A PRIMER:

THE LOW INCOME HOUSING TAX CREDIT

By
Willam Traylor
Vice President and Managing Director
New York Equity Fund

Third National HIV/AIDS Housing Conference

September 16-20
 A PRIMER:
THE LOW INCOME HOUSING TAX CREDIT
The Tax Reform Act of 1986 established a tax credit for low income housing;
the Omnibus Budget Reconciliation Act of 1993 (enacted August 10, 1993) provided
a permanent, retroactive extension of this tax credit. Previously, the tax credit had
been subject to annual renewals and had expired June 30, 1992 without renewal.
These tax credits are provided to states based on their population. The states annually
receive $1.25 of credits per capita. Each state then allocates the tax credits to
qualifying property owners, generally on a first come first serve basis, in accordance
with a qualified allocation plan.

As a result, qualifying owners who receive the tax credits may take a dollar-
for-dollar credit against their Federal income taxes for expenses incurred in the course
of acquiring and rehabilitating rental housing for occupancy by persons or families of
low income. The developer receives the tax credit on an annual basis for ten years.
This tax credit is in addition to the other tax benefits provided by the Internal
Revenue Code ("IRC") to owners of rental residential properties.

Qualifying Projects

In order to qualify for the tax credit a project must (1) not have been ready for
occupancy prior to 1986 (the first year the tax credit was available) and (2) have a
tenant income mix1 in which (a) twenty percent of the total units in the project are set
aside for persons earning fifty percent of the area median income or less or (b) forty
percent of the total units in the project are set aside for persons earning sixty percent
of the area median income or less.

In order to qualify for a tax credit on the costs of acquisition, additional

stipulations apply. First, the property may not have been placed in service by more
than one owner within the last ten years. A waiver from this provision, known as the
"ten year rule," is available for certain properties including those with a federally
assisted mortgage, a federally assisted project that may convert to a non-low income
use or a project acquired from a failed depository institution including all those sold

1In New York City, projects qualify for the tax credit if twenty five percent of the units are set aside for persons earning sixty percent of area median
income or less.
 A Primer: The Low Income Housing Tax Credit

by the Resolution Trust Corporation. Secondly, the acquisition credit is provided

only in conjunction with the rehabilitation credit. As a result, a minimum of
rehabilitation work, valued at the greater of $3,000 per low income unit or ten
percentof the unadjusted basis of the building, must be done.

Eligible and Qualified Basis

The eligible basis of a building is equal to the depreciable basis2 of the

building less any ineligible costs or ineligible sources of funds. Acquisition costs
associated with the improvement, even though they form a part of the property's
depreciable basis, are ineligible costs for purposes of calculating the tax credit if the
acquisition does not comply with the aforementioned "ten year rule." Other ineligible
costs which are subtracted from the depreciable basis in order to obtain the eligible
basis are costs incurred to improve non-low-income units to a quality in excess of low
income units.

Ineligible sources of funding, even though these amounts are included in the
depreciable basis, are subtracted from the depreciable basis in order to arrive at the
eligible basis. Ineligible sources of funding are any Federal sources of funds such as
direct or indirect grants of funds or a federally subsidized loan.3 For instance, if the
developer receives a grant of Federal funds to renovate a property for which the
developer is also applying for tax credits, then the developer will subtract the Federal
funds from the depreciable basis in order to determine the eligible basis. Likewise, if
another entity such as a unit of State or local government loans Federal funds which it
has received to a developer then these are likewise subtracted to arrive at the eligible
basis. Another common source of federally subsidized funds which must be
subtracted to obtain the eligible basis are the proceeds from tax exempt bond
financing.

The qualified basis of a property is equal to the amount of the eligible basis
attributable to the low income units in the project. In other words, the qualified basis
is the low income percentage of the eligible basis. The IRC further stipulates that the
low income percentage used to calculate the qualified basis must be the lesser of (a)
the percentage of the number of low income units in relation to the total number of
units or (b) the percentage of the gross floor area of the low income units in relation to
the floor area of all units. Example: The eligible basis of a seventy unit building is
$500,000; twenty one units (thirty percent of the total number of units) are designated
for the low income occupancy. These low income units comprise 13,650 square feet
of the total 78,400 square feet of the building (or seventeen percent of the total floor
area). As a result, the qualified basis of the project is $500,000 times seventeen
percent or $85,000.

