The Rundown on Tax-Exempt Bonds

8 min read

A Critical Component of Affordable Multifamily Housing Projects 

Private activity bonds (PABs), a type of tax-exempt bond, are a critical component of affordable, multifamily housing projects. But just how are the bonds divvied out by states and how are they most often used? We spoke with some experts in the bond field to learn some of the ins and outs of this revenue source.

“In 2015 and 2016, usage of the PABs for rental housing ramped up in a big way…states began to really run out of them,” explains Peter Lawrence, director of public policy and government relations for Novogradac & Company LLP.

Affordable housing developers who are awarded a PAB are then awarded four percent Low Income Housing Tax Credits. This process differs from the other part of the LIHTC program – the nine percent tax credit program, which awards tax credits directly, without the need for a PAB award. The LIHTC statute requires that at least 50 percent of the land and building costs of each development be financed through Federal PABs in order to be awarded four percent LIHTC. The Affordable Housing Credit Improvement Act, expected to be reintroduced early this year would push that requirement down to 25 percent. Regardless, applying for the bonds can be complicated with each state taking a different approach, adds Paula Prahl, partner and chief policy and corporate affairs officer and executive vice president for development at Dominium Development & Acquisition, LLC.

“It’s not for the faint of heart,” explain Prahl. “It takes time to apply, and you have to understand how each state does it…You have to learn the ropes and play by the rules.”

A Patchwork of Programs Across the Nation
The programs for PABs vary widely throughout the nation. The bonds are issued by the federal government and each year the Internal Revenue Service sets a per capita amount for the revenue bonds. For 2023, the per capita amount is $120 per person in each state or about $359 million, whichever is greater. Most states use the per capita figure. California, for instance, will likely receive about $4.7 billion because of its large population, although the Internal Revenue Service has not yet issued its annual state population notice.

Tax-exempt PABs, which are administered by the states, can be used for a wide variety of purposes from rental housing or mortgages for first-time home buyers to student loans and industrial development bonds. Some states have statutes in place that describe how the bonds will be used, while in other states the governor determines the eligible uses.

“It is not uncommon for a state to make an initial bond allocation plan and if things don’t turn out as they planned, they may adjust mid-year,” explains Lawrence.

Lawrence says the nation’s housing crisis compelled a growing number of states to use their PAB volume cap for housing, specifically multifamily rental housing, which is the only use that will trigger federal tax credits. In 2020, the top five states that used the bonds for multifamily housing were California, New York, Texas, Florida and Georgia, with Washington close behind. Massachusetts, Colorado, Ohio and Minnesota also are big users of the funds for housing.

“California has a huge housing issue, like every state at this point,” says Prahl. “California says they will take 100 percent of the bonds and use them for housing.

Tennessee is similar, but not quite at 100 percent.”

Minnesota, Prahl adds, uses part of the annual allocation for multifamily housing projects, and preserves another portion to help first-time homebuyers.

“The second use does not get any tax credit,” Prahl explains. “It’s a great public policy, but it leaves federal money on the table.” Any use that is not multifamily development leaves federal money on the table. As states look to use surpluses and try to solve housing availability, they would be wise to remember that. One-time expenditures could be used for the other PAB uses and the state could maximize multifamily development, using the full federal funding available to them.”

“Lawrence says his firm collaborates with Tiber Hudson, a law firm that specializes in PABs to estimate the status of demand for the bonds in each state. They rank a state as “oversubscribed” if demand exceeds the amount of bonds. A “parity” state is one where demand is equal to the bonds. An “undersubscribed” state is one where more bond money is available than there is demand. Based on that study, 20 states, including the District of Columbia are categorized as oversubscribed, eight states are at parity and 22 states are undersubscribed.

“Oversubscribed states tend to be more highly populated and have high housing costs,” explains Lawrence. “The undersubscribed states tend to be smaller states and those with lower housing costs.”

Process for Divvying Out the Bonds
Prahl explains that the process for divvying out the bonds also varies from state to state.

“Some states give the funds to agencies and the agencies allocate as they see fit,” she says.

For instance, in Texas, the funds are dispersed to 15 agencies, which then disburse the funds to applicants. In Minnesota, a statute dictates how much of the annual money will go to housing, some of which is dispersed by the state fiscal agency, while other funds go directly to the state housing agency and others to big cities.

Khayree Duckett, a government relations associate for Dominium, explains that in some states, Georgia among them, a formula for disbursement is developed that divvies up the funds between rural and urban areas.

The application process and qualifying criteria for the bonds also vary from state to state so developers are advised to study the process closely and apply due diligence to the application process.

Sometimes states have PAB volume cap left over at the end of the year, explains Lawrence. States may carry unused cap for three years, but those funds will expire once the fourth year is hit, he adds.

“Once an authority has carried over funds that are targeted for a specific usage, they have to be used for that specific use,” Lawrence says. “You can’t change your mind for a subsequent year.”

Lawrence says the competition for bond capital can be intense, especially in California and Washington. He adds that it can be more intense than the competition for nine percent LIHTC. Maximizing the affordability of projects can make a project more competitive, Duckett adds, for instance by targeting housing at 50 percent of the area median income rather than 60 percent.

“Every state has a slightly different process with scoring (of the applications),” explains Lawrence. “It is competitive.”

Demand Increased in 2015, But May Go Down
Lawrence says demand for the bonds increased around 2015 to 2016 for a variety of reasons.

“People started to rent a lot more and rents increased,” he says. “When rents are not very high, it is hard to make financing work in bonds. You need to have high enough rent to support the debt. In 2015, you began to see rents come up considerably to the extent that more bond transactions became financially feasible.”

During that period, several states also established or increased State LIHTCs, which provide a good source of gap financing.

Lawrence says the usage of the bonds may shift now that interest rates are on the rise.

“A lot of states are under pressure to use more bond cap for homeownership for first-time low-income home buyers,” says Lawrence. “In the past, interest rates were so low, it wasn’t as much of an advantage to use PABs for homeownership, but now since mortgage rates have doubled, the competitive balance has shifted.”

Lawrence adds, “As interest rates rise, the financial feasibility of affordable rental housing comes under stress because of the higher level of debt. We are anticipating demand will start to slowly come down a little bit so there may not be as high of a bond usage as there has been in the past. We will monitor that to see if it is the case.”

Advocacy Helps
Prahl advises members of the development community to become active and communicate with policymakers about the need for these bonds.

“These are all discretionary decisions made by policymakers,” Prahl says. “In Idaho, the governor chooses what to do with the bonds. In other states, it is the legislature. These decisions are not set in stone. It is up to us to advocate…These are scarce resources. It is up to us as the development community to use these resources wisely.”   

Pamela Martineau is a freelance writer based in Portland, ME. She writes primarily about housing, local government, technology and education.