This content was originally published by the Tax Credit Advisor

For nearly four decades, the low-income housing tax credit (LIHTC) has fueled much of America’s affordable housing construction. The functional bedrock of that credit, and the means by which it is calculated, is determining which costs are basis eligible and thus will make up the total cost from which the tax credit is calculated. In today’s dynamic building landscape, this fundamental component of a developer’s funding stack is receiving fresh attention as to how it can be better utilized to continue to fund badly needed affordable housing.

Basis eligibility is, in theory, a straightforward process rooted in the Federal Tax Code and is determined the same way for both 4% and 9% deals. From the outset of the project, the developer will have compiled projected eligible costs, and will later hire a CPA to audit those costs and submit them to state agencies, which ultimately make a final allocation determination and administer the funds.

Beth Mullen, CPA, a partner at CohnReznick, says that the cost certification process involves three steps. “If a client hires us to do cost certification, the first thing we’re doing is getting their books and records and what they say the costs were, and determining if those are the real costs – we’re auditing the costs.”

The second step is generally the most important, and one where the widest gulf can exist between a developer’s projected eligible basis and their certified costs. “Step 2 is determining if those costs are depreciable costs,” says Mullen. Those determinations are made using previously published IRS guidance, including the Tax Code, regulations and Technical Advice Memoranda, or TAMS. If a cost is depreciable, it is generally then eligible as a basis cost.

Finally, the CPA must look for special case costs that, though depreciable, are ineligible for the tax credit. For example, explains Mullen, the construction of commercial spaces is generally ineligible for the tax credit. “Though the cost would be depreciable, if you’ve got a commercial space, or costs that you charge a separate fee for, the IRS specifically outlines in Section 42 that those costs are not includable in the eligible basis.”

“The 9% program provides a higher subsidy amount than the 4% program,” explains Jennifer Schwartz, the director of Tax and Housing Advocacy at the National Council of State Housing Agencies (NCSHA). “Sometimes state agencies reduce the eligible basis available to a 9% project to ensure the property is not over subsidized. By law, state agencies may provide only as much housing credit equity as is necessary to make that property financially feasible. It is not uncommon for a state to reduce the total amount of basis, especially when there is a basis boost and depending on the degree to which other subsidies are available to the project. Because of this, there may be developers who will not even bother including certain things, because they know the state’s going to reduce basis to ensure that the property meets financial feasibility but isn’t over subsidized.” In a 4% program, however, because the subsidy level of credit equity is much lower than a 9% development, “developers are probably including every basis eligible cost” to maximize their tax credit allocation. “Those developments usually need every bit of equity they can get.”

The rise of the 4% deal

Until recently, the vast majority of LIHTC deals were done using the 9% program. However, today, developers have started to take more and more advantage of the 4% program, largely due to the combination of ever-rising development costs with the increased competitiveness of 9% deals. Khayree Duckett, government relations manager and policy lead at Dominium, estimates that the vast majority of LIHTC deals have historically been using the 9% credit. That dominance has begun to fall, however. “The 9% program is as competitive as it’s ever been,” says Duckett, “in part, because there aren’t as many resources that are available in that program as there were even two or three years ago. And that comes at a time when all those same expenses – rising cost of construction labor and materials – are going up for the 9% program.”

This has caused large firms to take advantage of the 4% tax credit’s non-competitive application process in larger numbers than ever. “From a mechanical perspective, you’ve had many folks in the development community that have really changed their business model when they think about the credit program realizing that ‘Okay, we’re competing and not being successful in this hyper-competitive program’ – 9% – and you have this whole other program – 4% – that’s undersubscribed.”

Today, Duckett estimates that the 4% production has eclipsed production funded by the 9% credit in many states.

This shift has had huge implications for the way that developers analyze their basis-eligible costs. “There’s not as much money on the table anymore, because costs are going up,” says Duckett. “And so, everyone in the 4% industry has had to look under every cushion on the couch for additional sources of funds. And that’s why this has become such a huge topic, because 4% deals, unlike the 9% deals, are not limited. The federal government doesn’t limit how much development is eligible. It’s however much you have in cost.”