2Depreciable basis equals the total project costs less land costs and amortized and expensed costs.
3Community Development Block Grant and HOME funds are exempt from this provision. Moreover, a developer may choose not to subtract the
federally assisted funds from the project basis and apply the four percent credit rate to the qualified basis. Since the 4 percent credit rate is applied to
the qualified basis related to acquisition, this rule makes no difference if the federal funds are used to acquire the building. However, to achieve the
maximum amount of credit the developer should simply exclude federal sources of funds from the eligible basis if the amount of these funds is less
than 57.1 percent of the construction costs and take the 9 percent credit rate on the balance of the qualified basis.

3
A Primer: The Low Income Housing Tax Credit

Basis Boost

Projects located within difficult development areas or in qualified census

tracts, both of which are designated by the Federal government, can qualify for a
boost of the qualified basis related to rehabilitation up to 130%. As defined in the
IRC, a difficult development area is one in which land, labor and material costs are
high in relation to the area median income. In New York City, the Bronx is currently
the only borough considered a difficult development area. A qualified census tract is
one in which fifty percent or more of the resident households have incomes at or
below sixty percent of area median income. Projects located in either of these
designates will multiply the project's qualified basis, excluding the qualified basis
related to acquisition, by 130% to achieve an adjusted qualified basis.

Calculation of the Tax Credit

The amount of the tax credit an owner may receive is a percentage of the
qualified basis. These percentages or credit rates differ for both the acquisition and
the rehabilitation portions of the qualified basis. These credit rates change on a
monthly basis and are published each month by the Treasury Department.4 These
credit rates are adjusted each month so as to provide the developer with a present
value on the acquisition-related tax credits over the ten years equal to thirty percent
(generally this credit rate is around four percent and is commonly called the "4
percent credit") and a present value on the construction-related tax credits equal to
seventy percent (generally this credit rate is approximately nine percent and is
commonly called the "9 percent credit"). The Treasury Department calculates the
credit rate based on a discounted after tax basis where the discount rate is the average
of the Federal government's mid-term and long-term obligation rates.

The applicable credit rate is that rate in effect the month that the building is
placed in service, meaning when the building is ready for its intended use. However,
the developer may irrevocably elect the credit rate in effect at the time credits are
reserved for the project by the credit allocating agency.

From this point forward, calculation of the amount of the tax credit for which
a project is eligible is relatively simple. The developer will receive a credit equal to
the sum of the four percent credit rate times the amount of the qualified basis related
to acquisition plus the nine percent credit rate times the amount of the qualified basis

4Credit rates as published by Treasury for selected months

MONTH 9% Credit Rate 4% Credit Rate

May 1994 8.60% 3.68%
June 1994 8.70% 3.73%
July 1994 8.68% 3.72%

4
 A Primer: The Low Income Housing Tax Credit

associated with the construction. Example: A developer placed her project in service
in October 1991 when the credit rate for acquisition was 3.79% and for construction
was 8.85%. Her total qualified basis was $500,000 including $50,000 for acquisition
and $450,000 for construction. Her total annual credit allocation is $41,705 (3.79%
times $50,000 plus 8.85% times $450,000). The developer will receive this credit for
each of next ten years beginning with the placed in service date and will deduct this
amount from her annual taxes.

Rent Restrictions and Compliance

Congress' intent behind creation of the Low Income Housing Tax Credit was
to increase the available stock affordable of rental housing for low income persons
and families. As a result, owners claiming the tax credit are restricted in the rents
which they may charge low income persons and families. The maximum rent payable
by a low income person or family is thirty percent of the annual income for the
project's targeted low income group. As a result, if the owner elected to provide
twenty percent of the total number of units to persons or families earning no more
than fifty percent of area median income, then the maximum collectible rent from the
low income tenants would be thirty percent of fifty percent the area median income.
On the other hand, if the owner set aside forty percent of the building's units for
persons or families earning sixty percent of area median income, then the maximum
collectible rent would be thirty percent of sixty percent of the area median income.
The balance of property's units could be rented at market rates.

The maximum rent payable by the low income tenants must account for utility
costs. This is based on the principle that no person or family should pay more than
thirty percent of their income towards total housing costs. As a result, if tenants will
pay for their own gas and electric, then the owner must deduct a utility allowance,
determined by the Treasury Department, from the rent calculations stipulated above.

However, rent subsidies paid on the behalf of the tenant do not count towards
the maximum rent paid. Therefore, projects which benefit from any number of
Federal, State or local programs which pay higher rents than would otherwise be
permitted under this program will not be adversely affected by the limitations on
collectible rents as long as the tenant's contribution does not exceed thirty percent of
the area median income.

