Washington Wire: Looking Beyond Legislation: Ideas to Expand LIHTC Investor Base

Published by Michael Novogradac on Friday, October 1, 2010
Journal thumb October 2010

Expanding the investor base of the low-income housing tax credit (LIHTC) program is a top priority for professionals in all sectors of the affordable housing community. While much attention has been focused on legislative changes—such as extending the current law LIHTC carryback from one to five years and altering the passive activity rules—there are a number of approaches to expanding the investor base that don’t require federal tax legislation.

Some of these ideas have been the subject of discussion for months, and even years in some cases, as the tax credit community has banded together to weather the recession and resulting market disruption. Much like the consensus that was built behind a set of legislative improvements last year, in recent months agreement appears to be building in support of non-legislative efforts to increase investor interest in the LIHTC market.

For example, at a recent meeting of LIHTC stakeholders hosted by the Treasury Department, wide-ranging discussions covered a variety of ideas for expanding and increasing investor interest in LIHTCs. Two ideas that garnered the most support: broadening Community Reinvestment Act (CRA) assessment areas and making accounting rule changes to expand use of the effective yield method.

Because the LIHTC investor base is currently dominated by CRA investors, the tax credit equity market has been split into two tiers, one with high credit prices in high-demand CRA assessment areas and a second with lower or no demand in non-CRA assessment areas. The suggestion to broaden CRA assessment areas was also made by banks, investors and other commenters during the recent hearings held by federal regulators as a part of an effort to revise CRA rules. (To read more about the LIHTC stakeholder meeting and the proposal to broaden CRA assessment areas, please see The Buzz on page 7. To read more about CRA investors’ plans for 2010, please see the related article on page 11.)

Also drawing a lot of interest during last month’s meeting was the idea to change accounting rules regarding use of the effective yield method—specifically making changes that would allow effective yield accounting treatment to be used for nonguaranteed LIHTC investments. For years, Novogradac & Company has been pushing for changes in the accounting treatment for LIHTCs, including expanded use of the effective yield treatment. However, many in the LIHTC accounting and investing community perceived such changes as a hill too high to climb. Given the challenges that recent federal legislative efforts have faced, many now agree that the LIHTC community should try scaling the accounting treatment mountain.

A couple of years ago, as part of our efforts to expand the use of the effective yield method, we analyzed the definition of “creditworthy” guarantor, a key condition to using the effective yield method. (To read a discussion regarding what constitutes a creditworthy entity for the purposes of using the effective yield method of accounting, please see the April 2008 issue of the Novogradac Journal of Tax Credit Housing.) More recently, discussions regarding the effective yield method have focused more on how the rules could be amended to increase its use, thereby making LIHTC investment more attractive to potential investors.

About the Effective Yield Method
The effective yield method is generally a preferable alternative to the equity method of accounting for LIHTC investments. Generally, the equity method of accounting is required in accounting for limited partnership investments, unless in certain circumstances the even less desirable consolidated method of accounting is required. However, limited partners that meet three criteria may elect to use the effective yield method in recording their investment in a qualified affordable housing project through a limited partnership investment. One of the criteria for using the effective yield method is that there is a positive rate of return from the tax credits. When investors in some areas were paying more than $1 per $1 in tax credits, showing a positive rate of return on the credits was difficult. However, since tax credit prices have dropped to less than $1, more investors may consider using the effective yield method as an alternative to the equity method. The other two criteria are that there is a creditworthy guarantor of the tax credits and the investor is a limited partner in the affordable housing project for both legal and tax purposes. (Additional guidance about the effective yield method from the Financial Accounting Standards Board (FASB) can be found in Emerging Issues Task Force (EITF) issue No. 94-1, which discusses how an entity that invests in a qualified affordable housing project through a limited partnership should account for its investment.)

Under all three accounting methods, effective yield, equity and consolidated, tax credits are recorded as reduction of income tax expense. On a company’s financial statement that is often referred to as a “below the line” benefit, meaning it is recorded below the pre-tax operating income line. But, a key benefit to using the effective yield method is that the amount invested to purchase the LIHTCs is recorded as amortization expense, and the amortization expense is also recorded “below the line” as a component of income taxes. This compares to the equity and consolidated methods, where rental real estate losses, principally from depreciation and impairment expense, are recorded “above the line” or as a reduction of pretax income. This means that under the equity and consolidated methods, book losses are reflected “above the line” and income tax benefits are recorded “below the line.” Quick summary — under the effective yield method, the risk of distorting operating performance metrics (such as “earnings before interest, taxes, depreciation and amortization,” or EBITDA) is reduced.

Currently, under the effective yield method, the investor recognizes tax credits as they are allocated and amortizes the initial cost of the investment to provide a constant effective yield over the period that tax credits are allocated to the investor. The effective yield is the internal rate of return on the investment, based on the cost of the investment and the guaranteed tax credits allocated to the investor. Any expected residual value of the investment should be excluded from the effective yield calculation. Cash received from operations of the limited partnership or sale of the property, if any, should be included in earnings when realized or realizable.

What the Proposal Would Change
The proposal is simple: allow effective yield treatment even when there is no creditworthy guaranty. Supporters of the proposal believe that based on the successful track record of the LIHTC program and the nature of LIHTC investments, such a guaranty is both redundant and unnecessary, as it does not reflect the economic reality of the investment. One piece of evidence to which LIHTC supporters point is the foreclosure rate of properties funded with LIHTCs, which is relatively low compared to other property types. A 2007 survey by Ernst & Young reported an annualized rate of loss to foreclosure (or deed in lieu of foreclosure) of only 0.03 percent. The annualized foreclosure rate for all apartments, by comparison, is historically nearly 10 times higher at 0.29 percent. This further compares to the annualized foreclosure rate of office buildings of 1.24 percent.

Conclusion
A broad and varied investor base is vital to the continued success of the low-income housing tax credit program. The changes described here to expand the use of the effective yield method would widen the pool of investors and help invigorate the LIHTC investment market. If you have thoughts about this proposal, or would like to join the effort in support of this change, please contact Bentley Stanton, a partner in Novogradac & Company’s Atlanta, Ga. office, at [email protected] or (678) 867-2333.