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Ironing Out Mixed-Income Projects

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7 min read

As financing of affordable housing projects becomes more complex, ironing out the tax issues can make you appreciate today’s casual dress code. The industry struggles with rising construction costs, limited credits and volume caps, and continued demand for middle-income housing. The newly constructed Trella building (see sidebar) was able to tackle these wrinkles by having one legal entity own the Code Section 42 Low Income Housing Tax Credit qualified units and a separate legal entity own the market-rate units. By splitting costs between the two distinct projects, the development team was able to keep costs allocated to the low-income project low enough to satisfy the 50 percent test without any additional tax-exempt bond volume cap under Code Section 146. This article identifies strategies to consider when faced with a mixed-income project. 

1.   Why go to the trouble of dividing costs and ownership interests? 

A.  Bond Transaction – 50 Percent Test
To qualify for the LIHTC on a tax-exempt bond-financed transaction, buildings must meet the Code Section 42(h)(4)(B) requirement that 50 percent or more of the aggregate basis of any building and the land on which the building is located be financed by tax-exempt bonds satisfying the volume cap rules of Code Section 146 (50 percent test). The available volume cap bonds may be insufficient to finance 50 percent of the costs of both the low-income portion of the building (LIHTC Project) and the market-rate portion (Market Project). Thus, we need to ensure that the costs attributable to the Market Project are not included in the LIHTC Project’s 50 percent test computation. And because the 50 percent test applies on a building-by-building basis, the LIHTC Project must be treated as a separate building from the Market Project for tax and local law purposes. 

B.  Next Available Unit Rule
For a LIHTC unit to continue to generate credits when a tenant’s income increases over 140 percent of the applicable income limit (over-income unit), any next available unit in the building (that is of comparable or smaller in size) must be rented to a low-income tenant (Next Available Unit Rule). If the only unoccupied unit in the project at the time a LIHTC tenant goes over-income is a market-rate unit, the project would be forced to lease the market-rate unit to a low-income tenant and accept rents lower than projected at closing. However, a unit is not subject to the Next Available Unit Rule when it is no longer available for rent due to contractual arrangements that are binding under local law. If the legal ownership of the LIHTC units and the market-rate units is separate, the owner of the LIHTC units would have no right contractually to rent a market-rate unit to a low-income tenant.

2.   How can you demonstrate separate legal interests?
Dividing legal ownership of real estate—and ensuring the entity owning the LIHTC Project (LIHTC Owner) and the entity owning the Market Project (Market Owner) are treated as two separate legal entities—will rely heavily on local law. It is important to work closely with your local counsel to ensure the proper ownership and financing documentation is in place, otherwise, the IRS may treat the LIHTC Project and Market Project as one. Projects should ensure as many of the below-listed factors as possible are met:

Separate Entities and Estates

  • Separate LIHTC Owner and Market Owner entities are duly formed under the applicable state law;
  • Property conveyance documentation (1) conveys separate and distinct estates in the building, and (2) generates separate and distinct tax parcels pursuant to local law; 
  • Documentation consistently represents that the parties intend for LIHTC Owners to be the owner of the LIHTC Project for tax and local law purposes, but not the Market Project;
  • Each entity holds a separate title insurance policy, which insures that entity’s interest in its respective portion of the building; and
  • Each project could be acquired separately and apart from, and irrespective of, the acquisition of the other project.   

Separate Financing

  • Plans of finance are separately negotiated, generated and documented for each project;
  • Each entity directly incurs all debt relating only to its respective project;
  • Tax-exempt bond documents expressly specify that the bond proceeds should be used solely on the LIHTC Project;
  • No proceeds of the Market Owner’s financing are used for the LIHTC Project; 
  • Projects are not cross-collateralized; and 
  • Any default by the Market Owner constitutes a default as to the Market Owner only.

Separate Acquisition, Construction & Operation

  • Each entity enters a separate construction contract and architect contract for the construction of its respective portion of the building;
  • LIHTC Owner is only entitled to the operating profits (i.e., tenant rent payments) of the LIHTC units (and the Market Owner has no right to recover unpaid rent owed by LIHTC tenants);
  • LIHTC Owner is only responsible for operating expenses, real estate taxes and insurance costs of the LIHTC Project; 
  • Each project is operated independently of one another, other than with respect to certain common areas within the building and the physical connection of the two projects; and 
  • All construction costs paid for and included in the eligible basis for the LIHTC Project should be attributable to the LIHTC units.

These factors, and their documentation, help establish that tax-exempt bond proceeds are used solely for the LIHTC Project. Further, they help support the conclusion that the LIHTC Owner has no legal right or interest in the Market Project. As a result, Market Project costs should be excluded from the 50 percent test computation and the LIHTC Owner cannot rent a market-rate unit to an over-income tenant. 

3.   How do I divide costs between the LIHTC & Market Project?
The Internal Revenue Service requires that costs be allocated using a “reasonable method.” The most common allocation methods in LIHTC transactions are square footage and unit count (i.e., if the LIHTC units comprise 70 percent of the rentable square footage of the building, then 70 percent of the costs should be allocated to the LIHTC Project). These cost allocations must include both hard costs and soft costs of the development (i.e., including developer fees), as well as the division of the land underlying the project. Owners should obtain land appraisals or reasonableness opinions from experts supporting the purchase price or ground lease payments being paid by each project owner. Costs associated with shared elements of the building (i.e., common spaces, roofs, hallways, shared HVAC, etc.) must also be allocated between the projects. With the cooperation of local counsel, pursuant to a cost-sharing agreement between the LIHTC Owner and the Market Owner, each owner should be responsible for paying its respective share of common costs. 

Development teams are finding efficiencies in the creation of entities, which only own and pay for the portion of facilities that will be used by low-income tenants through cost-sharing agreements, reasonable allocations and separations of legal ownership. With these strategies, mixed-income properties may be another “wrinkle releaser” in our LIHTC laundry room to ensure efficient use of our limited credits and volume cap.   

Urban Atlantic and Horizon Development Properties are under construction on a development located at the intersection of Eighth and Tryon in Uptown Charlotte, NC.

The project, Trella, is part of a larger 353-unit mixed-income development, including 106 affordable units and 247 market-rate units evenly dispersed throughout the building. The development will feature various shared common areas/community amenities integrated throughout the property. Notable community amenities will include an on-site management office, covered outdoor area, community room, computer center, fitness center, a rooftop pickle-ball court and swimming pool.

The development is projected to be completed in 2025.