Private Activity Bonds And 4% Low Income Housing Tax Credits

Federal housing programs generally fall into one of two categories, those that provide a f direct subsidy to people to pay for housing and those that use financial tools to facilitate the building of housing. Among financial tools, the most significant is the Low Income Housing Tax Credit (LIHTC). This creature of the tax code monetizes a tax break for investing in affordable housing. But in the poverty programs reviewed by former Congressman Paul Ryan, there also exists an interesting but complex tool – the Private Activity Bond or PAB. The PAB allows local governments to sell tax exempt bonds on behalf of entities building projects that benefit the public, including housing. When paired with tax credits, PABs can be a powerful tool for builders looking to assemble capital for housing projects. But the complexity and costs are high. (If you want a window into LIHTC here’s a post on how they work).

The Congressional Research Service published an excellent primer on Private Activity Bonds. Like tax credits, PABs are embedded in the tax code and include two types of bonds. one for projects that serve government purposes; the other for those that serve private purposes, so long as they benefit the public. If private activity bonds are for “qualified private activities” like housing, purchasers of the bonds pay no taxes on the interest they earn. Congress limits the amount of debt that can be issued for private activities; $150 million and $50 per capita in 1986 to the greater of $335 million or $110 per capita in 2022. There are also limits by type of project as well in order to influence investment. Congress also intends to limit the tax expenditures (exemptions mean fewer dollars in tax revenue).

How these bonds can be combined with LIHTC, specifically 4% tax credits, is handled well in a paper by the Corporation for Supportive Housing (CSH), Financing Supportive Housing with Tax-Exempt Bonds and 4% Low Income Housing Tax Credits. Here’s a summary of the requirements for using tax exempt bonds with tax credits.

Only state and local governments along with quasi-governmental agencies can issue the bonds. Usually, this is the Housing Finance Agency (HFA), the state agency that receives tax credit allocations. But because the amount of tax-exempt bonds that can be issued are subject to a volume cap (the limit mentioned above), all these governmental entities compete aggressively to fit in under the cap. Also, projects can’t access bond proceeds until a project receives approval from the state HFA, and those proceeds are limited to residential costs and can’t be used for commercial space, for example.

There is one important limit worth noting with respect to combining tax credits and tax-exempt bonds. To receive the tax credit allocation, the project manager must cover at least 50% of construction costs (the “50% rule”) with bond proceeds; and of course, any housing built using these bonds and tax credits must be available to people who earn less than 60% of Area Median Income (AMI). Usually, 20% of the units must be affordable to people at 50% of AMI or less, or 40% of the units at 60% of AMI.

If it’s not obvious already, these sorts of projects are complicated. Add to this the fact that often these sorts of “deals” include additional funders. For example, the one housing project I worked on as a developer was a 4% project using tax exempt bonds. But we also had funds from the state’s housing trust fund as well as a construction loan. To be honest, I’ve had to wrack my brain and pore over old emails to recall exactly how the project came together. The CSH paper does a great job of showing through seven different case studies some of the distinctive ways this financing can come together. For example, one of the simplest case studies is from Michigan. Here’s a chart that shows the funding for the project.

The MSHDA is the Michigan State Housing Development Authority, the state’s Housing Finance Agency. The MSHDA sold the bonds and the debt is being serviced through the modest income from tenants, which partially comes from Section 8 vouchers. Each of the funders in the project has different requirements, and in these sorts of projects fulfilling one requirement can upset one of the other funder’s requirements.

In some cases, tax credit equity can be used to pay debt service. The CSH paper uses a case study that used the bonds and then “fully took out the bonds a permanent conversation with other public loans, grants and tax credit equity.” That looks like using tax credit equity to retire bond debt. This is compelling: although the 4% tax credit is a smaller percentage of the eligible basis of an affordable project, being able to use the credit to pay back the bonds is a good idea. So is combining various sources of funding.

Ryan doesn’t spend much time on PABs other than to suggest that “few studies on the effectiveness of the Private Activity Bonds . . . as it relates to improving upward mobility of tenants.” This is true, and his look at the outlay for the program shows that the bonds haven’t been used as frequently as low income housing tax credits.

And not much has changed in the decade since his analysis (chart data from the United States Treasury).

My view is that PABs should be utilized the way all debt is utilized: value capture. In the case of housing, I’ve suggested a value capture scheme for homeless housing in which the costs of encampments, for example, are quantified, bonds sold to implement interventions to end the encampments, then as savings are realized, using those savings as debt service. The problem with assembling what is known in the non-profit world as “a capital stack” is the level of complexity which is problematic for the following reasons:

● Time – these sorts of financing arrangements chew through time, and time is money. Holding costs while waiting to assemble and align funding are a real additive to total development costs;

● Transactions – more funders mean more transactions costs, and these costs also add to total development costs;

● Lawyers and consultants – at every step of the way, in order to avoid catastrophes that could cause a project to fail, lawyers and consultants must be hired; and

● It isn’t very efficient – with all the moving parts, and additional costs, is this the most efficient way to provide housing for people who need it now?

In the end I go back to the basic rule of thumb, any housing financing proposal should be as simple as possible, getting needed funds or units to people who need them today. While I am intrigued and enjoy the challenge of solving a financing puzzle, playing these games doesn’t get people’s rent paid; we need to find ways to reposition PABs for a better purpose than complex financing deals for the construction of subsidized housing.