• North Carolina Low Income Housing Tax Credit: A Missed Opportunity?
  • June 27, 2003 | Authors: Todd C. Brockmann; Andrew H. Foster
  • Law Firms: Womble Carlyle Sandridge & Rice - Charlotte Office ; Womble Carlyle Sandridge & Rice - Research Triangle Park Office
  • In 1986, Congress created the federal low income housing tax credit. Since its enactment, the federal credit has been used to finance the development of more units of affordable rental housing in the United States than any other federal program. The federal credit is so effective because it provides commercial real estate developers with the economic incentive to invest in affordable residential rental communities. Without the federal credit in these deals, there would be no economic justification for such private investment. The federal credit creates a win-win by providing good returns to private real estate investors and stimulating the development of much needed affordable rental housing.

    Due to the benefits and success of the federal credit, North Carolina and an increasing number of states have enacted similar state low income housing tax credits. As enacted and administered in North Carolina, the state credit unfortunately has several features which make it unattractive to prospective real estate investors. Developers, investors and professionals in the affordable housing community are working to address these problems, but at the present time, the state credit remains a missed opportunity for investors and the State of North Carolina.

    How Do the Tax Credits Work?

    The development of affordable rental housing in North Carolina is primarily facilitated through the syndication of the federal credit and state credit to private equity investors. The federal credit and the state credit are awarded to projects through a competitive process conducted by the North Carolina Housing Finance Agency. Once the tax credits are awarded to their projects, the developers then syndicate the tax credits to investors who contribute equity to the project in exchange for allocations of the tax credits. Investors in the tax credits include national equity investment funds, private financial institutions and other real estate investors.

    In a typical transaction in today's market, an investor will invest approximately 80 cents for each dollar of federal credit and approximately 40 cents for each dollar of state credit to be allocated to such investor. The price paid by the investor is based upon the investor's potential use of the tax credit and an acceptable rate of return based upon the risk and the time value of money. Since the project will have restricted rents for the low income tenants, the equity generated by the allocation of tax credits allows the project to be developed and maintained with a lesser amount of debt financing and with little or no additional equity from the developer.

    Most state credits are structured so that one investor can invest and receive the allocation of the federal credit and another can invest and receive the allocation of the applicable state credit. This process is referred to as the "bifurcation" of the tax credits. The rationale behind bifurcation is that some investors will only be able to invest in the federal credit since they have no income in the state in which the project is located. Bifurcation allows the allocation of the state credit to a separate investor that has state income to offset. Allowing bifurcation increases the pool of eligible investors for the applicable state credit.

    As originally enacted, the North Carolina state credit could not be bifurcated from the federal credit. As a result, the same investor was required to receive the allocation of both the federal credit and the state credit. This requirement limited the pool of investors in the state credit and has led to its underutilization. To remedy this problem, on October 6, 2001, North Carolina enacted Senate Bill 181 which modified the state credit statute to permit the bifurcation of the state credit and the federal credit in North Carolina. Investors, developers and affordable housing professionals initially applauded this modification, but significant problems have arisen in regard to the application of its requirements that jeopardize the effectiveness of the state credit.

    What are the Problems with the State Tax Credit?

    The most significant problem with the North Carolina state credit is that the statute provides that a developer may only allocate the state credit to an investor to the extent that the amount of the state credit allocated to the investor does not exceed the investor's adjusted basis in the development entity. In essence, this means that an investor must put $1 into the project for each $1 of state credit received by such investor. Because an investor naturally will invest at a discount relative to the amount and timing of the receipt of the state credit in order to maintain a sufficient economic return, this requirement eliminates the economic incentive underlying the state credit.

    As an example of the problem created by this statutory provision, consider the following situation. A developer is awarded an allocation of $500,000 in state credit ($100,000 per year for 5 years) for a project to be developed in North Carolina. In the current market, a state-only investor would likely be willing to invest $200,000 in the project in exchange for the $500,000 worth of state credit. The statute, however, prevents the amount of the state credit allocated to the state-only investor to exceed the amount he invested in the project, i.e. his tax-basis in the development entity. Thus, in order to receive the full $500,000 allocation of state credit, the investor would have to increase the amount of his investment to $500,000. Because no rational investor would invest $500,000 in order to receive a return of $500,000 spread over a five year period, the tax basis requirement creates a practical prohibition against bifurcation and limits the ability of real estate investors to take advantage of this investment opportunity.

    In addition to this problematic tax basis requirement, the statute also contains several features that unnecessarily increase the risk and complexity for investors. For example, the state credit is subject to recapture in the event the investor's interest in the project is reduced materially during the five (5) years subsequent to the date the state credit is first claimed. Therefore, a state-only investor is tied to the project for the full five year period, even if the cash flows generated by the project are sufficient to enable the developer to buy the investor out. In addition, the state credit can only be used to offset 50% of the investor's tax liability in any given year. Finally, to the extent an investor cannot fully utilize the state credit in any year, the investor can carry the credit forward for up to five (5) years but cannot carry the credit back to offset the tax liability of prior years. Most other states with a state credit allow for a carry back of up to three years. All of these restrictions could be removed or modified without significant cost to the state treasury, and by doing so, the state credit would become far more favorable to real estate investors.

    What Can Be Done?

    The affordable housing industry in North Carolina is looking to further amend the state tax credit statute in the upcoming special session of the North Carolina General Assembly. As they craft proposals to fix the problems with the state credit discussed above, it is critical that North Carolina-based real estate professionals become engaged in this process so that they can help ensure the final proposal meets their needs. If properly modified, the state credit has the potential to become a powerful tool for financing the development of affordable rental housing, as well as an attractive investment option for North Carolina's real estate investors.