By Sidney Grossfeld, Partner and National Director, Affordable Housing Group

Successful affordable housing programs are beginning to line America's roadways, replacing the failed developments that have blighted urban landscapes since the 1950s. Visits to cities across the country are visible proof that affordable housing initiatives for low-income individuals and families are being steered into a new and prosperous era.

For more than 10 years, federal and state governments have been driving this new, more effective means of providing affordable housing. This has been accomplished by providing tax credits to developers, syndicators, financial institutions and direct investors as an incentive to build rental housing for Americans who are financially challenged.

Section 42 low-income housing tax credits have generated public/private cooperation since their introduction in 1986. Congress created the program to promote the development of affordable, safe and sanitary housing for employed and employable low-income individuals and families. Rather than a direct subsidy, as in the past, the low-income housing credits encourage investment of private capital by providing a tax credit to offset an investor's federal income tax liability.

To date, Section 42 tax credits have spurred the building of more than 900,000 housing units, accounting for nearly 40% of all multi-family housing generated nationwide in the past decade. The average household income for these properties approximates 38% of the area median income, well below permitted maximums. The program has created well-managed residences with very affordable rents.

In April 1997, the program received positive review form the fact-finding arm of Congress, the U.S. General Accounting Office (GAO). If the government wants to afford every low-income American an opportunity for decent, standard housing and promote a drug and crime-free environment, then Section 42 has come a long way toward achieving that goal. The program appears to be the most successful government initiative of those designed to provide suitable housing and affordable rents.

The initiative is working where so many others before it have failed. The success is a direct result of the reliance upon capital form the private sector rather than direct government financing. Additionally, individual states administer the program and issue credits to properties meeting state-specific housing requirements as detailed in their respective Qualified Allocation Plan (QAP), and not dictated by an unfamiliar federal government. The credits are issued for private investment in renovation or new construction of affordable housing.

The government starts the process - market forces handle the rest. Investors, from small developers to large corporations, can take advantage of this program if they know how to utilize it properly while avoiding potential pitfalls. Both investors and residents of the new or renovated housing ultimately benefit.

Section 42 goes beyond a simple tax credit. Flexibility keeps the program valuable and viable. The program gives developers architectural leeway as to what types of properties they are permitted to build - thus granting them more independence. The rules are not federal guidelines that dictate construction direction. On the contrary, the developers have the leverage to establish more down to earth, friendly, home-centered neighborhoods and not the concrete jungles that resulted from past failed developments.

The credit allocations available are based upon federal guidelines. The federal government grants each state an annual cap on tax credits equal to $1.25 for each state resident. The annual tax credit is calculated by multiplying the applicable credit percentage by a given development's "qualified basis" - which is that portion of the cost of acquisition, construction and rehabilitation that is dedicated specifically to low-income housing.

Some terms need definition in order to calculate tax credits: the eligible basis, is generally equal to the total cost of construction (both hard and soft costs) determined at the end of the first year of the credit period; the applicable fraction, is the lesser of the ratio of low-income units to all residential units in the project, or the ratio of total floor space in the low-income units to the total floor space of all residential units in the project; the qualified basis, is the eligible basis, multiplied by the applicable fraction. To determine annual credit, multiply the qualified basis by the applicable percentage generally approximately 4% or 9% of qualified basis depending on the circumstances. It is important to note that in order to secure the credit and avoid recapture, certain income targeting and rental restrictions must be maintained throughout the holding period. (The example provided represents the fictional development of "Sun Oak Apartments.")

Section 42 tax credits are generally allocated and monitored by an agency, designed by the State's Governor. As a general rule, states must give priority to projects that serve the lowest income tenants, but they have a lot of leeway to determine how and why, and in what manner they utilize their credits. For example, the state can decide whether it will focus on blighted urban areas or establish priorities for development in their depressed rural areas, or whether to provide incentives for mixed income or special targeted populations.

The competition for credits has been intense and healthy. For example, as of July 1997, Colorado had 29 development applications seeking $10 million - only $3.2 million in credits were awarded to 10 developers. Michigan received 56 applications and approved 13. The Illinois Housing Development Authority (IHDA) had 51 applications and 17 approved. California saw 170 applications and approved only 38.

Large "C" Corporations with a steady stream of taxable income have fueled the demand for the credits. The treasurer's department of these large corporations, required to meet corporate goals with regard to return on investment view tax credits as a prime investment in meeting corporate objectives. Even today, with annual yields as low as 9%, demand continues to be brisk.

To secure one of these coveted credits, a developer must be prepared. There are two general items developers, syndicators and other parties interested in Section 42 should thoroughly understand. First, before becoming involved, the parties should determine how applications have progressed in preceding rounds of credit allocations and how many credits a state has already allotted. For example, while it may be advantageous to construct or rehabilitate housing in Florida, new investors are not going to earn any tax credits in 1997 since that state exhausted all available credits in June.

