LOW INCOME HOUSING TAX CREDITS A Beginner's Overview A Quick and Dirty History of Tax Shelters
Prior to the Tax Reform Act of 1986 billions of dollars were invested in real estate
by investors who were attracted by tax write offs (these were the so "tax sheltered
In the early 1980's the biggest tax goodie was "accelerated depreciation"
wherein real property could be depreciated over artificially short periods of time
with a large percentage of the tax write-offs being taken in the early years.
These substantial tax benefits were then sold to investors through the sale "limited
partnership" shares. As a result, many real estate projects were undertaken
not because they necessarily made economic sense but because of the tax write offs.
The Tax Reform Act of 1986 did away with accelerated depreciation and most other
forms of tax shelters
The 1986 Act did, however, create a new tax shelter for investors in affordable
rental housing. This was the Low Income Housing Tax Credit Pro gram (LIHTC).
What is the Low Income Housing Tax Credit?
LIHTC allows developers of qualified rental housing to take a credit on their tax
returns. The credit spread out over a 10 year period and it can be for as much as
90% of the actual cost of construction (with a somewhat lesser percentage for the
cost of rehabilitating of existing units).
The apartments have to be affordable to persons earning less than 50% of the median
income of the locality. Affordability must be maintained for at least 15 years.
Developers (including non profit corporations) can raise capital for their affordable
rental housing project by doing the deal with a "pass through" type of
entity the then selling ownership interests to investors. A "pass through entity
is one that the IRS treats as partnership where the tax "goodies" pass
through to the investors(as opposed to most corporations where the there is double
taxation and the tax goodies do not pass through to the stockholders). Typically
limited partnerships and limited liability corporations (LLC's) are the entities
Choosing The Right Entity
When two or more people want to participate in real estate development, some kind
of "structure" has to be created to facilitate their involvement. This
can either be a corporation or some kind of partnership.
In order for the investors to claim the low income housing tax credits the entity
must be taxed like a partnership and not like a corporation.. The difficulty
is, however, the investors also want the limited liability of a corporation.
HOW CORPORATIONS ARE TAXED: Corporation are taxed just like individuals and the
shareholders can not claim the tax "goodies" on their own individual tax
HOW PARTNERSHIPS ARE TAXED: Partnerships, however, do not pay tax at the partnership
level. All the taxable gains, losses, and credits pass through to the individual
partners and are reported on their own individual tax returns.
"SHAREHOLDERS" ENJOY LIMITED LIABILITY: shareholders of a corporation
are not liable for the corporation's debts (i.e. liability is limited to the dollar
amount of the shareholder's investment)
"PARTNERS HAVE UNLIMITED LIABILITY: Members of a partnership can be sued for
partnership debts. The creditor can choose to sue only one partner and the court
can award a judgment for the entire debt (not just that particular partner's share
of the debt).
What are "Limited Partnerships" and "Limited Liability Companies"
Limited Partnerships and LLCs are taxed like patnerships but have the limited liability
of a corporations. Thus, selling shares in a limited partnership is the ideal vehicle
for a nonprofit to attract investors to their LIHTC projects.
Limited partnerships and LLCs are very similar. They are special types of entities
authorized by state law. If it is properly set up they are taxed like a partnership
but the investors enjoy limited liability similar to shareholders of a corporation.
A limited partnership must have one or more "general partners" who have
unlimited liability. In addition, there would be one or more limited partners who
have limited liability (but who are taxed like "partners" and not "shareholders").
An LLC, on the other hand, all of the "members" have limited liability
The limited partners (or LLC "members") are the investors who contribute
all of the money. Limited partners are not allowed to play part in the day to day
management (whereas members of an LLC can). These investors are allowed to deduct
a portion of the depreciation and other deductions and take credits on their individual
tax return thereby sheltering their other income and paying less overall taxes.
The general partners are allowed to keep substantial "developer's fee"
for their efforts.
Passive Investment Rules
Before 1986 tax shelters were often sold to rich individuals who needed tax write-offs
to shelter their otherwise taxable income.
In most cases these investors were "passive" meaning that they took no
active part in the management of the properties.
The 1986 Tax Reform Act, however, prohibits "passive" investors from claiming
deductions and credits generated by their properties. An exception was made for
corporations. For this reason shares in a LIHTC eligible limited partnership can
only be sold to corporations.