are left to speculate as to the specific documents that need to be submitted, and the specific procedures to be followed, for HUD review and approval as part of these Section 202/811 mixed finance transactions.

    HUD awards funding for the Section 202 and 811 programs each year using a Notice of Funding Availability, which sets forth the requirements for the Section 202/811 proposal to be submitted to HUD and HUD's scoring criteria. Though the HUD fiscal year 2006 budget has not yet been finalized, the House/Senate conference has agreed to maintain the funding levels for those programs at similar levels to the past several years at $239 million for Section 811 and $742 million for Section 202 -- in 2005, those amounts were $238 million for the Section 811 program and the $741 million for the Section 202 program, and in 2004, those amounts were $249 million for the Section 811 program and $773 million for the Section 202 program.

    The final Mixed Finance rule is a good step by HUD towards allowing the Mixed Finance development of Section 202 and 811 projects to finally being able to proceed, five years after the 2000 Act allowed this structure, though as indicated above there are still certain issues that need to be resolved by the IRS to fully maximize the utility of Low Income Housing Tax Credits in these transactions. In addition, the further guidance that HUD indicated it will be issuing as to closing documentation and procedures still needs to be released in order for these transactions to move forward.