How Tax Credits Work for Sellers, Buyers

Federal income tax credits, which can amount to 90% of the cost of building or rehabilitating an apartment complex, have come to represent one of the few low-cost sources of financing for both private and nonprofit developers of affordable housing.

Tax-credit financing works like this: If a developer building a $10-million apartment complex qualifies for the maximum $9 million in tax credits, the developer can then sell the tax credits to a corporation at a discount--say, $7 million. The developer now has $7 million of cash to put toward the project, and the corporation has $9 million worth of credits that it can use to reduce its income taxes.

The system has become extremely popular with developers and corporations alike, said Kathleen Head, a principal in the Los Angeles office of Keyser Marston Associates Inc., a real estate consulting firm.

“The tax credits are paid out annually over a 10-year period, but if the owners sell the credits they can get their money when they need it, during construction of the project. Whoever has bought the credits then takes them on an annual basis and applies them against their income taxes,” Head said.

The tax credits were authorized initially by the Tax Reform Act of 1986 as a temporary measure, but Congress later made them a permanent part of tax law.

One of the earliest and biggest buyers of the credits was San Francisco-based Chevron Corp. Bob White, president of Chevron TCI, a subsidiary that owns and administers the credits, said the company owns about $500 million worth of the tax credits.

“We pay about 75 cents for a dollar’s worth of credits, and we have to wait 10 years to get our money, but we get a return on our investment. It’s not a great return, but it’s a return,” White said.

The investment is not without risk. One big risk is that buyers must generate enough taxable income to be able to use all of the credits.

In addition, White said, developers must agree to keep the qualifying apartment units affordable, or the federal government will require them to return a portion of the credits. That means that whoever bought the credits could be required to return a portion of them and lose future years’ credits if the developer fails to maintain the units as affordable apartments.

There are also the usual risks that go with any apartment investment: The complexes must be managed efficiently and must have enough tenants to make them profitable. And projects typically include other sources of financing other than tax credits, often a small amount of conventional financing, so there is some risk of foreclosure by a conventional lender if the developer mismanages the project.

Chevron’s ownership of tax credits makes it a big owner of affordable housing, with interests in about 200 developments. Typically, the developer who qualifies for tax credits forms a partnership that owns the property, with Chevron as a partner.

The deals are structured with the developer as the 1% general partner, and Chevron is a limited partner with 99% ownership. The tax credits then are actually assigned to the partnership, with 99% of the credits going to limited partner Chevron and 1% to the developer, who manages the day-to-day operations of the apartment complex.

The structure is common in real estate, in which financial partners often own the majority of a partnership but leave the management and operation of a property to the general partner.

Chevron now spends about $25 million a year on tax credits, compared with $100 million a year in the early 1990s, because the company now has a limited need for additional credits.

But White said demand for credits remains very strong, with buyers paying higher and higher prices. That means developers can sell the credits at less of a discount while buyers, although they get less of a return on their investment, still find the returns worthwhile.

“Early in the game, there was less demand for the credits because the law was new and not many people understood how it worked. Now it has become a very efficient way to build low-income housing,” White said.