Every year, millions of dollars of federal low income housing tax credits (LIHTC) are distributed to the States under Section 42 of the Internal Revenue Code. Credits are authorized by the Federal Government and are used to promote the development of low income housing. Credits, in Maryland, are allocated to property owners by the Maryland Department of Housing and Community Development (HCD), based upon an annual competition and ranking of prospective housing development projects. Competition to win the tax credit allocation is very intense, driven largely by the market value of the tax benefits. Tax credits are sold to investors (limited partners), and the revenue resulting from the sale of the credits is used to help finance the construction of the property. Housing projects may be for low income individuals, including senior citizens or disabled tenants. Credits may be granted for new construction and also for renovating properties. 

Properties developed under Section 42 will often reflect a multi-tiered rental structure. By federal law, projects that are designed to serve the lowest income level tenants are given preference in the award of the available tax credit dollars. However, all units that qualify for credits must be both income and rent restricted, as affordable to households earning no more than 60% of the area median gross income. Other factors may also influence the awarding of the credits, but the result is that rent levels within the same property may vary for the same type of unit, due to differences in the income levels of the tenants. This multi–tier rent structure is often referred to as “affordability standards”. These rental standards are locked-in for a minimum of 30 years, and are established as part of the tax credit allocation process. Tax credits are paid out over ten years, but there is an additional five year period required, as part of the compliance period. Tax recapture can be enforced by the IRS for the initial 15 year compliance period if the property does not remain both income and rent restricted, or if the project has serious building code violations. For the remaining 15 year “extended use” period, while no longer subject to IRS regulation, the project’s income and rent restrictions are still subject to regulation by HCD. Over the years, as a result of the competitive process, rental restrictions have been extended to forty years. The compliance and extended use periods and affordability standards are recorded as deed restrictions for the property.

Rent levels are set as a percentage of the area median income, as determined annually by HUD and adjusted for the cost of tenant-paid utilities. Rents are usually far below market rates for similar units, and are subject to an annual review and certification process which is monitored by HCD, to ensure that the target income levels are maintained. Rent level adjustments can be made, but usually will be limited to increases of only 3% to 5% per year of existing rents. Such properties often experience higher than normal maintenance, payroll and utilities expenses, and total expenses will often exceed 60% of actual income. When rent increases are granted, after the fact, expenses will usually have increased to consume the profit margin created by higher rent levels.  

Since July 2005, assessors are required to apply an income approach when assessing such properties. Tax Property Article §8-105(3) reads as follows: “In determining the value of commercial real property developed under §42 of the Internal Revenue Code the Supervisor:  

i. shall consider the impact of applicable rent restrictions, affordability requirements, or any other related restrictions required by § 42 of the Internal Revenue Code and any other federal, state or local programs;
ii. may not consider income tax credits under § 42 of the Internal Revenue Code as income attributable to the real property; and
iii. may consider the replacement cost approach only if the value produced by the replacement cost approach is less than the value produced by the income approach for the property and it is reflective of the value of the real property.” 

This means that all property developed from Section 42 of the Internal Revenue Code shall be valued based upon the income approach, even when new. Rent projections, and the controlling affordability standards, are established before the project is approved and the credits are awarded. A budgetary operating statement will also have been prepared and should be available from the developer. It is essential that the rent structure and operating projections be considered when the property is being first assessed.

     Generally, the valuation for tax credit properties should conform to the model shown in the following example:

Rental mix and rental rates will vary. For new properties a 5% average vacancy level is recommended, actual vacancy conditions may be considered for subsequent valuations, as reflected in the performance of the property. Expense ratios will sometimes exceed 40% to 50% of rents. Expenses are best analyzed on a cost per unit per year basis. Currently for 2004-2005, the unit operating costs are typically $3,500 to $4,700 per unit. Averages published by the Urban Land Institute would suggest an average on the high end of this scale. Actual expenses should be considered, especially for older projects of smaller scale (50 units or less), where the target rents are predominately for lower median income tenants. With the example shown above, expenses of $285,356 will equate to $2,038 per unit. Pro-forma expenses may reasonably be adjusted upward, approaching the $4,000 per unit range, as supported by actual operating results. It is suggested that expenses be otherwise capped at no more than 70% of income, inclusive of reserves for replacements. Exceptional expense characteristics for the specific property should be recognized when properly documented. Capitalization rates should be 150 to 200 basis points higher than the rates applied for conventional apartments of similar character. For PILOT properties, the effective tax rate calculation should be used. The actual PILOT taxes paid should not be entered as an expense.  

Annual listings of Section 42 award winners being developed in Maryland are available at www.dhcd.state.md.us, the web site for the Maryland Department of Housing and Community Development. Listings of current and past award winners can be viewed there.  

The supervisor will insure that an income approach is maintained for each project. All Section 42 property will be identified by the BPRUC code 1842, to designate this special classification of subsidized housing. When rental restrictions expire, the property should be reclassified consistent with the use of the property. It is possible for a property nearing the expiration of the rental restriction period, to enter into a voluntary extension of the regulatory period. When recorded, a voluntary extension will perpetuate the special status of the property.​