The Fundamentals of Tax Credit Development
Experienced real estate developers know how to leverage tax credits to make their projects pencil. Here's what you need to know about them.
LIHTC. New Markets Tax Credits. Renewable Energy Tax Credits. Opportunity Zones. Historic Tax Credits. Production Tax Credits. Investment Tax Credits. Veteran real estate developers know what all these mean, and—more importantly—how and when they can be applied to projects to maximize financial returns.
While some in real estate see government as a nuisance to be managed—with zoning restrictions, discretionary reviews, building codes, and the occasional grift—Uncle Sam is also the single biggest financial backer of real estate projects in the United States. Knowing how to leverage the public sector can be the difference between a project penciling out and not.
Government support for real estate development usually takes the form of tax credits. While some developers have sufficient tax liabilities to use tax credits directly, the vast majority of credit recipients either partner with tax credit investors or sell their credits through brokers and advisors. (We’ll discuss more of the mechanisms of that later in the letter.)
Today’s letter will:
Outline the major types of tax credit programs as well as other advantageous public programs available to real estate developers;
Discuss when each program may or may not be applicable and examples of their use;
Provide a high-level overview of the pitfalls and tradeoffs of major tax credit programs.
While most of this letter will be focused on the United States, similar programs exist in other countries. For example, UK R&D tax credits and innovation grants can both be used in some circumstances to support real estate development projects in Great Britain.
Big shout-out to tax credit attorney Hara Perkins at Goulston & Storrs and tax credit developer & advisor Erik Wishneff at Wishneff & Associates for helping me get smart about tax credits for this letter. But please note that I am not a lawyer and this is not legal or tax advice. Please consult an attorney who specializes in tax credit work (like Hara) before actually incorporating tax credits into your business plan. Now let’s get into it:
The Basics of Tax Credits
Real estate tax credits are financial incentives offered by federal, state, or local governments to encourage real estate owners and developers to do specific things. They might be designed to stimulate economic growth, produce low-income housing, create jobs, preserve historic buildings, or improve neighborhoods.
While tax credits are typically designed to offset income tax liability, secondary markets and other investment structures allow developers to benefit from tax credits even if they have no income tax liability by working with tax credit-specific investors or selling credits to buyers through secondary markets.
There are many different types of tax credits available to real estate developers, and each program has its own criteria, quirks, drawbacks, and nuances. But developers and investors should have a familiarity with all of them; recognizing that a site is a fit for a lesser-known tax credit program can give a buyer an unfair advantage in a bidding process. In the next section, we’ll review the major categories of tax credits available to real estate developers.
A Taxonomy Of Tax Credits
While there are a wide variety of tax credit programs at work today, some programs are better-known and more commonly used than others.
Low-Income Housing Tax Credits (LIHTC)
The Low-Income Housing Tax Credit (LIHTC) is probably the best-known of all real estate tax credit programs. LIHTC is a federal program that has contributed to the development of nearly 3 million affordable rental units over the past 30 years and is the single largest contributor to the US’s affordable housing stock today. Under the LIHTC structure, investors receive a dollar-for-dollar reduction in federal tax liability over a 10-year period in exchange for providing affordable housing.
I spoke with Hara Perkins at Goulston & Storrs, an expert in structuring LIHTC deals. “LIHTC is the foundation of affordable housing subsidy [in the US],” said Perkins. “The vast majority of affordable housing built over the past two decades has layered in a LIHTC.” While the details of LIHTC complex are enough to fill at least one entire Thesis Driven letter, we’ll cover the basics here.
To begin, there are two types of low-income housing tax credits: