Best Practices: Combining the Low-Income Housing Tax Credit with the (Historic) Rehabilitation Tax Credit

Over the years our firm has had the benefit of representing clients combining (or ‘twining’) multiple tax credit programs in their real estate development projects. 

This article will present a few technical challenges when combining or twining the low-income housing tax credit program (LIHTC) with the historic rehabilitation tax credit program (HTC) and some best practices to address these challenges.

Basis Reduction

For projects that combine (or twin) LIHTCs with HTCs, the LIHTCs are calculated after the Owner reduces its eligible basis.

In general, the Owner’s basis must be reduced by the amount of federal HTCs claimed.[1]

When considering the basis reduction keep in mind the reduction is not equal to 20% of LIHTC eligible basis. That’s because LIHTC eligible basis is significantly different from qualified rehabilitation expenditures (QREs) used to calculate HTCs.  For instance, land improvements, additions, and personal property (and sometimes acquisition costs) qualify for LIHTCs. These expenses are not QREs, and do not generate HTCs.

We, also, have a state historic tax credit program in New York. If eligible[2], projects can receive a state credit in an amount equal to the federal credit (20% of QREs). The basis is reduced only by the federal HTCs. More importantly, the project would generate a significant amount of additional equity as a result of qualifying for the NYS HTCs.

Cash Flow Waterfall & Allocation of HTCs

Underwriting cash flow in a combined LITHC and HTC project is different from a standalone LIHTC project. Typically, in a standalone LIHTC project, at the end of the cash flow waterfall 90% available cash is distributed to the GP or managing member.

In general, HTCs are allocated in accordance with profit interests during the 5-year HTC compliance period. Therefore, 99% of net cash flow after payment of deferred fees and other waterfall fees, must be distributed to the investor.

If 90% of the net available cash flow is distributed to the managing member during the 5-year HTC compliance period, then there is a potential that the IRS would reallocate 90% of the HTCs to the managing member. Instead of receiving 99% of the HTC, the investor would receive 10%, potentially triggering downward adjusters and/or repurchase obligations.

After the first 5 years, the managing member can receive 90% of the available cash flow. In a combined HTC LIHTC project, there should be two different waterfalls, one in effect during the five (5) year HTC recapture/ compliance period; and another waterfall thereafter.

To the extent there is excess cash flow during the first five years that would otherwise flow to the investor, a portion of this could be captured with a fixed fee to the guarantor or an incentive fee based on gross rents. As a cautionary note, any related party fee would need to be reasonable and approved by your investor’s tax counsel.

Investor Transfers and Recapture

LIHTC investors often transfer their interest in the company/ partnership to specific investment funds that are either identified or established after the initial construction financing closing and admission of the investor.

This sometimes occurs after placement in service of the project, which in a standalone LIHTC project would not cause recapture of the LIHTC, provided the property remained an affordable project.

In general, the HTC recapture period is a 5-year period starting when the building is placed in service. During the HTC recapture period, HTCs would be recaptured if a partner transfers more than 2/3 of its interest in the project.

A project with both HTC and LIHTC components needs an initial investor that is committed for at least the initial five-year HTC recapture period.

Many tax credit syndicators plan on transferring the investor interest to a target fund(s) after construction financing closing. Therefore, it’s important to identify this issue early on with the syndicator (before construction financing closing).

If possible, you should identify the ultimate investor/ fund for the project, and admit that entity at closing. Alternatively, request the investor member transfer occur at an upper-tier level, instead of at the project-owner level.

As a failsafe, we generally recommend including carve outs in the operating agreement (and other tax credit investment documents), so that there is no penalty nor reduction in the investor’s capital contributions, if an investor transfer causes recapture of credits during any tax credit compliance period (HTC or LIHTC).

Tax-Exempt Bond/ 4% Low-Income Housing Tax Credit Projects

Tax-exempt bond financed projects with 4% LIHTCs need to pass the 50% test, meaning more than 50% of certain property costs (land and depreciable assets) must be financed from bond proceeds.

The HTC basis reduction (discussed above) is not included in the 50% test calculation, therefore a project may need more bond financing to ensure more than 50% of construction costs are properly funded from bond proceeds.

Phil Borrelli, Managing Member


[1] The owner’s basis is not reduced in a master lease (or lease-pass through) transaction structures. Nonetheless, NYS Homes and Community Renewal (DHCR) does not allow master lease transaction structures for combined LIHTC and HTC projects.

[2] A project is eligible for NYS HTCs if the project: (1) qualifies for federal HTCs and (2) is located in a (qualified) census tract that is identified as being at or below 100% of the state median family income.

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