Beyond rent restrictions several other restrictions apply to projects receiving

the tax credit. First, the owner must maintain the income distribution among the
tenants that first qualified the project for the credit. Therefore, at least twenty or forty
percent of the units must be set aside for low income persons for the entire tax credit
compliance period. If a low income unit is vacated, then it is to be rented to another
low income person. If a low income person's or family's income increases beyond
140% of the targeted income, then the next available vacant unit must be rented to a
low income person or family at the qualifying rent until the required building-wide
income distribution is re-achieved.

5
A Primer: The Low Income Housing Tax Credit

Moreover, while owners receive the credit in equal increments over ten years,
they must operate the project, with all the stipulated restrictions, for fifteen years. If
an owner fails to operate the project in accordance with the stipulated restrictions
throughout the fifteen year compliance period, the owner will be subject to recapture
penalties for non-compliance.

The penalties for non-compliance are calculated as follows. First, no tax

credit can be claimed in the year that the non-compliance occurs. Moreover, the
owner must repay the IRS the accelerated portion of the tax credits with interest for
all prior years. The accelerated portion is the difference between the amount of the
credit actually claimed through that year and the amount of credit earned until the date
of non-compliance. The credit earned is the total credit allocated divided by fifteen
years times the number of years the project complied with the regulations.

Example: A project with $6,000 a year in credits falls into non-compliance in

year six. As of year six, the owner will have claimed tax credits in the amount of
$30,000 (five years times $6,000 per year). However, the property owner will have
earned $20,000 in tax credits (total tax credit equals $60,000 which divided by fifteen
years equals $4,000 per year; five years times $4,000 per year equals $20,000). The
accelerated portion of the credit in year six is $10,000, the difference between the
$30,000 claimed and the $20,000 earned. As a result, the owner owes the IRS
$10,000 plus interest.

6
 A Primer: The Low Income Housing Tax Credit

Legal Structure

The Low Income Housing Tax Credit is of little value to middle and upper
income individuals given passive loss restrictions and the alternative minimum tax;
however, this credit can be extraordinarily valuable to corporations. As a result, the
typical scenario of a project utilizing the tax credit involves a non-profit developer
selling the credits, for a series of cash payments, to one or more corporate investors.
Often this sale is brokered by an intermediary or syndicator. The cash generated by
the sale of the tax credits is then used by the non-profit to develop the project or to
provide an additional revenue stream to insure the low income use of the project.

However, in order for corporate investors to benefit from the tax credits and
other tax benefits arising from a project, a special structure must be established. This
structure is called a limited partnership. A limited partnership consists of a general
partner and one or more limited partners. Under uniform partnership law, general
and limited partners have specific roles within the partnership. The general partner,
who is also known as the managing partner, has complete responsibility for the day-
to-day operations of the partnership and therefore the project. The general partner has
broad discretionary powers in the business operations of the partnership and generally
does not require the consent of the limited partners in the execution of its powers,
duties and responsibilities. In contrast, the powers of the limited partners are severely
limited by law unless the general partner violates the law or the agreement among the
parties in which case the limited partners may replace the general partner or assume
its powers and duties.

However, because the limited partners do not exercise day-to-day control over
the property they are not liable to the project or to its creditors beyond their initial
investment.5 The obverse is true for the general partner who not only holds broad
powers within the partnership but is also saddled with the lion's share of the liability.6

The tax credits, profits, losses, and tax benefits generated by the project are
divided among the general partner and the limited partners according to terms set
forth in the partnership agreement, the legal document which establishes the
partnership and defines all of the rights, duties and obligations of the parties to the
agreement. Since the general partner is selling its interests in the project in order to
generate cash, the general partner's share of the project is rarely more than one
percent, the minimum required under law. The limited partners therefore receive
ninety nine percent of all benefits generated by the project. The project's tax credits,
profits, losses, and tax benefits are divided among the limited partners proportionate
to the amount they paid to enter the partnership or the number of shares they
purchased in the partnership.

5The pronoun "limited" connotes the limitations placed on both the powers and the liabilities of these members within the partnership.
6Again, the modifying pronoun, "general," relates to both this party's powers and consequent liability.

7
A Primer: The Low Income Housing Tax Credit

Within this structure, the non-profit developer is either the general partner or it
forms a subsidiary corporation which is the general partner.7 In this manner, the non-
profit, whose primary interest is presumably creating affordable, low income housing,
maintains control over the project's operations and decisions effecting its future and
use.

