CRS Examines Low-Income Housing Tax Credit

The LIHTC, created under the Tax Reform Act of 1986, is a federally provided tax incentive that is intended to encourage the development of affordable rental housing for low-income families. LIHTCs are allocated to each state according to its population. States, in turn, award LIHTCs to developers of qualified projects. Developers can either keep the tax credits to reduce their own tax liability, or sell them to investors to raise capital for their projects. The LIHTC, which is claimed annually over a 10-year period, is used to offset a portion of the project's cost. The cost offset provides developers of affordable rental housing a production subsidy. As a result, the tax credit can, potentially, lead to the construction of more affordable rental properties.¹

The LIHTC program is designed to deliver a 30% or 70% subsidy, depending on the nature of the project. Rehabilitated and federally subsidized construction is eligible for the 30% subsidy, whereas new non-federally subsidized construction is eligible for the 70% subsidy. The subsidy is computed as the present value of the 10-year tax credit stream expressed as a fraction of the project's eligible basis (costs).

The U.S. Department of the Treasury uses a formula designed to ensure that the 10-year tax credit stream produces the 30% or 70% subsidy. The formula depends on three factors: credit period length, desired subsidy level, and current interest rate. Under current law, the length of the credit period and the subsidy levels are fixed, while the interest rate changes over time. Given the current interest rate, the formula determines the LIHTC rate that delivers the desired subsidy level. Because there are two different possible subsidy levels, there are two possible credit rates. The lower credit rate, generally referred to as the "4%" credit rate, is used to obtain the 30% rehabilitation subsidy. The higher credit rate, generally referred to as the "9%" credit rate, is used to ensure the 70% subsidy for new construction. Once the credit rate has been determined it is multiplied by the project's cost to obtain the annual LIHTC.

In general, the rehabilitation and new construction credit rates are not exactly 4% and 9%, respectively. The actual credit rates depend on the current interest rate used in the Treasury's credit rate formula. The interest rate used by the Treasury is subject to market fluctuations.² These fluctuations in the interest rate cause the LIHTC rate to change over time. Since 1987 the credit rate associated with the 30% subsidy has ranged from 3.33% to 4%, while the credit rate associated with the 70% subsidy has ranged from 7.69% to 9.27%.³ At the same time, the project subsidies themselves have remained constant at 30% and 70%.

There may be a difference between the credit rate a project is expected to be awarded and the credit rate actually awarded. This difference in expected and actual credit rates arises from the time between when the credit is awarded and when the credit claim is made (when the project is placed in service). The credit rates are determined each month to ensure that all projects placed in service in that month receive the appropriate 30% or 70% subsidy. Potential developers and investors interested in pursing a LIHTC project will form an expectation about the credit rate they believe will be awarded once the project is completed. The accuracy of their predictions will determine to what extent the expected and actual credit rates differ. Once a project is placed in service and an award has been made, the credit rate is then fixed for the entire 10-year credit period. Regardless of the size and timing of the credit rate award, the subsidy a project will receive at completion is always fixed. This fixed subsidy feature of the LIHTC program was intended to insulate the subsidy from market fluctuations.

An Example

The LIHTC rates are calculated each month by the U.S. Department of the Treasury. The credit rates for a particular month are applied to all projects placed in service that month. The formula used to determine the credit rates ensures that the present value of the 10-year tax credit stream produces a total subsidy equal to either 30% or 70% of the project's eligible basis, depending on whether the building is rehabilitated or new. The present value of the 10-year tax credit stream depends, in turn, on interest rates that vary monthly. Therefore, as interest rates change, so too will the tax credit rate.

Table 1 presents an example of how a change in the current interest rate will cause the tax credit rate to vary. In the example, a new construction project is assumed with eligible basis equal to $500,000. The project is thus eligible to receive the "9%" credit. As previously mentioned, the actual credit rate awarded to the project will be such that the present value of the 10-year tax credit stream produces a subsidy equal to 70% of the project's cost, or $350,000. The credit rate that satisfies this requirement will depend on the interest rate used in the Treasury's credit rate formula.

      Table 1. LIHTC Rate Response to Interest Rate Change

Columns A and C of Table 1 illustrate the relationship of the credit rate to the interest rate by considering a one percentage point deviation from the interest rate in column B. A decrease in the interest rate used by the Treasury leads to a fall in the credit rate, whereas an increase in the interest rate causes the credit rate to rise. Again, however, the subsidy is constant at 70% of the project's cost across both of these interest rate changes.⁴

The relationship between the interest rate, the credit rate, and the subsidy follows from the formula used by the Treasury to fix the present value of the subsidy. To see this, consider an increase in the interest rate. All else equal, an increase in the interest rate would cause the present value of the tax credit subsidy to fall below 70%. Current law requires, however, that the present value remain constant. Thus, the credit rate must increase to keep the present value of the total 10-year tax credit stream at 70%. Likewise, all else equal, a decrease in the interest rate would cause the present value of the tax credit subsidy to rise above 70%. Again, current law prohibits this. Therefore the credit rate must fall in response to an interest rate decrease if the subsidy is to be held constant.

