How Much Should You Pay for a Tax Credit Site?
The IRS is considering an amendment to the Internal Revenue Code (IRC) Section 42 to provide a method for establishing the value of a tax credit site when the owner wants to sell at the close of the 15-year compliance period. With the help of tax credit expert A.J. Johnson, we will explain the IRS proposal and how the new valuation formula would work, if implemented.
What IRC Section 42 Says
According to IRC Section 42, a tax credit unit must be occupied by an eligible household at the restricted (below-market-rate) rent for at least 15 years, with another 15-year extended-use period following thereafter, says Johnson. In some states, the extended-use period can continue beyond 30 years, he notes. Also, the government will offer additional incentives to developers who are willing to agree to even longer-term extended-use periods, he adds.
Unless the right to do so has been waived during the tax credit application process, an owner can request—anytime after the 15th year of the compliance period—that the Housing Finance Agency (HFA) allocating credits find a purchaser for the project.
According to tax credit law, once this request is made, the HFA has 12 months to find a buyer who is willing to continue to operate the project as low income and rent restricted until the extended-use period (EUP) terminates, Johnson says. If no buyer can be found, the owner is permitted to terminate the EUP, he adds.
The IRS proposes a formula for calculating a tax credit site's purchase price, taking into account various factors, Johnson says. First, because a site may contain low-income and market-rate units, the market-rate section of the site must be sold at fair market value, he notes. But the fair market value must reflect the use restrictions of the section comprised of low-income units, he adds. This is because the purpose of the tax credit program is to continue the restricted rents for an extended period of time.
The IRS further proposes that the value of the land underlying the project must be based on fair market value, Johnson says.
Tentative Regulatory Formula
To determine how a site's fair market value is subject to change based on its tax credit component, the IRS has developed a regulatory formula with the following three steps.
Step #1: Add together:
The site's outstanding debt;
The adjusted investor equity, which the IRS defines as the amount of owner-invested cash that is used for qualifying building costs. The cash is subject to a 5 percent cost-of-living adjustment; and
Other capital contributions—that is, the cost of any capital improvements that have been made, such as a boiler replacement, new electrical wiring installation, or repair of an entire roof.
Step #2: Subtract cash distributions from the figure reached in Step #1. The IRS defines “cash distributions” as funds provided to owners from the proceeds of refinancing, or funds in operating accounts or replacement reserves at the time of sale.
Step #3: Multiply the figure from Step #2 by the “applicable fraction”—that is, the percentage of the building occupied by low-income residents. The resulting figure is called “the qualified contract formula,” Johnson says.
The IRS is currently reviewing comments that housing practitioners submitted prior to deadline on the proposed qualified contract formula, Johnson says. The IRS is also considering whether cash distributions should be included in the formula, Johnson notes. In addition, the IRS will be deciding whether the qualified contract formula should change when an entity other than a corporation or partnership owns the site, he adds. The Insider will provide continued coverage of IRS developments in this area.
A.J. Johnson: A.J. Johnson Consulting Services, Inc.; Williamsburg, VA