Analysis of the North Carolina Low Income Housing Tax Credit Statute

By Todd C. Brockmann

Last year, the North Carolina General Assembly passed SB1416, which provides remedial provisions to the state low income housing tax credit for 2000 - 2002 allocation years and completely overhauls the state credit for transactions receiving allocations in 2003 - 2005.  The statutory provisions applicable to prior allocation years can be found in N.C.G.S. §105-129.41, and the statutory provisions applicable to current and future allocation years can be found in N.C.G.S. §105-129.42.  The following is an analysis of the changes and the issues related to the revised state low income housing tax credit.

I. Remedial Changes Affecting  2000 - 2002 Allocations

A. Bifurcation Basis Limitation Reduced to 40%.  Prior to the revisions to the statute, a state-only investor was required to invest $1 into the project for each $1 of state credit received by the partnership.  Because an investor naturally will invest at a discount relative to the size, timing and federal tax consequences of any state tax credit, the dollar-for-dollar requirement in the prior version of the statute eliminated any economic incentive to invest in the state credit unless one investor was willing and able to invest in both the state and federal credit.  Under the modified statute, an investor is now only required to invest at least $0.40 for each $1 of state credit received.  This lower hurdle reflects the economic realities of syndication and allows for the bifurcation of the state credit to a state-only investor.  This ability should induce greater investor competition and a higher price paid for the state credit on projects that received allocations in 2000, 2001 and 2002.

B. General Recapture Limited to Five Years.  Prior to the revisions to the statute, any recapture of the federal credit during the fifteen year federal compliance period would result in a corresponding recapture of the state credit.  It seemed inappropriate that the fifteen year federal compliance period should apply to the five year state credit.  Based upon the revision to the statute, a recapture of the state credit resulting from a corresponding recapture of the federal credit now will be limited to the years in which the state credit was claimed.  Therefore, if the federal recapture event occurs subsequent to the fifth year (or sixth year in the event of a partial first year) of the federal compliance period, no recapture of the state credit will occur.  This limitation reduces the potential recapture risk of the investor and should help increase the state credit price for projects that received allocations in 2000, 2001 and 2002.

C. Change of Ownership Recapture Unchanged.  Unfortunately, there was no change to the recapture provision related to changes in ownership contained in subsection (f) of the existing statute.  Since the state low income credit statute was modeled after the state historic tax credit statute, this provision made its way into the initial state low income credit statute and has survived every subsequent amendment thereto.  In the context of the historic credit statute, this provision logically prohibits an investor from pulling out of the project immediately subsequent to its receipt of the one year historic credit.  However, because the state low income housing tax credit is a five year credit, a tax credit investor would be required to remain a partner for the full five years (or six years in the event or a partial first year) in order to claim the state credit.  In an attempt to prohibit an abuse that does not exist in the context of the five year low income tax credit, the statute unnecessarily prohibits the substitution of state credit investors in the event the current state credit investor can no longer use the state credit.

II. Nuts and Bolts of New “Refundable” Credit for 2003

A. Basic Statutory Structure of the 2003 Credit.  Now that the affordable housing community is generally comfortable with the structure and implications of the state credit in regard to past transactions based upon the remedial provisions in the statute, all 2003 projects will be based upon an entirely different program.  The credit for 2003 will be a one time refundable credit that is entirely “received” in the allocation year and must be used by the partnership to fund the costs of construction. 

The use of the word “received” is a bit deceiving since the money generated from the tax credit will not be available to the partnership until some time later in the construction period, depending on certain elections made by the partnership.  The partnership must elect (the timing of this election will be discussed in detail below) whether to (i) receive the credit as a “direct refund” or (ii) assign the credit to the North Carolina Housing Finance Agency (NCHFA), which will then lend the tax credit refund back to the partnership. 

Under the direct refund method, the full amount of the credit will be held by the NCHFA and released to the partnership upon certification of fifty percent completion of construction and used to pay down the outstanding balance on the project’s construction loan. 

Under the transfer/loan method, the refund will be assigned to the NCHFA and then loaned to the partnership for construction costs.  The 2003 Qualified Allocation Plan (QAP) provides that the loan structure will be thirty years with no interest and no amortization unless the partnership desires more stringent terms.   

B. Formula for Calculating Credit Amount.  The new method for calculating the state credit is based upon the “eligible basis” of the project for federal credit purposes.  The amount of the credit will be equal to 10%, 20% or 30% of the eligible basis, depending upon the location of the project and income limits (see the chart in subsection (c) of the new statute for more information).  This method is a distinct departure from the prior method of calculating the credit as a percentage (75% or 25%) of the federal credit. 

One appealing facet of the new credit is that the amount is fixed at the carryover allocation, so no adjustments will be made in the event the eligible basis changes during construction.  In the event of a non-compliance recapture of the federal credit during the first five years of the federal compliance period, the “corresponding portion” of the credit would be recaptured.  Interestingly, the recapture provision does not apply in the event the partnership elects the loan method of receiving the credit.  However, a federal credit recapture event would likely trigger a default under the loan made to the partnership by the NCHFA, so the effect would be similar under either option.

C. Tax Credit Delivery Mechanism.  Perhaps the most intriguing aspect of this new refundable credit is the mechanism for delivery of the tax dollars to the project.  Typically, tax attributes are passed through to the partners of the partnership.  This credit will not follow traditional tax methodology.  It will instead be “refunded” directly to the partnership (not its partners) and be converted into either (i) a cash receipt to the partnership under the direct refund election or (ii) a loan to the partnership from the NCHFA under the loan option.  In essence, the “refund” will be completely ignored for state income tax purposes because it will not be applied to the tax of the partnership or passed through to the partners even though the statute itself contemplates applying the state credit to tax due from the taxpayer (see subsection (d) of the new statute). 