Syndicator
(GP)

Investment LP Subsidiary Non-Profit

(LP) (GP) Developer

Investors
(LPs)

Limited Building/
Partnership Project

Figure 1: Legal Structure of Typical Tax Credit Syndication

When a syndicator is involved, which is often the case, the syndicator forms a
specific type of limited partnership known as an investment limited partnership,
whose sole raison d'être is to invest in various limited partnerships by becoming the
limited partner therein. The purpose of this structure is two-fold. First, it removes
the corporate investor further from the day-to-day operations of individual projects
and thereby decreases further the investor's liability. Moreover, the structure allows
the syndicator to pool contributions of numerous investors and spread them over tens
or hundreds of projects thereby reducing investment risk in the event that any one
project should fail. As a result, syndicators are often able to attract more
sophisticated investors who, as a result, have more money to invest.

Generally, the partnership agreement provides that the non-profit will be able
to re-acquire the property at the end of the compliance period by assuming the
outstanding debt on the property and by covering the cost of the sale and paying the
investor's exit taxes including any potential tax on capital gains. As a result, the non-
profit will have, in theory, received sufficient funds to develop and operate the low
income housing project, maintained control over its management throughout the
compliance period and regained ownership of the project at the end of the compliance
period. The investors, at the cost of their capital contribution, will have reduced their
tax bills at a respectable rate of return.

7New York State not-for-profit law prevents not-for-profit corporations from being the general partner in a for-profit partnership and, as a result,
New York is the only state which so limits not-for-profits. Moreover, given that the general partner in a limited partnership has pronounced legal
liability, the non-profit is much better served if it forms a subsidiary corporation, whether non-profit or for-profit, to serve as general partner.

8
 A Primer: The Low Income Housing Tax Credit

NON-PROFIT DEVELOPER
The mission of Community Access, Inc., the non-profit developer of
Gouverneur Court Apartments, "is to help seriously mentally ill individuals make the
transition from homeless-
ness and institutions to
independent living."8 In 16%
3% 1974-78
furtherence of this mission,
Community Access engages 3%
1979-83
in advocacy, employment
training and placement, 1984-88
edu-cation, social service
78% 1989-93
pro-vision (i.e. entitlement,
case management, and
counsel-ling), housing
management and Figure 2: Growth as a Percent of New Housing Added Each Period
development. With re-gard
to the latter, Community Access initiated an aggressive strategy only within the last
five years. As a result of this development activity, the group has experienced
explosive growth over the course of this five year period (See Figures 2 and 3). If
one looks at the number of housing units which Community Access owns or manages
as a measure of growth in activity, Community has experienced seventy eight percent
of its growth within the last five years (See Figure 2).

Community Access was founded in 1974 by family and friends of mentally ill
individuals to provide housing and support to some of the many individuals released
from psychiatric hospitals during the beginning phases of de-institutionalization.
Community Access began small. In 1975 the group rented several apartments,
renovated them with funds provided by its board members for six formerly homeless
individuals and thereby began its housing program. More apartments were leased as
the program expanded.

In 1977 Community Access purchased two small, partially occupied apartment

buildings to house forty four members9 in addition to the low income families already
in residence. At this time, the group also hired its first staff person who maintained
connections and contacts between the members and their mental health service-
providers. These two buildings became part of a urban renewal site and were taken
through eminent domain in 1981 to make way for a federally financed low income
housing project. Community Access subsequently resorted to its original strategy of
renting apartments for its members within privately-owned buildings.

8Community Access, Inc. , 1992 Annual Report.

9Consistent with its institutional philosophy that the persons its serves are part of a family and community rather than clients, Community Access
refers to the individuals it serves as "members."

9
A Primer: The Low Income Housing Tax Credit

Over the next several years Community Access expanded. Even as it lost its
first two buildings, the group received its first public contract which provided the
funding to add more members and staff and to expand its developing program goals.
Over the course of the next several years, the non-profit moved from being its
members' connection to mental health and social services to being the provider of
these services.

However, Community Access never gave up its aspirations to be a housing

developer. In 1986 the group was awarded funding from the Federal Department of
Housing and Urban Development ("HUD") to renovate a small tenement into a
supervised residence for fifteen members. In 1988 the developer received financing
from New York City's Department of Housing Preservation and Development
("HPD") to renovate another tenement building, also as a supervised residence, for
twelve members.10 Both of these facilities are operated with funds provided under
contract with the New York State Office of Mental Health.

In 1990 Community Access received a loan from HPD to acquire and renovate
a larger tenement building into permanent housing for members moving out11 of its
transitional residences and for other homeless, mentally ill persons. This project
contains forty six efficiency apartments. In 1991 the group received funds from the
New York State Housing Trust Fund to build a new fifty one unit building consisting
of twenty nine two-bedroom apartments and twenty two efficiencies. Also in 1991
Community Access received funding from HPD to acquire and renovate the old
Gouverneur Hospital building, the current project. The latter was completed in
December of 1993.

