Community Affair

Nobody likes paying taxes. But investing in an affordable housing tax credit program allows investors to take some of the pain out of this lifelong commitment and be socially responsible at the same time. That’s a rare combination these days.

The economics of affordable housing tax credit investing are simple: Tax credits lower an investor’s tax bill and increase after-tax income. This is an attractive investment for two primary reasons. First, this vehicle generates steady income that does not fluctuate with the markets, the economy, or interest rates. Second, it helps finance the development of affordable multifamily housing across the United States.

Why is the development of affordable housing so important? A recent Harvard University study found that one U.S. household in eight spent at least half its income on housing in 2001, the latest full year with available figures. Thirty-eight percent of elderly renters spent at least half their monthly income on housing and two million households headed by single women spent half or more of their income on housing in 2001. The National Low Income Housing Coalition (NLIHC) found that a full-time minimum-wage worker cannot afford to pay the fair market rent for a two-bedroom unit anywhere in America.

However, in the past decade the tax credit program has been responsible for the private construction or rehabilitation of more than one million rental units for low-income families. During the same period, the federal government has retreated from its traditional housing sponsorship role. In fact, the tax credit program has become the country’s primary catalyst for developing affordable multifamily housing. To qualify for the tax credits, property developers must set aside 20% to 40% or more of their rental units for tenants who earn 60% or less of the area’s median income.

As we are all painfully aware, today’s economic environment is uncertain and traditional investment vehicles have suffered over the past few years. Top-rated bonds have delivered solid returns as a safe haven, but that status may not last when interest rates rise, a more likely occurrence now that the Federal Reserve raised the discount rate by 25 basis points on June 30. As an alternative, you may wish to consider federal housing tax credits for certain clients.

For investors, tax credits offer true tax savings because they translate directly into increased after-tax income. Unlike tax deductions, which only reduce taxable income, tax credits reduce federal income tax liability on a dollar-for-dollar basis.

For example, a dollar of tax deduction only reduces taxable income by $1. Assuming a 28% income tax bracket, each dollar of tax deduction would have a real value of only 28 cents. A dollar of tax credit, on the other hand, reduces tax liability by $1, thereby providing a dollar of additional after-tax income. This makes tax credits, unlike deductions, tax bracket neutral and impervious to different tax rates.

Credits in Context

Before getting into the nuts and bolts of the tax credit program, let’s address an obvious question: How do tax credits fit into the financial plan?

First, tax credit investments are typically sold to investors who reasonably assume they will pay taxes over the next 10 to 12 years, meet their individual state’s suitability requirements, and have the money to invest for the long term. Individuals usually invest through a broker or a financial planner, with a minimum investment of $5,000.

Second, because tax credits are allocated at a predetermined rate and are not tied to the equity markets, they may provide predictable results. Don’t expect sky-high returns–or sky-high risk. In fact, tax credits offer just the opposite. By investing in a diversified portfolio of real estate, investors receive a steady, predictable stream of tax credits over a 10- to 12-year period. They also retain partial ownership of the properties at the end of the tax credit cycle, which could result in capital appreciation if the properties are sold or refinanced. Of course, there is the possibility that you could lose all your money if the properties do not have any value at the end of the investment.

Third, housing tax credits help satisfy the growing need to reduce personal tax liability, whether from active, passive, or portfolio sources. Individuals in their peak earning years appreciate tax credits because they free up tax dollars and allow them to retain more of their current income.

Conversely, investors on fixed incomes can also benefit from tax credits. While their incomes may be fixed, their taxes aren’t. Many retirees are forced to withdraw and pay taxes on funds from qualified retirement plans. Assume a client in the 28% tax bracket expects to withdraw $25,000 per year from a retirement account. The client could invest $70,000 in a typical tax credit fund using dollars from outside of the retirement fund. The investment will generate $7,000 in tax credits annually for a total of $70,000 over 10 to 12 years. With this strategy, taxes on the withdrawals are reduced dollar for dollar. The client can now withdraw $250,000 over 10 years, keeping the full value of the retirement fund’s distributions.