I just stumbled upon this interesting paper from the FRB on how to re-ignite the market for low-income housing tax credits. These are credits that investors buy so they earn tax credits they can apply to lower their tax liability. Currently this market has been limited to large players but the FRB paper suggests it may be good to open it to individuals directly.
The universe of Low Income Housing Tax Credit (LIHTC) investors is limited to a small group of large institutions. Since the tax credit was created in 1986, banks, corporations and government-sponsored enterprises (GSEs) have purchased nearly all the credits made available through the program. Unfortunately, the concentration of investor demand in a small group of institutions has introduced volatility to the LIHTC market. Specifically, demand for these tax credits has proven extremely cyclical. As financial institutions and other large institutional LIHTC investors suffer losses (as they have in the current recession), their appetite for tax credits decreases rapidly. The result is a collapse in the price of LIHTCs, which endangers the very feasi bility of tax-credit-financed affordable housing projects.
Affordable housing investment was not always domi nated by large corporate entities. In fact, individual taxpayers played a prominent role in financing afford able housing development during the early 1980s. That role changed with the passage of the Tax Reform Act of 1986.
Prior to this legislation, individuals could deduct construction period interest and taxes, accelerated depreciation, and amortization of building costs. Taken together, these tax benefits were significant enough to attract many wealthy individuals to the mar ket. By 1986, however, Congress had become wary of overly generous tax benefits, loopholes and deductions. The result was the passage of new passive loss, passive credit and at-risk rules. Among other changes, the new rules established a financial disincentive for individual taxpayers to claim credits in excess of their marginal tax rate multiplied by $25,000. These rules have not been updated since 1986 and continue to suppress individ ual demand for tax credit investments.
Benefits of Individual Investors
Bringing individual investors into the LIHTC market would have several important benefits.
First, bringing individuals into the LIHTC investor pool would stabilize pricing and create a more robust market for the credits. Of course, individuals are not immune from economic hardship. Nevertheless, most people carry tax liability from year to year and, presumably, would benefit from a program that offsets this liability.
Second, individual investors would also help round out the LIHTC market’s financing of smaller projects and underserved geographies. Increasingly, large institu tional LIHTC investors have dealt directly with afford able housing project developers. To maximize efficiency, investors have sought large projects with correspond ingly substantial tax credit allocations. As a result, “it has been difficult to attract corporate investor interest to small and rural deals, since corporate investors look for larger deals with higher amounts of tax credits to offset their federal tax liability,” according to the National Association of Home Builders.2 Individual investors, by contrast, have lower tax liability than corporations and might be more attracted to smaller deals.
Finally, opening up the LIHTC market to the grow ing number of individuals seeking social impact invest ments would diversify the investor pool. According to the Social Investment Forum, “socially responsible investment (SRI) encompasses an estimated $2.71 trillion out of $25.1 trillion in the U.S. investment marketplace.”3 This growing market indicates that investors are increasingly looking for mission return in addition to financial return. Financial products such as socially responsible mutual funds, positive and nega tive stock screens, and deposit accounts in community development credit unions are frequently used by individual investors to satisfy both social and financial preferences. Socially motivated individuals might also invest in LIHTCs if given a cost-effective, efficient way of doing so. This would benefit the market by further diversifying the pool of LIHTC investors.
Barriers to Individual Participation in the LIHTC Market
In addition to passive loss tax restrictions, individuals have largely remained outside of the LIHTC market because of four key challenges: high transaction costs, program complexity, compliance risk and the illiquidity of the investment.
High Transaction Costs
The limited tax benefits offered by LIHTC are often insufficient to offset the cost of individual participa tion. Tax-credit-financed deals can be multimillion dollar projects. New construction financed by LIHTCs can require raising tax credit equity of 70 percent of eligible construction costs. The cost of soliciting such investment from small-dollar individual investors is cost-prohibitive for most affordable housing developers (and most syndicators, for that matter). Historically, it has been more cost-effective to engage a select group of large investors not restricted by passive loss rules that can finance whole projects on their own.