350
Number Persons Housed

300

250

200 Total
150
A dded This Period
100

50

0
1974-78 1979-83 1984-88 1989-93

Figure 3: Growth of Community Access Measured by the Total Number of Persons Housed and Number of New Units Added Each Period

Over the last twenty years, Community Access has grown significantly in its
capacities as both a housing developer and a service provider on the Lower East Side
of Manhattan. The next five year period will be the key to the success of this group.

10These residences, Access House and Libby House, respectfully, provide twenty four hour supervision and services. They are intended as
transitional housing, where formerly homeless members receive the appropriate assistance to stabilize their lives and acquire necessary skills prior to
moving into permanent housing situations. Generally, members move onto other situations within a year. Community Access continues to rent
apartment units in privately-owned buildings to provide permanent housing. It currently rents thirty six such apartments.
11Community Access speaks of members "graduating from" its supportive residences rather than leaving.

10
 A Primer: The Low Income Housing Tax Credit

Community Access' dynamic expansion mirrors that of many non-profits which have
added and assumed client services at an explosive rate. Most of these non-profits
have been strained to the point of faltering until their "back-office" operations (i.e.
financial and accounting, personnel and administrative services) have been enhanced
to address the needs of this institutional growth. Moreover, the funds for this crucial
"back-office" support have been difficult to obtain.12 Community Access' future
success will depend on how it manages this next phase of its development.

SYNDICATOR

The Local Initiatives Support Corporation ("LISC") was founded in 1979 by

the Ford Foundation as a support for local community-based development
corporations ("CDCs"). LISC works solely with CDCs. LISC provides technical
assistance and guidance thereby building the capacity of the CDCs. LISC's guiding
assumption has been that CDCs, being dependent on local persons taking ownership
of the revitalization of their communities and neighborhoods, are the most effective
vehicle for addressing the various crises facing American communities.13 The areas
of LISC's interest have gradually expanded and currently these include economic
development, provision of health care services, access to day care, employment and
job development, education and housing.

To this end, LISC established the National Equity Fund, Inc. ("NEF") in 1987
to organize partnerships by and among CDCs and Fortune 500 corporations to support
the development of low income housing and to utilize the Low Income Housing Tax
Credit. NEF itself is composed of three separate funds for corporate equity
investment. These are the National Fund which finances projects across the country;
the California Fund, which operates throughout that state; and the New York Fund, a
collaboration with the Enterprise Foundation investing in projects in New York City.

NEF is now one of the largest corporate investment funds which supports
community-based housing development. Since the Low Income Housing Tax Credit
was created, NEF has raised $620 million to assist in creating more than 14,000 units
of affordable housing in over of 300 projects located in sixty two cities.14

12Funders of direct client services have been loathe to provide adequate contract administration fees which would permit the non-profits to fund
their accounting and personnel offices to levels necessary to fulfill the intent of their contracts. Moreover, traditional property management fees ,
given the relatively small number of units managed and the relatively low rents, do not generate the income required to build up and maintain required
"back office" operations.
13Local Initiatives Support Corporation, 1992 Annual Report.
14All numbers and figures are based on data from NEF's 1992 Annual Report .

11
 250

200
A Primer: The Low Income Housing Tax Credit
150
Dollars Raised (in Millions)
Each year NEF forms an 100 Number of Projects
investment limited partnership
and issues an offering 50

memorandum to solicit interest

0
from potential investing 1987 1988 1989 1990 1991 1992

corporations. The of-fering

Figure 4: Gross Equity Funds Raised by LISC and Number of Projects Assisted
memorandum outlines the terms
of the investment (i.e. mini-mum
investment, rate of return, 7000
threshold criteria for project in-
6000
vestments, etc.), potential risks,
5000
tax implications and the roles of Per Unit Investment (in
4000
the various parties within the Tens)
investment limited partnership. 3000
Number of Units
NEF is the managing general 2000

partner in each investment limited 1000

partnership that is formed. After 0
NEF raises a sufficient pool of 1987 1988 1989 1990 1991 1992

funds from corporate investors, it Figure 5: Total Number of Units Assisted by LISC and Average Per Unit Investment
seeks individual projects in which
to invest these moneys.

Project Investments and Rates of Return on Investments15

The offering memorandum delineates minimum criteria for investment. NEF

must be able to demonstrate to the investors that a particular project meets these three
criteria. First, financial projections of the estimated annual Federal tax benefits and
cash flow must show an estimated after-tax return to the investors, when the present
investment under consideration is combined with all other investments previously
made and all other investments to be made, equal to (a) an internal rate of return of at
least 20% and (b) a 105% return on each capital installment for each year in which the
installment is made.

