Why housing tax credits work
Although a case can be made for other programs (Section 202 non-profit elderly new construction and Section 515 rural family), most observers would rate the Low Income Housing Tax Credit (LIHTC), Section 42 of the Internal Revenue Code, as
- Politically, it’s existed for two decades, been made permanent and had its funding indexed to inflation in legislation cosponsored by almost 85% of Congress.
- Programmatically, it’s financed over 1,200,000 apartments, has minuscule default and foreclosure rates, today raises $6-8 billion of equity annually, helps finance something over 95% of all new affordable multifamily nationwide, and currently produces more apartments annually than conventional housing.
I doubt that anybody including its designers (such as Bobby Rozen) could have predicted this twenty years ago when the LIHTC was plucked from the tax shelter sinking ship.
“All the other tax shelters but you were drowned.”
Legislatively, the LIHTC was like the vulcanization of rubber, concocted almost by accident, and spectacularly useful.
It just happened that way.
How did it become so successful? For that matter, why?
Investment tax credit: definition
An investment tax credit is a fiscal initiative, deliberately created by government, intended to stimulate or give advantage to a particular investment.
Before we start, we have to distinguish the three species of tax credits.
We’re all graceful.
Three species of tax credits
· Social benefits transfer. Some tax credits are simply a disguised social benefit program that government thinks can be efficiently delivered through tax filings. In the
· Direct consumption. Some tax credits are intended to be consumed by the sponsor as an ex post facto rebate for a particular investment. Weatherization credits and Washington DC’s homeownership tax credit are two examples.
· Investment tax credits. Some credits are fiscal instruments; they are intended to stimulate a particular investment and depend for their success on syndication – that is, the sponsor selling the future tax credit to an investor for current cash.
Of these, social benefits transfer tax credits are the interlopers, trying to pass themselves off as investment tax credits when they are nothing more than a government rebate claimed through the internal revenue rather than through a normal welfare agency.
I think I can pass for an investment tax credit, don’t you?
[This linguistic blurring has given 'tax credits' an unwarranted black eye in places like the United Kingdom and Ireland, each of which used tax credits as a social benefit without appreciating that such a use is quite different from investment tax credits.]
There I was, defendin’ tax credits to the Brits.
Direct consumption tax credits really do act like a tax credit — they stimulate stakeholder behavior by promising an after-the-fact reward. Because they are used by the sponsor, they are very efficient in delivery (eliminating both the buyer and the middleman investment banker), and tend to be used at a small scale.
Investment tax credits — including the historic tax credit and the LIHTC — by their very nature create a market mechanism, because the amount of credit is so large that a typical real estate sponsor cannot consume it personally. Hence the sponsor is sent to the capital markets to find soft equity, which means there is (a) a market dynamic between buyer and seller, and (b) the manifestation of an investment banker who makes a business structuring buyer and seller investments.
But there are investment tax credits and investment tax credits, and yet in political and programmatic terms, the LIHTC stands head and shoulders above the others.
“One of these things is not like the others, one of these things is just not the same.”
What makes the LIHTC so nifty? A remarkable, one might almost say prescient, confabulation of features, some of which are intrinsic to fiscal tax expenditures rather than appropriated programs.
1. Risk transfer so government pays only after performance. Appropriated programs lay out the capital before the property is built, occupied, and successful. Investment tax credits pay afterwards.
Would he be as cheerful if you paid him up front?
2. Post-audit compliance. Participants self-certify their results, maintain backup documentation, and face severe financial penalties if they are discovered to have certified falsely. This out-sources the regulation (participants monitor themselves) keeps bureaucracy small. Further, compliance costs are built in to the underwriting, so properties pay their own costs.
3. Recapture is collectible because enforcement is against an investor, not against the property, and hence there is no economic hostage problem.
Appropriated programs (where the government pays cash up front) can simulate these three features — risk transfer, post-audit compliance, and recapture collectibility — but cannot duplicate them. For governments whose financial ecosystem is sufficiently complex, soft equity is a better kind of money to spend than either soft debt or hard debt.
Additionally, the LIHTC has several other features which could be duplicated on appropriated programs but often are not:
4. Capped and competed. The amount of credit is fixed, so sponsors have to compete with one another. This leads to a virtuous-circle feedback cycle as each year’s competition is a bit fiercer than the preceding one’s.
Each time I cycle, I get better.
5. Allocated on a use-it-or-steal-it basis. Each state has a specified amount to spend, with uncommitted amounts returned to a national pool where other states can claim it. As a result, each state is highly motivated to spend all of its credits.
Wanna try to steal those tax credits?
6. State-level allocation. As among the geographic levels of government — local, state, and Federal — local perspectives are too parochial, Federal perspectives too loftily distant. With most real estate markets metropolitan in scale, states are best positioned to develop an overall strategy.
State-level allocation is just right.
7. Annual award and feedback cycles. Each state’s cycle is yearly, and the allocation/ award process is largely transparent. The combination of published allocation plans, transparent scoring, and repeat competition leads both to rapid sponsor sophistication (losers learn from their mistakes, winners have to improve to stay ahead) and to lateral best practice (states sharing with states).
“It takes all the running you can do just to win an award each year.”
These features mean that the LIHTC, once created, has been able to self-replicate, like amino acids, which appear to have been a primeval fluke, a spontaneous creation of high temperature and lightning.
Simple, wasn’t it?
