In recent years, commercial real estate owners and investors have learned a secret: they can greatly maximize their tax savings if they combine Low-Income Housing Tax Credits with a cost segregation study.
The Low-Income Housing Tax Credit (LIHTC) is the federal government’s major tool for creating affordable housing. As a federal tax credit administered by states, it’s replaced HUD’s direct investment in public housing.
“What most real estate owners and investors don’t realize is that the LIHTC program has created a massive windfall of tax benefits for affordable housing,” said Daryl Petrick, Partner with the CPA firm Bowman & Company, who specializes in tax issues around affordable housing. “And when you combine LIHTC eligibility with a cost segregation study, you can achieve impressive tax savings using bonus depreciation.”
How Does LIHTC Work?
The Low-Income Housing Tax Credit subsidizes the acquisition, construction, and rehabilitation of affordable rental housing for low- and moderate-income tenants. Since it was enacted as part of the 1986 Tax Reform Act, it’s resulted in the creation of over two million new housing units.
After the federal government issues tax credits to state and territorial governments, state housing agencies use a competitive process to award the credits to private developers of affordable rental housing projects. These developers sell the credits to private investors to get funding. Once the housing project is opened to tenants, investors can claim the LIHTC over a 10-year period.
How Does An Investor Qualify for the Credit?
A wide variety of rental properties are eligible for LIHTC, including apartment buildings, townhouses, and duplexes, but project tenants must meet an income test and a gross rent test. They can meet the income test in three ways:
- At least 20 percent of the project’s units are occupied by tenants with an income of 50 percent or less of the area median income (AMI), adjusted for family size.
- At least 40 percent of the units are occupied by tenants with an income of 60 percent or less of AMI.
- At least 40 percent of the units are occupied by tenants with income averaging no more than 60 percent of AMI, and no units are occupied by tenants with income greater than 80 percent of AMI.
According to the gross rent test, rents must not exceed 30 percent of either 50 or 60 percent of AMI, depending upon the share of project’s tax credit rental units. All LIHTC projects must comply with the income and rent tests for 15 years; otherwise, credits are recaptured. Also, an extended compliance period (30 years in total) is generally imposed.
Cost Segregation: The Bonus Depreciation Bonanza
Low-income housing projects are being developed by public entities or larger C corporations. These include insurance companies, utilities, and especially banks. Under the Community Reinvestment Act, also known as the CRA, banks are obligated by law to help provide housing for low-income people.
“Historically these types of developers haven’t applied cost segregation, thinking it doesn’t create any value,” said Daryl Petrick. “But now they’re aware of the bonus depreciation bonanza, cost segregation makes sense. When you add LIHTC’s low-income credits to accelerated depreciation, it not only creates a windfall of tax savings, but also it expedites return on investment.”
For example, an investor could enjoy $7 million savings in cost segregation depreciation for a $20 million building—and that’s just in the first year. The credit is based on eligible basis. While land is not eligible, the bulk of the building is eligible for credit.
Case Study: $3,648,709 of Depreciation in the First Year
This case study illustrates the virtues of cost segregation. The project had a construction cost of $12,581,756. Thanks to a cost segregation study, the investor was able to claim $3,648,709 of depreciation in the first year. In comparison, without the cost seg study, the depreciation would only be $428,000 in the first year.
Pick the Right Advisor
However, the regulations about cost segregation and Low-Income Housing Tax Credit are complex. For that reason, we recommended selecting a specialty tax advisor like Engineered Tax Services, which has over 20 years’ experience in helping the construction industry to gain tax advantages, specializing in cost segregation studies, R&D tax credits, and 179D tax deductions.
“Now that bonus depreciation has drastically increased the rate of depreciation, it’s helping investors get faster returns on their capital and improving the ROI on these projects,” said Petrick. “There’s no question—cost segregation greatly magnifies the overall tax benefits for LIHTC projects.”