Secondly, the project must demonstrate sufficient cash flow and reserves after
the project has been fully leased to pay all operating expenses and debt service and to
make any required reserve contributions.

Finally, there must be sufficient projected proceeds from the sale or

refinancing of the project at the end of the compliance period to pay the investors'
projected and estimated Federal income taxes on any gains resulting from the sale or
refinancing.

THE LENDER - THE CITY OF NEW YORK

15This information is taken from the Private Offering Memorandum of The National Equity Fund 1991 Limited Partnership, the limited partner in
Gouverneur Court Apartments.

12
 A Primer: The Low Income Housing Tax Credit

The development of low income housing often requires more subsidy than
provided by the Low Income Housing Credit itself. In almost all areas of the country,
the development of such housing has required and will continue to require the
involvement of the public sector. Local and State governments have been
instrumental in the development of low income housing through the provision of low
interest loans and grants. No where has this been more true than in New York City.

In 1984, New York City began an ambitious ten year housing plan. The City
has invested billions of dollars of its own funds to create new housing units for
moderate, low and very low income persons and families. To date, 34,000 housing
units have been created and an additional 74,000 housing units have been renovated.
As part of this plan, the City is working with LISC and the Enterprise Foundation to
create low income housing using the Low Income Housing Tax Credits. Through the
end of 1992, these efforts have resulted in the production of 6,605 low income
housing units in 107 projects.

A specific subset of
the City's overall low income
housing production has been
1993
carried out by its Division of
Homeless Housing Develop-
Number of SRO Units
ment through its Single 1992
Room Occupancy Loan and City Funds Commited (in
Tens of Thousands)
Tax Syndication ("SRO")
Pro-gram. Through this 1991
program 3,800 units have
been created of which 1,841 0 500 100015002000250030003500400045005000
in fourteen projects have been
syndicated since 1991. Figure 6: Annual Production and Commitments in SRO Tax Syndication Program
Another 709 units in ten projects will be syndicated by the end of 1994.

The SRO Program was established to make acquisition and renovation loans
to non-profits to develop housing specifically for homeless, special needs individuals
including the mentally ill, persons with AIDS, the frail elderly, and recovering
substance abusers. The SRO Program provides its funds at one percent interest for
the term of the loan. The loan is structured with a balloon payment of the full amount
of the principal at the end of the term which is thirty years. As a result, the borrower
pays only interest on the loan. In addition to the interest, which is payable monthly,
the City collects a quarter percent servicing fee on the full amount of the outstanding
principal.

The City recognizes the inherent risks of housing projects operated solely for
homeless persons with special needs. As a result, the City has taken several unusual
steps to insure the long term financial viability of these projects. First, the City does
not seek to write down its capital costs with the equity generated from the sale of the
Low Income Housing Tax Credits. Instead, the City requires that reserves be

13
A Primer: The Low Income Housing Tax Credit

capitalized from the proceeds of the tax credit sale. In most cases, two reserves are
capitalized for each project, an operating reserve and a social service reserve. The
operating reserve covers projected deficits arising from the loss of rental subsidies in
year six and given that income is expected to rise at two percent per annum and
inflation on expenses is expected at five percent per annum. The social service
reserve covers the costs of providing twenty four hour building coverage and some
social work personnel.

Secondly, while the City charges interest on its loan, it requires that these
interest payments be placed in a sinking fund to pay interest at some time in the
future. However, if the project requires funds to cover unexpected deficits and such
funds are not available from the operating reserve or other reserve, then the funds may
be taken from the sinking fund without penalty. As a result, the sinking fund operates
as a reserve of last resort.

Finally, the City generally makes substantial social service commitments to

these projects to cover the cost of social services for the targeted population. For all
projects targeting the homeless, the City's Department of Homeless Services provides
funds for social services intended to assist the homeless to make a permanent
transition out of homelessness. If the project is intended for the mentally ill,
additional contract support is available from the City's Department of Mental Health
for counseling and case management services. If the project is for the frail elderly,
additional contract support is available for the City's Department for the Aging for
entitlement counseling, nutrition services and recreation. If the project targets persons
with AIDS, contracts covering the cost of home health care, food programs, personal
care and case management are available from the City's Human Resource
Administration. Generally, all of these contracts carry multi-year commitments.

