There is unprecedented demand for private activity tax-exempt housing bonds paired with 4% low-income housing tax credits (LIHTCs), driven by several factors, including a recently enacted minimum 4% credit rate. This increased demand for tax-exempt bonds paired with the 4% LIHTC has prompted several states to change the way they approach tax-exempt bond allocations, making it all the more critical for developers to understand the nuances of the 50% test.

What is the 50% Test?

Under Internal Revenue Code (IRC) Section 42(h)(4)(B), qualified residential rental projects applying for  tax-exempt bonds can receive the 4% LIHTC under IRC Section 42 on 100% of the qualified low-income units if the project is financed at least 50% with tax-exempt bonds from a state’s bond volume cap under IRC 142 and 146.

If a project is financed less than 50% with tax-exempt bonds, then the 4% LIHTC is only received on that percentage, rather than on 100%. This shortage in credits would leave projects with a sizable financing gap that many would probably not be able to cover with other sources. Hence, the 50% test is often considered a cliff test, much like the 10% test for 9% projects–if a project does not pass the test, it’s likely not financially feasible.

What Has Changed?

The calculation of the 50% test has not changed, but the private activity tax-exempt housing bond environment has. Between 2015 and 2019, private activity bond issuance for multifamily housing jumped to $16.4 billion from $6.6 billion. Fifteen states used all of their 2019 private activity bond cap and at least another 10 states were nearing their limits.

With the increased competition for 4% LIHTCs and tax-exempt housing bonds, some states have implemented a limit to the maximum percentage of a project’s financing from tax-exempt bonds. Currently, there are at least five states with such a maximum. California, Colorado, Georgia and Washington have a 55% maximum, while Illinois underwrites at 54%.

This new cap on the percentage of bonds creates a narrow margin of error. On one hand, 4% LIHTC developers must meet or exceed the 50% threshold for the percentage of financing from tax-exempt activity bonds. On the other hand, developers cannot exceed a certain maximum in some states such as 55%. In addition, developers are pressured to request fewer bonds because some states favor projects requesting fewer bonds.

Tips for Satisfying the 50% Test

The narrow window to meet the 50% test underscores the need for developers to be vigilant about several factors that can significantly affect whether a project satisfies this test. The following is a nonexhaustive list of tips for developers to consider.

1. Closely estimate and monitor costs. As mentioned earlier, a project will receive the 4% credit on 100% of qualified low-income units if 50% or more of the aggregate basis of any building and the land on which the building is located is financed by tax-exempt bonds. The numerator in the 50% fraction is the amount of tax-exempt bonds and the denominator is the aggregate basis of the building and land. The tax-exempt bonds numerator is generally fixed, based on the amount allocated by the state agency, unless the owner applies for and receives more bonds. Therefore, the building and land costs in the denominator are the main variables. Estimate these costs with as much accuracy as possible when submitting the bond application and monitor these costs closely during construction to avoid failing the 50% test.
2. Know what costs are included and excluded. Additional IRS guidance such as private letter rulings (PLRs) on the 50% test requires building and land costs to include many other items such as site improvements, furniture and fixtures, off-site costs and commercial costs (See PLR 200035016). It’s also important to note that aggregate basis does not have the same definition as “eligible basis” under IRC Section 42 that LIHTC practitioners often use. Aggregate basis can include costs that are depreciable that might not be otherwise included in “eligible basis” such as commercial costs. Therefore, many project costs are included in the denominator except items such as permanent loan fees, bond issuance costs, organization and syndication costs, lease-up and marketing costs, and reserves.
3. Don’t forget to account for other tax credits. If a development qualifies for other federal tax credits such as historic tax credits, solar tax credits or energy-efficiency tax credits, then the depreciable basis is generally reduced by these tax credits (only half in the case of solar tax credits). However, IRC Section 1012 provides that the basis of property shall be the cost of such property, not including any reduction for tax credits; therefore, it appears that the credit basis reduction would not apply for purposes of the 50% test (See PLR 199917046).
4. Remember that bonds should be drawn and outstanding in order to count for the 50% test. For example, if a developer is allocated $10 million of bonds, then in order to count $10 million toward the 50% test numerator, as the PLRs on this topic have noted, the developer must draw down all $10 million and have that $10 million outstanding in full before the close of the first year that tax credits are claimed. If instead, $6 million of bonds were drawn down and then paid back with some money from another funding source received during construction, and then the additional $4 million was drawn down later at the end of construction, only $6 million at most would count toward the 50% test numerator. In this second scenario, the $10 million was drawn before the close of the first year that tax credits were claimed, but the $10 million was never outstanding in full at any point in time. That would be a problem if a developer needed the full $10 million to pass the 50% test. Therefore, developers should draw down the full amount or at least an amount to comfortably pass the 50% test before considering paying back any bonds.
5. Timing is key. Bond financing must occur before the close of the first year that tax credits are claimed (See PLRs 9816018 and 201049018). However, the term “financed by” does allow for either construction or permanent financing, so developers have the flexibility to use the bonds for construction, and then pay them down or pay them off before closing on the permanent loans.
6. Be creative. Developers who are struggling to meet the 50% test at the end of the first year may need to think out of the box for solutions. For example, a developer may consider deferring the first credit year for a portion of their buildings in a project in order to have additional time to meet the 50% test. A tried and true but still not desirable option is decreasing the developer fee to reduce aggregate basis. Many partnership agreements for partnerships using tax-exempt bonds may already have included that option. One would need to weight the impact of the timing adjuster versus the overall credit adjuster.

There are several potential pitfalls with the 50% test, so engaging experienced tax professionals early in the process is key to avoiding potentially costly errors.