Second, interested parties need to know about a state's qualified allocation plan requirements and other extended-use agreements. The federal government requires that projects must make at least 20% of the units available to renters with 50% or less of the area median income, or ensure 40% of the housing is available for tenants at 60% or less of the area median. Developments must then be held for low-income use for a minimum of 15 years.

In contrast, states can stipulate further restrictive requirements. For example, some states require that such housing be reserved for low-income use for 30 years or more. Other states prioritize mixed income housing, or accessible housing for disabled persons and the elderly. While still others seek to provide more development in rural areas. As such, the program allows each state to customize its involvement to best suit the needs of its community.

This information is especially important for property managers. The individual sitting in the leasing office need to know the state-specific requirements of the program if the project is to remain in compliance and avoid recapture.

Other questions that must be considered before beginning the process include: What is needed to complete the application? What type of housing developments is the state looking for? What kind of interest is there in the proposed development? Who are the competitors? Reading all associated information carefully prior to filing an application is paramount in low-income tax credit programs. Developers can not be too prepared. Because all states have different application processes, developers should seek out local experienced and qualified consultants to provide state-specific and federal information. State agencies can file a Form 8823 - Notice of Non-Compliance, or even sue for breach of contract, if a property is not in compliance with state requirements.

Currently, the states have been penalizing developers for certain non-compliance issues. It therefore behooves a developer to insure that his management company has a copy of the credit application and reservation in the leasing office so that the property manager knows exactly what set-aside and other requirements, as well as rental restrictions, exist for a given property.

The differences aside, all states seek one thing: prepared applicants. Most states will not consider applications unless a developer can demonstrate that they are ready to proceed with the project almost immediately. Having full descriptions of the property, architectural drawings, zoning waivers, permanent financing, commitment letters and as 15 year projection of operations illustrating that the project will remain financially feasible throughout the federal holding period are the minimum requirements necessary to show the state agency that a development is ready to proceed once the credits are granted.

States have the ultimate fiduciary responsibility for these developments, as such they do not want to grant credits to an unprepared developer whose development may fail after it starts. One suggestion from the recently issued GAO report will require states to obtain independent verification of the developer's submitted sources and uses of funds in conjunction with the development of the project.

Developers also must be aware that state credit allocating committees have individual requirement deadline dates for submitting credit requests and that states differ in requirements for report submission. Cost certifications and carry-over credit allocation reports for developments not completed in the year the credit is granted must be submitted to the respective states by predetermined dates.

In addition, the choice of "place in service" date can affect the year in which the credit is first taken and the number of years in which the credit can be taken. Often developers and/or investors rely on consultants for their expertise for performing initial due diligence and ongoing compliance monitoring. Having a firm on board that is familiar with tax credit projects can provide additional security from the drawing board to completion of the project's holding period.

State compliance monitoring requirements and the frequency of such monitoring vary. The IRS requires extensive record-keeping and the retention periods are generally long. Moreover, the calculation of gross rent and the maintenance of set-aside requirements can be complicated and must be administered by a reliable property management company to prevent credit recapture.

Further, trouble can always arise between the parties themselves which are involved in the development. In such instances, due diligence is the key. It is important to be certain everyone knows what everyone else's obligations are and ensure that all parties can meet their responsibilities.

Due to the popularity of the program and the difficulty in attaining credits from a state's limited set-aside, many developers have, and all developers should, consider utilizing tax exempt bond financing. The rules with respect to tax exempt bond financing and tax credits are complex and either a consultant or other professional should be contacted before starting the application process.

On the downside, in the 11 years since the program began, the amount of tax credits has not kept up with inflation. Today there are less credits available and the price of those available has gone up significantly, lowering the overall return. If the program is going to continue to succeed, it needs to be indexed to inflation. To address this situation, proposals are currently before Congress to increase the credits to $1.75 per resident per state.

Despite its minor problems with respect to parody between the program and the rate of inflation, Section 42 credits are certainly worth a closer look for potential investors. If the program continues on track, thousands more families will have decent housing by the next century. These people will have the sense of security that comes from a safe and respectable home, while investors and developers who took the time at the front end of the tax credit application processed will have the security of a respectable return on their investment.

Sidney Grossfeld , National Director of the Affordable Housing Division of Altschuler, Melvoin and Glasser LLP, is based in Los Angeles. His areas of expertise include syndication, development, due diligence (pre and post acquisition), government auditing, compliance reporting and property management, with special emphasis on HUD programs, low-income housing credits and compliance reporting. For additional information on this subject, please e-mail, sgrossfeld@amgcpa.com , or call, 310.282.8588, or 1.800.247.6987.