The respective purposes of the New Markets Tax Credit Program (NMTC) and the Low-Income Housing Tax Credit Program (LIHTC) are entirely complementary. NMTCs attract privateinvestment into low-income community businesses by providing a 39% tax credit based on the amount of an investor’s qualified equity investment (QEI) into a community development entity (CDE), which makes a qualified low-income community investment (QLICI) in or to a qualified active low-income community business (QALICB) located in a low-income community. LIHTCs encourage the construction and development of affordable rental housing. Together, they can transform a community by creating thriving businesses and safe and affordable housing. However, on a regulatory level, LIHTCs and NMTCs are virtually incompatible.
LIHTC and NMTC Incompatibility
LIHTC and NMTC incompatibility is the direct result of two conditions. First, the requirement that an NMTC project receive at least 20% of its income from commercial activity prevents the project from benefiting from the Internal Revenue Service’s (IRS) favorable depreciation rules for residential property thereby essentially eliminating one of the most important incentives in housing development. Second, and more significantly, Treasury Regulation §1.45D-1(g)(3)(C)(ii) specifically prohibits any loan or investment from being categorized as a QLICI if a building’s eligible basis for the LIHTC is financed from that loan or investment. Simply speaking, NMTCs are not made available to a project when NMTC funds are used as the basis for LIHTCs. Despite these issues, it is still possible for developers to use both tax credits to finance one project.
Dual Ownership Condominium Structure
The depreciation and basis limitations are considerable, but they do not completely prevent LIHTCs and NMTCs from being used to finance the development of the same project. The most common method for combining the credits is to divide the project into two condominium units whereby the QALICB owns the commercial condominium unit generating the NMTCs and a single purpose entity created specifically for the project owns the residential condominium unit generating the LIHTCs. The advantages to this structure are obvious. The developer is afforded the opportunity to maximize tax credit equity to fund construction, and city planners and prospective tenants benefit from the mixed-use amenities. From a lender perspective, however, the dual ownership condominium structure can create additional complications. Issues including Intercreditor Issues, Property Management and Condemnation & Insurance Proceeds are highlighted below.
Generally, developers will use the same lender for both the commercial and residential condominium units. As such, the lender becomes familiar with both sides of the project and can develop a comfort level with the prospects of both condominium units. Yet, due to the considerable differences between the units and their respective sources of operating income, it is not unusual for different lenders to finance each unit. Naturally, this creates a host of complications.
The project will only succeed, and the lenders will only benefit, if both units are successful. Each lender must be assured that the terms provided by its counterpart are feasible and suitable for the project. If one unit is thrown into financial distress, the turmoil will undoubtedly create a drag on the other unit. This could be particularly damaging during construction. Depending on the building’s layout and condominium plan, the inability to finish construction on one unit could irreparably harm the development of the other unit. The residential unit in particular needs to be constructed in accordance with a strict timeline to meet its placedin- service deadline to qualify for the LIHTCs and to avoid certain repurchase dates imposed by the LIHTC investor. Failure to meet these deadlines could severely jeopardize the residential unit’s receipt of the LIHTCs.
In a similar vein, the developer will need to decide whether each unit should have a separate construction contract or whether both unit owners should be a party to a single construction contract. If the former option is chosen, the developer must ensure that the lenders are aware of how delays or disputes under one contract will affect the other. In the case of the latter option, the single contract will need to be very specific about how costs are allocated between the two units so as not to jeopardize each unit’s respective basis calculation. The condominium plan is also of utmost importance. A lender must be comfortable that if it foreclosed on its unit, the unit could be operated or sold as a stand-alone project. Accordingly, the lender and its advisors need to scrutinize the condominium plan to determine if the common elements are sufficient to service both units and whether the foreclosure of one unit might affect the access or services provided to the other.
Most developers that attempt to combine LIHTCs and NMTCs through the dual ownership condominium structure are savvy enough to choose experienced property managers familiar with both the LIHTC and NMTC regulatory regimes. Nonetheless, lenders should still thoroughly evaluate the property manager. Property managers serve on the front line with respect to a project’s tax credit compliance. For example, property managers are essential for screening and selecting tenants. Selecting the wrong tenants, such as an excluded business (e.g., massage parlors and credit unions) for the NMTC unit or non-qualifying persons for the residential LIHTC unit, could seriously jeopardize the tax credits for one or both of the units. Lenders should always reserve approval rights for the property manager in their loan documents and scrutinize the property manager’s experience in managing tax
credit supported projects.
Condemnation & Insurance Proceeds
Lenders should be particularly aware of how condemnation and insurance proceeds might be shared among the various parties, including the unit owners and the lenders themselves. It is possible, depending on when a condemnation or casualty event occurs during the NMTC and LIHTC compliance periods, that the NMTC parties and the LIHTC parties will have competing interests with respect to how proceeds should be applied across the condominium. Moreover, the condominium plan must be precise in its demarcation of the units. The plan must be such that the parties involved can quickly determine which unit the condemnation or casualty affects. Without such clarity, the two owners, the tax credit investors and the lenders could easily get bogged down in otherwise avoidable disputes which could delay and adversely impact the viability of the entire project.