THE PROJECT

14
 A Primer: The Low Income Housing Tax Credit

The project, located at 621 Water Street, is in Community Board 3 on

Manhattan's Lower East Side. The surrounding area is a thriving, vibrant, medium
density residential neighborhood with
several low, moderate and middle income
public housing projects including LaGuardia
Houses, Land's End Houses and Gouverneur
Court. The project is situated within
walking distance to the East Broadway IND
station and the numbers 14, 19 and 22 bus
lines. P.S. 137 is located within two blocks
of the project and Seward Park High School
Annex is within one block. Recreational
facilities within the neighborhood include
Vladeck Park on the adjacent southerly
block and East River Park within walking
distance to the northeast. The medical needs
of the area's residents are met by
Gouverneur Hospital, which is located
within three blocks of the project, as well as Figure7: Lower East Side and Gouverneur Site
by several community clinics.

The neighborhood remains a "melting-pot" with a rich blend of humanity

including the remnants of the original eastern European immigrants and newer
arrivals of Asian and Hispanic descent.

The property comprises the entire block bounded by Front Street and the FDR
Drive to the south, Water Street to the north, Gouverneur Slip West to the west and
Gouverneur Slip East to the east. The structure is U-shaped with the main portion
running along Water Street and two wings, each ending in rounded bays, extending
east towards the water. The five story building with cellar is being converted to 123
small "efficiency" apartment units to house 125 very low income individuals (two of
the units shall be large enough for occupancy by two persons each). Many of the
prospective tenants, approximately sixty percent, will be formerly homeless
individuals who will have either a diagnosis of mental illness or HIV illness. In
addition to the residential rental units, the building will contain a two bedroom
apartment for the building superintendent and recreational, social service and
administrative office space. The latter will be housed in the cellar, which on the
Water Street elevation is slightly above grade and is progressively higher above grade
as one moves toward Front Street.
The project will provide supportive social services to enable the mentally ill
and HIV ill tenants to maintain their independence within the community. The social
services will be funded under contracts with the New York City Department of
Mental Health and City's Division of AIDS Services within the Human Resource
Administration. These services will be provided by the project developer/sponsor.

15
A Primer: The Low Income Housing Tax Credit

The center portion of the current structure, originally a police station, opened
in 1885 as Gouverneur Hospital, the first hospital on the Lower East Side, just as the
population of the area was exploding with the recent influx of immigrants. Expansion
of the hospital began in
1898; the east wing was
completed in 1903 and the
west wing in 1906. The
building's unique shape is
attributed to a nineteenth
century belief that corners
could not be properly
sanitized and thus
provided a breeding
ground for germs. As a
result, the new hospital
wings, epitomizing medi-
cine's most sophisticated
technology and philoso-
phy, were built without
corners. The building
served the community as
a hospital until 1961 when
it moved into a new
facility nearby. The New
York State Office of
Mental Health took over
Figure 8: Typical Floor Plan of Gouverneur Court Apartments the building and housed
mentally ill per-sons there
until 1978 when the State closed such large institutions and moved towards a
community-based model of treatment. Parenthetically, many advocates for the
mentally ill, while lauding the State's move towards community mental health, fault
both the State's poor planning and lack of adequate funding for community mental
health as the chief causes for the numeric explosion in the mentally ill among the
City's homeless population.

With New York State's closing of Gouverneur in 1978, the classic Eighties
cum Nineties real estate story ensued. The property passed through the hands of four
developers each intent on converting the grand old structure on the waterfront into
luxury condominiums and each going bankrupt after gutting or removing some part of
the building. After the last developer failed, Yorkville Savings and Loan, the project's
construction lender, foreclosed and acquired the building in 1990. However,
Yorkville itself fell into insolvency, the result of a portfolio predominated by poorly
conceived real estate loans, and was taken over by the Resolution Trust Corporation
("RTC"). RTC, a Federal agency charged with cleaning up failed Savings and Loans,
sold the property to the current developer, the non-profit Community Access, in June
1991 for a price equal to the amount of the City's liens on the property.

16
 A Primer: The Low Income Housing Tax Credit

PROJECT COSTS AND FINANCING

The total project development costs are $13,735,807 including reserves

required by the lender. The developer purchased the property from RTC for
$1,440,537. An appraisal established that value of the land at $755,526. The
developer hired a contractor for $7,100,000 to renovate the building according to
drawings and specifications produced by an architect. The architect was hired for
$414,875. The developer has a construction contingency equal to five percent of the
contractor's price or $355,000 for unforeseen conditions during construction. Other
project related costs, excluding reserves required by the lender, total $1,090,160.