III. Issues and Planning Decisions

A. Federal Tax Consequences Ignored in Legislative Process.  The most problematic issue with the new credit is the federal taxation of the state credit -- partly because of the economic effect and partly due to the failure of the legislature to consider federal taxation while structuring the state credit.  For example, the fiscal note attached to Senate Bill 1416 incorrectly assumed there would be no federal tax impact from the receipt of the credit.  However, income for federal tax purposes will be realized by the partnership upon receipt of the credit by the partnership under the direct refund method and may be realized under the loan method (see Section II.B., below).  Assuming a 35% federal tax bracket, the maximum potential efficiency of the credit will be 65 cents received by the project for every dollar of credit.  Moreover, the unexpected allocation of income prior to receiving tax benefits may reduce the efficiency to less than 65% as the tax credit investor grapples with the problem.

B. Tax Treatment of Loan Method.  As indicated above, the selection of the direct refund option would lead to income to the partnership in the amount of the credit.  The selection of the loan option is less clear in light of the unique structure of the credit.  Is it truly a loan that is non-taxable or something more similar to the taxable direct refund? 

The answer to this question hinges upon the determination of whether the partnership constructively received the credit before it is transferred to the NCHFA and subsequently loaned to the partnership.  The NCHFA has taken the position that the selection of the loan option should be treated as a loan for federal tax purposes (i.e. non-taxable to the partnership), and on March 11, 2003, it submitted a request for a private letter ruling from the IRS to that effect. 

In order to bolster its position, the NCHFA moved the election date for choosing between the direct refund option or the loan option so that the partnership must irrevocably elect its method of receiving the credit prior to receiving its reservation of tax credits on or about August 15th.  The theory is that the taxpayer’s ability to choose between the direct refund and the loan may cause the IRS to treat both options as taxable.  If the taxpayer has irrevocably elected to receive the credit as a loan prior to receiving an award of tax credits, it has no choice and no ability to receive the taxable direct refund. 

Initially, the NCHFA amended the QAP to require the election contemporaneously with the filing of the final application in May, but has since moved the date back to the earlier of July 31^st or the date which is two weeks subsequent to the issuance of the private letter ruling by the IRS.  The July 31^st date was targeted with the hope that the IRS will issue a favorable ruling prior to the announcement of 2003 awards in August. 

In any event, the requirement of an irrevocable election in the QAP appears to be in conflict with the plain language of the statute that provides for the election to be made in conjunction with the carryover allocation date (November 14^th in 2003).  At this point, it is anyone’s guess as to when or how the IRS will rule, so the entire process is still in flux.

C. Timing of the Income.  Assuming the credit is taxable to the partnership (we believe that taxpayers should assume the loan method is taxable until the IRS clearly indicates otherwise), when will it be income to the partnership?  Since the amount of the credit will be pegged at carryover allocation and the partnership will be an accrual taxpayer, it seems logical that the income will be triggered on the carryover date. 

However, if one digs deeper into the statute and the QAP, the taxpayer is not eligible to receive the credit until (i) 50% completion of construction if the taxpayer chooses the direct refund credit or (ii) the date the balance of the construction loan exceeds the amount of loan method credit.  Therefore, it appears that the income from the tax credit will not be triggered until well into the construction process at a time when the tax credit investor will likely be admitted to the partnership. 

A significant impact on federal tax credit pricing will occur if the investor is required to realize the income.  There are two issues to consider: (1) the investor must understand that income will likely be generated by the receipt of the credit and must price its equity accordingly and (2) the NCHFA cannot use a blanket underwriting approach to equity pricing in determining the amount of credits to allocate to the project.  For example, if the NCHFA uses a standard assumption of 75 cents for underwriting purposes but the developer uses a price of 68 cents to account for the income received by the investor, it is possible that the NCHFA may reduce the award assuming that the project is over-funded.  The downward effect on equity pricing will be the greatest in the 30% credit areas which have the greatest need for tax credit equity.  This issue must be carefully reviewed on each project by all parties involved in the transaction. 

D. Direct Refund or Loan?  The most substantive decision is the choice between the direct refund method and the loan method of receiving the tax credit.  As discussed above, while there is general agreement that the receipt of the direct refund will be income to the partnership for federal income tax purposes, the taxability of the loan method hinges upon the outcome of the private letter ruling request.  In the event a ruling has not been issued by July 31, each applicant will be required by the NCHFA to elect its method based upon less than all of the relevant information.  Keep in mind that selecting the loan option makes no sense if it generates income since the direct refund would have the same tax impact without the complications of a loan on the project.  As a result, if no resolution on this issue has been reached by July 31, the conservative approach would be to elect the direct refund and structure the income into the equity pricing.  Nonetheless, some developers may elect to take the risk that the loan option is not taxable.  There will be some tough choices to be made in the event the private letter ruling is not received in a timely fashion.

E. Revolving Construction Loan.  Even though the statute does not have this requirement, the QAP requires that the state credit be used to pay down the project’s construction loan.  The construction lender will need to be aware of this requirement, and the loan documents will need to allow it.  In essence, the construction loan will need to be a revolving loan that allows the one pay down during the construction period.

Todd C. Brockmann, Esq., is an attorney in Charlotte, North Carolina, specializing in affordable housing transactions that utilize low income housing tax credits.  He can be reached at (704) 331-4964 or tbrockmann@wcsr.com .