Duckett says that the rapid rise in 4% program usage has caused a lot of internal education not only at Dominium but also for vendors, contractors, and state agencies, since up to now, “everyone involved in the process is more familiar with working from the assumptions of the 9% program than with the 4%. They haven’t had to grapple with a lot of these basis eligibility decisions at all, because developments are limited by the number of credits they have in the 9% program.”

One outcome of this internal education is a realization that communication about costs needs to be clearer and more precise, according to Duckett. Many times, Duckett says, if an invoice is not communicated clearly, a cost may be denied because the CPA and the state agency are unable to exactly determine the circumstances of the cost. “Part of our job is to plan for this better in our design process to be more specific about each and every part of the expense. We need to communicate with our contractors and our vendors. Your invoice can’t just read ‘landscaping,’ for example. Your invoice must articulate specifically ‘shrub installation at Building 9.’ ”

Today’s basis eligibility landscape

Ultimately, Mullen says that there shouldn’t be much surprise or variation in basis eligibility rules among states as developers continue to expand their 4% activities. Aside from a few nuances between states – excluding tax-exempt bond costs, for example, the eligibility of which Mullen says only a minority of states deny – in general, the eligibility rules should be the same regardless of building location since all eligibility guidance comes from the federal government and is not internally generated.

However, since the program is state-administered, Mullen says that variation can exist between how different states interface with the CPA and their recommended certified costs. “Some states have asked for more information than just saying, ‘Okay owner, you have determined these costs qualify’ and ‘Okay auditor/CPA, you’ve determined that these costs qualify, we’re done.’ That would be the ideal scenario. However, some states require additional documentation regarding some of these costs.”

Some gray area does exist, which can cause a pain point for developers who might expect certain costs to be accepted in every state and situation, and who need every dollar during this challenging building environment to construct high-quality affordable housing.

“One place where there might be some different interpretations going on has to do with relocation costs,” says NCSHA’s Schwartz. “Those relocation costs were, for a long time, considered basis eligible, and it was regular practice to include that in basis. And then when the IRS came out with its audit technique guide several years ago, it said that those costs should be deductible, not capitalized and therefore not basis eligible. But the audit technique guide is not regulation, so it doesn’t have the force of regulation behind it. So, my understanding is that some accountants are still allowing relocation as a basis eligible cost.”

Because that guidance is not official, Schwartz says that those costs are currently “a little bit of a gray area,” which can cause confusion for developers and risks for CPAs who put their certification on the line. “We would like relocation costs to always be considered part of the rehab and therefore basis eligible and not a deductible cost,” says Schwartz. “It’s one of the things we’re pushing for in federal legislation, to essentially undo the audit technique guide.”

There are some risks involved with aggressively pursuing basis-eligible costs for 4% deals to maximize the credit. One challenge is overburdening the funding that exists for 4% deals and leading to cost limits down the line. “The area that’s probably been the most challenging recently is the effort to contain total costs, whether it’s total development costs, or per unit cost,” says Mullen. “States want more of their tax credit dollars to go farther, but they also want quality housing to be built. So, to decide, ‘Hey, we’re going to allocate all our tax credits to the deals with the lowest per unit cost, the lowest per bedroom cost,’ or whatever other metric, they’re coming up with sort of a race to the bottom. But states have not done that, which I applaud.”

As well, Mullen points out the need to meet the 50% test as another potential risk for basis-maximizing developers. “It’s sort of a delicate balance of ‘How much cost can I get into my depreciable tax credit basis,’ versus ‘Can I still meet my 50% test,’ ” says Mullen. Simply, the more cost that developers pursue, the higher their tax-exempt bond funding must be, to match or exceed 50% of the project’s total funding. However, Mullen has found that “the landscape in many states to get a tax-exempt bond allocation is now more competitive than it’s ever been. So, the more bonds you ask for, the more challenge you have there, too.”