Program Complexity
LIHTC deals are extremely complex. The technical expertise required to complete a LIHTC project is a dizzying array of real estate, legal, tax, development and policy know-how. Most individual taxpayers lack even a basic understanding of the LIHTC program—let alone how to responsibly evaluate the investment risks.
Compliance Risk
LIHTC investors are subject to credit recapture and penalties should a project fall out of compliance during the first 15 years of its operation. Compliance is a function of the rents charged to the development’s low-income tenants. Should rents exceed specific federal guidelines, the project is deemed out of compli ance, the credits are recaptured and a penalty is levied. Individual investors have likely shied away from tax credit deals because they lack the expertise to quantify and price the risk posed by this central program requirement.
Investment Illiquidity
The 15-year compliance period, coupled with restric tions placed on the reselling of credits, makes purchas ing LIHTCs a relatively illiquid investment. This tends to favor investors with long investment time horizons. Further, the tax benefits that flow from a LIHTC investment only begin when the project is completed. This can be up to three years after the credits are originally allocated. To date, corporate entities with long-term tax obligations have been most comfortable with the illiquidity of the investment.
An Individual Investor Solution
First and foremost, the easiest way to attract indi viduals into the LIHTC market is to change the passive loss restrictions that discourage individual investment. Whether the passive loss limit is increased or the rule is
eliminated altogether, increasing the tax benefit would make the credit more appealing to individuals. Even with tax reform, however, the barriers outlined above would still discourage many individuals from partici pating in the program.
While only a partial solution, the creation of a fully transparent online platform to broker the sale of tax credits to individual investors would address some of these challenges, specifically high transaction costs and program complexity. An online marketplace for LIHTC investments would keep the cost of soliciting capital low while simultaneously organizing and com municating important information to potential small- dollar investors. In fact, such technology already exists in the form of so called “peer-to-peer” (P2P) lending. P2P lending sites attempt to lower transaction costs by cutting out the middleman in debt transactions—usu ally a bank or a credit card provider. While the long- term viability of their core business model is unknown, P2P lenders such as Prosper, Kiva, LendingClub and others have demonstrated that individuals can lend responsibly in the consumer debt market. The same technology could be adapted to match LIHTC inves tors with affordable housing projects.
Direct Investment Model
The simplest method for organizing a LIHTC platform for individual investors is to directly connect these investors with affordable housing developers that have received tax credit allocations. Developers could post project listings on the platform and the tax credits they have available. As part of the listing, develop ers would also have the opportunity to promote the project’s financial and social merits as well as set the initial price for the credits. The investment period could be designated by a preset date or simply end when sufficient equity has been raised to proceed with the development.
Tax Credit Syndicator Model
A second way to organize an online LIHTC plat form would be to use tax credit syndicators. The platform could connect individuals to syndicators who identify and invest in LIHTC projects on their behalf.
There are two reasons to favor this approach. First, it addresses the complexity barrier noted above. Even with detailed project listings, most individuals would be ill-equipped to evaluate the range of risks that come with an affordable housing investment. In contrast, tax credit syndicators have a great deal of expertise and in-house capacity to accurately assess these risks and invest responsibly.
Conclusion
The recent collapse in the price of LIHTCs has exposed the folly in the market’s over-dependency on large corporate investors. Encouraging individual par ticipation in the LIHTC market would diversify and expand the overall investor pool, smooth LIHTC price cycles, bring untapped capital to the market, and help finance small, often rural, affordable housing develop ments that today struggle to raise tax credit equity.
An online LIHTC platform, while potentially dif ficult to scale and develop, would lower transaction and information costs and allow individual investors to enter a market that, heretofore, has been nearly the exclusive purview of institutional investors. Also, such a marketplace could allow for dynamic, real-time price setting. If sufficient scale could be achieved, a price auction mechanism would be effective in either of
the models outlined above and, importantly, it would create complete price transparency. Online platform or not, however, the benefits are clear: It is time to get individuals into the LIHTC market.