QOZ investments were just hitting the market when we first addressed them in our 2019 article1. Created by the Tax Cuts and Jobs Act of 2017, Qualified Opportunity Funds (“QOFs”) were slow to launch due to uncertain tax consequences, a problem which has now been cured by Treasury regulations. The QOZ tax benefit regime is aimed at attracting new sources of capital to under-developed neighborhoods in need of investment.
Many of the early QOFs have delivered as intended. However, many others have been criticized for directing their substantial tax benefits to projects which would have been completed without the tax incentive. You can follow the ongoing policy debate elsewhere—this article discusses how QOFs can be combined with the LIHTC to create or preserve affordable housing that takes advantage of two exceptionally rich tax benefits.
As of July 28, 2021, the National Council of State Housing Agencies reported that 238 multi-project QOFs have been created, seeking to raise a combined $48.3 billion of investment, and that 60% of the funds were earmarked for affordable housing and community development. It’s likely that many of these projects are designed to combine the QOZ and LIHTC tax benefits.
Regardless of your investment objectives, if you are exploring real estate investments, affordable housing may make sense.
Many residential real estate projects are eligible for LIHTCs and are located in QOZs. The investment can be structured to deliver both tax benefits. Combining the two tax benefits in a customized project is a potential win-win investment. Of course, there are complex requirements that must be satisfied, but now that there are final regulations for QOFs, many professional developers know how to structure the investments.
There is an additional benefit for individual investors: while the at-risk and passive activity rules generally apply to the real estate investments of individuals, it’s now possible to structure a QOZ/LIHTC deal that takes advantage of certain special exceptions for at-risk and passive investments that apply to affordable housing.
QOZ projects inherently take significant risks in exchange for delivering a speculative return. As such, they may fit into your portfolio either as alternative investments or as impact investments. Either way, you should embrace strategies that enhance the potential return.
While IRRs vary, LIHTC transactions have been around for a long time and their rates of return tend to be predictable. Broadly speaking, there are two categories of LIHTC projects (known as “4%’s” and “9%’s,” that roughly correlate to the amount of eligible basis at which they are funded). Novogradac & Company LLP, an accounting firm, has used a series of reasonable assumptions and modeled the impact of combining LIHTC and QOZ benefits for a standard 4% tax credit deal and a standard 9% tax credit deal. The company also computed the following enhancements that result from qualifying for both tax benefits and holding them for 15 years.
Every deal is different, and there are some challenges, but there are some nice synergies between LIHTCs and QOZ investment.
LIHTC projects enjoy remarkably low failure rates. Nationwide, the default rate on LIHTC transactions is less than 1%. This low default rate reflects the very high demand for affordable, low-income housing and the fact that government agencies offer too few subsidized housing-finance programs to satisfy that demand.
For both 4%’s and 9%’s, the number of approved projects able to seek investment is capped each year. The 9%’s are oversubscribed every year in every state. That competition means the projects awarded tax credits have been reviewed by independent state housing agencies and found to have both strong economics and experienced developers.
With the changes to the 4% credit passed in December, awarded projects are eligible for more tax credits, making them even more stable. At the same time, the number of LIHTC investors has not significantly increased, so investors are able to command more credits for a lower price. Now is a great time to invest in LIHTCs.
Both LIHTCs and QOFs are complicated. LIHTCs are sophisticated real estate transactions, subject to a strict regulatory framework and involving several layers of finance. The good news is that they have been around as tax equity investment vehicles since the Tax Reform Act of 1986. Although each deal brings different nuances and challenges, and laws and regulations are occasionally updated, the LIHTC industry and the laws that regulate it are mature. Within the industry, LIHTC deals have standardized conventions and expectations.
There are a few specialized syndication firms focused on LIHTCS who can act as sherpas for potential investors. While there are a few experienced direct investors in LIHTC transactions, most investors go through one of the syndicators, someone whose job it is to evaluate the deal, assemble the parties and financing, and get the project ready for your investment.
LIHTC housing projects require large minimum investments, ranging from millions of dollars to tens of millions of dollars. They are complex real estate transactions, subject to complicated regulatory requirements and multi-layered financing structures. They are used by sophisticated investors, so you are not competing in a retail marketplace.
Two major categories of traditional LIHTC investors are:
Both are sophisticated, they have a good understanding of the deals and they are large enough to make the minimum unit-sized investment.
Family offices can be competitive with these sophisticated investors, and they are not burdened with as many external regulatory requirements as commercial banks and publicly-traded corporations. What’s more, family offices often have more significant capital gains than do these corporations, which will enable the family offices to realize greater tax benefits from (and offer more competitive pricing for) LIHTC/QOZ deals.
Making a difference with your investments feels good. While there are sure to be many worthwhile investments in QOZs, facilitating the development of low-income housing as a vehicle for neighborhood revitalization is particularly satisfying because its impact on low-income families is so evident.
LIHTC investors also create more than tangible, beautiful buildings. New construction and substantial rehabilitation often spur additional investment in communities.
©All Rights Reserved. August, 2021. DailyDACTM, LLC d/b/a/ Financial PoiseTM
Kenneth Silverberg is an experienced tax attorney. He is Senior Counsel at Nixon Peabody and former CPA-partner at Arthur Andersen & Co. He currently focuses on the tax benefits inherent in real estate transactions, principally Qualified Opportunity Zone transactions. Ken’s practice also includes representing clients in tax controversies, including tax audits, appeals and litigation against…
Kathie Soroka is counsel in Nixon Peabody’s New York office where she focuses on affordable housing development. Prior to joining Nixon Peabody, she served as Senior Counsel to the General Counsel at the U.S. Department of Housing and Urban Development. She has helped public and private clients nationwide structure complex real estate transactions with multiple…
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