Legislative Developments

Legislation in the 110^th Congress has proposed several changes to the formula used by the Treasury to calculate the LIHTC rate. H.R. 5720 and H.R. 3221 (as amended and passed by the House) would change the applicable credit rate to the greater of the average rate over the preceding calendar year, or the variable rate as determined under the current method. A Senate amendment to H.R. 3221 (S.Amdt. 4983) proposes to temporarily institute a minimum credit rate not less than 9% for new construction placed in service before December 31, 2013.⁵ Therefore, the applicable credit rate would be the greater of 9%, or the rate as currently determined. A similar provision contained in S. 2666 provides that rehabilitation projects would receive a credit not less than 4%, whereas the credit rate awarded to new construction would be not less than 9%. This change would be permanent.

The effect of a credit rate floor on the applicable credit rates and the size of the subsidies would depend on the spread between future credit rates, as currently determined, and the proposed floors. The credit rate floor will have no effect if future credit rates are at or above the floor rates. This is because the credit rate floors impose a lower bound below which the credit rate can not fall. If future credit rates are above the floor, the lower bound becomes non-binding and therefore has no effect. Because the credit rate is not changed in this scenario, the subsidy level is also left unchanged at either 30% or 70%, depending on the type of project.

On the other hand, if future credit rates are below the floor, as current credit rates are, then the effect will be for the credit rates to increase. As a result, the projects subject to the floor will be conferred subsidies above the 30% or 70% level. The size of the subsidy increase will depend on the extent to which the credit rates fall below the floor. The greater the difference, the larger will be the increase in the subsidy.

As previously mentioned, the current LIHTC rates are less than the proposed floors, suggesting that if the floors were instituted today, the applicable rates and subsidy levels would increase. Current conditions, however, may not accurately predict future conditions. Some insight may still be gained from examining the trend in historical credit rates. Figure 1 displays the LIHTC rate for each month since January 1987, the beginning of the program. The two dashed lines represent the proposed 4% and 9% floors.

 

Figure 1. Historical LIHTC Rates

 

 

 

Figure 1 indicates a downward trend in both the new construction and rehabilitation construction credit rates. If these trends continue then credit rates in the near future may be expected to fall below the 4% and 9% floors, future credit rates may be less than a floor calculated as the average credit rate from the previous calendar year, and current legislative proposals would likely increase the subsidy projects receive. The increase in the subsidy would likely be larger under the fixed 4% and 9% floors rather than the average-rate floors. Moreover, if current trends continue over time the credit rates will tend to move further away from the fixed floors than the average-rate floors. The greater the difference between the floors, the greater the increase in the project subsidies.

Appendix. Present Value of Low-Income Tax Credit Stream

This example illustrates empirically that the present value of the 10-year tax credit stream presented in Table 1 is constant across all three interest rate scenarios.

The present value of the 10-year tax credit stream may be written mathematically as

 

 

Qualified costs are equal to $500,000 in the example presented in Table 1. The middle column of Table 1 assumes an interest rate of 2.90% which results in a credit rate of 7.93%. Plugging these values in to the formula above gives

 

 

 

 

 

 

² The interest rate used by the Treasury Department is equal to 72% of the average of the annual federal mid-term rate and the annual federal long-term rate (Internal Revenue Service Rev. Rul. 88-6).

³ U.S. Department of the Treasury, Internal Revenue Service, Revenue Ruling 2003-71, Table 4, Appropriate Percentages Under Section 42(b)(2) for July 2003, Internal Revenue Bulletin 2003-27, July 7, 2003; Internal Revenue Code Section 42(b)(1); Revenue Ruling 89-39, Table 4, Appropriate Percentages Under Section 42(b)(2) for April 1989, Internal Revenue Bulletin 1989-14, March 21, 1989; Revenue Ruling 2004-102 , Table 4, Appropriate Percentages Under Section 42(b)(2) for November 2004, Internal Revenue Bulletin 2004-45, November, 8, 2004; Revenue Ruling 89-65, Table 4, Appropriate Percentages Under Section 42(b)(2) for May 1989, Internal Revenue Bulletin 1989-19, April 20, 1989.

⁴ The Appendix verifies that the subsidies in Table 1 are indeed constant across all three interest rate scenarios.

⁵ H.R. 3221, then called the New Direction for Energy Independence, National Security, and Consumer Protection Act, was introduced in the House by Representative Nancy Pelosi on July 30, 2007. It passed the House on August 4, 2007. The Senate amended and passed H.R. 3221 on April 10, 2008. The House amended and passed H.R. 3221 on May 8, 2008. The Senate approved several amendments to the bill on July 11, 2008.