The City of New York through its Department of Housing Preservation and
Development provided a loan of $8,253,368. The loan is a balloon with one and one
quarter percent interest only payments and a term of 30 years. The sponsor received a
grant of $250,000 from the Federal Home Loan Bank which it loaned to the limited
partnership at 6.03% for thirty years. This loan is also a balloon with one percent
interest only payments and the balance of the interest accruing over the term of the
loan. NEF, as limited partner, brought $5,232,339 in equity to the project.

As a condition of its loan, the City required that the partnership use a portion
of the equity to capitalize operating and social reserves based on formulae provided
by the City. The operating reserve was to be underwritten assuming revenues would
rise at two percent per annum, expenses would rise at five percent per annum, rental
subsidies would be lost at the end of year five, that the funds in the operating reserve
would earn five percent interest per annum and any net operating income would be
deposited into the operating reserve. The amount of the equity contribution to the
operating reserve is to be $1,699,082. In addition, the City required the developer to
capitalize the cost of full time security and one social worker in the form of a social
service reserve. The equity contribution to capitalize the social service reserve is
$1,329,946.

Table 1, appended at the end of this case, provides a detailed itemization of

the sources and uses of project funds.

MARKETING AND TENANCY

Sixty percent of the tenants will be referred by the City of New York from its
emergency shelter system. Under the terms of a referral protocol agreement between
the City and the project sponsor, these referrals will be either mentally ill or HIV ill.
The City will provide rental subsidies for these tenants for five years in the form of
Federal Section 8 vouchers. The monthly rent for these tenants will be $416 per
month: the tenant will pay thirty percent of their gross adjusted income towards the
total rent and the voucher will pay the balance of the rent.

17
A Primer: The Low Income Housing Tax Credit

In year six, the rent subsidies

may be renewed if contract funds are
available from the Federal govern-
ment. In the event rent subsidies are
not available, the rent charged to
these tenants will be the Public
Assistance shelter allowance pro-
vided by the New York State
Legislature. This shelter allowance is
currently $215 per month for a single
person.
Figure 9: Typical Apartment Layout

The remaining forty percent of the units will be marketed to individuals

earning between fifty one percent and sixty percent of the New York metropolitan
area median income. The median income for a single individual is currently $29,200.
Therefore, forty nine of the apartment units are targeted for single individuals earning
between $14,892 and $17,520 annually. The units will rent for $402 per month or
thirty percent of fifty five percent of area median income. Comparable units it the
area and/or in comparable areas of Manhattan rent for $400 to $520 per month.

One hundred percent of the units, under this marketing plan, fit the income
eligibility standards of the Low Income Tax Credit program.

18
 A Primer: The Low Income Housing Tax Credit

STUDY EXERCISE AND WRITTEN ASSIGNMENT

(1) Be prepared to discuss how tax policy is used in this case to encourage a
particular social policy. Your answer should analyze and critique the value of setting
tax policy to achieve social goals. {For class discussion only}

(2) Identify, for each of the three parties described in the case, several reasons
why they are involved in the project. {For class discussion only}

(3) Calculate the Low Income Housing Tax Credit for the Gouverneur Court
Apartments project on Table 2 using the information provided in Table 1 and the text
of this case. The New York State Division of Housing and Community Renewal
allocated tax credits to the project on November 15, 1991 and the owner irrevocably
elected the credit rate then in effect.

(4) Review the cash flow projections provided in Tables 4 and 5. Table 4 is the
typical investment pro forma projections with which we are familiar (i.e. income and
expenses are projected to rise evenly over the course of the investment). Table 5
represent a "worse case" where income rises at two percent per annum and inflation
on expenses rises five percent per annum. In both cases, rent subsidies are assumed to
be lost after year five. Table 5 was used to underwrite the project operating reserve.
Based on these sets of cash flow projections, would you consider Gouverneur a
"risky" project. Substantiate your answer in several paragraphs.

(5) Complete Table 6 incorporating the results of your calculation of the tax credit
above. Calculate the IRR for the investment.

(6) What are some the non-financial considerations related to this project that add
to the attractiveness of the investment? Identify at least two such features and explain
your answer in several short paragraphs.

(7) You are a development officer for NEF, write a brief (2-3 pages, typed and
double-spaced) proposal to the investment committee with regard to whether NEF
should or should not invest in the project. Do NOT forget to consider NEF's
minimum investment criteria. Make reference to the project's financials and other
salient considerations.

N.B. The written portions of the answers to these case study questions must be
typewritten and shall be handed in at the beginning of the class period. Be sure to
make a copy to which you may refer during class discussion. Questions marked
"class discussion only" need not be written up but you should be prepared to discuss
these fully.

19