The Last Big Tax Shelter: Low-Income Housing

Since the 1986 Tax Reform bill, accountants and investors have lamented the loss of most of the good tax shelters.

Forget tax-favored investing in racehorses and wind farms and cattle ranches and solar barbecues. The federal government says that if these activities aren’t aimed at generating profits, you forgo the tax losses too.

But there’s one exception--one remaining tax shelter that allows you to get back more in tax savings than you invested: low-income housing.

In an effort to support construction of housing for the poor, Congress specifically provided for tax credits--dollar-for-dollar tax savings--for those who invest in specific projects.

Promoters say the tax credits alone will generate 10% to 25% annual returns for 10 years. Although these credits are set to expire at year-end, the expiration does not affect existing projects. Additionally, Congress is expected to reinstate the low-income housing tax credits retroactively in 1992 because there is widespread support for the program.

You don’t have to be rich to invest in low-income housing either. Often these deals are syndicated through limited partnerships. How much it takes to get in varies with each deal. Some require minimum investments of $100,000 or more, others accept significantly less.

But before you pull out your checkbook, take a long, hard look at the risks of investing in these deals. Like any other investment that promises double-digit returns, the risks are significant.

And in this case, the risks come on two fronts: from the deals themselves and from their structure.

First let’s look at the deals. They’re usually pretty complicated, but the short, simplified version is this: A developer decides to build a housing project that will cater to low-income families. The developer finds out what average incomes and rents are in the area and promises to keep rents below the norm. Most of the tenants must earn at least 40% less than the average income in the area as well. And the project manager must document that these requirements are met.

The developers and investors promise to maintain the project as a low-income development for at least 15 years.

If all goes well, a government agency designates this as a qualifying project and it receives federal tax credits that amount to as much as 90% of the construction costs. The credits can be taken over 10 years. How lucrative the credits are depends on how much the land costs, how much is borrowed against the project and various other factors.

The catch: First, you usually must maintain the investment for five years after the tax credits expire. Unless the project is profitable during those years, your return is zilch. Second, no one knows what the project will be worth at the end of the period.

Syndicators maintain that most developments will be worth at least half of what you invested. But some accountants say you shouldn’t count on any return of your principal. Obviously, this will have a huge impact on your overall rate of return. If there is no return of principal, these deals generally net 5% to 8% annually overall, said William J. Stirton, partner at the accounting firm Coopers & Lybrand. If you do get all or some of your principal back, the after-tax return could be in the 15% to 20% range, he said.

Finally, to keep the tax benefits, the project managers must make sure they meet all the federal requirements. If the manager breaks the rules--either accidentally or purposely--you could lose the tax credits. And that usually means a big investment loss too, said Philip J. Holthouse, a Los Angeles tax accountant.

That’s not all; there are additional risks and significant expenses because of the way these deals are structured.

Often investors get in by buying into limited partnerships, where investors put in capital for a prorated share of the project. A general partner, who may or may not have a stake in the deal, agrees to manage the partnership for a fee. The salespeople who peddle partnership interests also get a fee, and sometimes a host of additional fees are paid to related parties as well. In the end, about 15% to 30% of the investor’s capital is spent on these fees and charges, according to a recent ranking in Stanger’s Partnership Watch.

The risks of investing in limited partnerships are varied. They center on who is managing the partnership and how much control that individual or group has. Suffice it that before you invest in any limited partnership, you should know a lot about the background of the managers, whether they can transfer management without consent of the limited partners and what kind of fees they’re taking home.

Does all this mean you should avoid low-income housing investments? Not necessarily. But you should have a trusted financial adviser help you look at any deal before you put your money in. And you should personally read the partnership prospectus carefully and feel comfortable with the risks you are taking. Don’t be conned by those who say these are “risk-free” deals because of the “guaranteed tax savings.” In today’s market, there are no low-risk deals that offer double-digit returns.