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Friday, January 28, 2022

Weekly SSRN Tax Article Review And Roundup: Eyal-Cohen Reviews Layser's Financing Affordable Housing Through Opportunity Funds

This week, Mirit Eyal-Cohen (Alabama; Google Scholar) reviews Michelle D. Layser (Illinois; Google Scholar), Financing Affordable Housing Through Opportunity Funds, 19 Pitt. Tax Rev. __ (2022):

Mirit-Cohen (2018)

Affordable housing is a national challenge, now more than ever. While the idea is not new, utilizing the tax system to incentivize creation of affordable housing has been endorsed by current and previous administrations. The Opportunity Zone Fund and the Opportunity Zones tax incentive are programs that provide tax relief to taxpayers who would otherwise be subject to the capital gains tax but choose to invest in low-income communities.  Specifically, they provide deferral of capital gains from sale if gains are reinvested in an opportunity fund; they make available partial exclusion of pre-investment gains if kept for five years (through increases in basis); and they offer complete exclusion for post-investment gains if held for ten years.

As such, these programs deliver investors with a location incentive (to invest in a specific distressed zone), a realization incentive (to sell appreciated property and escape taxation), and a profit motivation to generate significant investment returns. However, Layser claims that despite the bipartisan political rhetoric around this measure as an effective tool to finance projects that benefit low-income communities and promote affordable housing, to date, its impact has been trivial. For example, Opportunity Funds are permitted to hold a broad range of investments (that do not necessarily benefit low-income residents) and may invest in a variety of business types as long as it is located in a designated opportunity zone.  So, while Opportunity Fund programs can spur development of distressed neighborhood, they cannot alone create an incentive to invest in affordable housing.

Tracy A. Kaye has recently used a case study to examine the pros and cons of such federal economic development programs. Similarly, Layser has surveyed in the past ways to effectuate tax measures to increased affordable housing. In this Essay, she adds to current literature on the topic by revisiting the practical barriers to financing affordable housing in Opportunity Zone programs. Some of these hurdles include lack of mission-driven investment, substantial improvement rules in rehabilitation projects, debt-to-equity ratios requirements for new construction, strict timing rules, and limits on nonqualified financial property holdings. Moreover, rent restrictions make such projects less profitable than other market-rent alternatives.  

Layser points out a similar tax preference- the Low-Income Housing Tax Credit (LIHTC) as an effective tool to promote affordable housing development. The LUHTC provides a tax credit over ten-year period equal to a percentage of the qualified basis of qualified low-income buildings. A strategy for monetizing the tax credit ex ante is selling partnership interests that give their investors the right to the future stream of tax credits. As a result, most LIHTC investors remain in the deal for the required ten-year credit period thereafter claim the tax credits and exit the investment. In that way the LUHTC succeeds in transforming a risky, low-profit investment into a relatively low-risk and profitable investment. Moreover, regulatory requirements under the Community Reinvestment Act demand commercial banks invest in low-income communities within their service area, which makes them the largest share of investors in the programs.

Opportunity Zone programs cannot generate such monetization for affordable housing investors. Accordingly, proposals to pair Opportunity Zones tax preferences with the LIHTC to create LIHTC-OZ benefits have been suggested. Affordable housing developers can create a tax credit investment fund (used for monetization) that also qualifies and invests substantially all of its capital in qualified Opportunity Zone property. Such combination can provide tax credits for the acquisition, rehabilitation, or new construction of rental housing targeted to lower-income households and increase the pool of investors beyond the financial institutions that currently participate in affordable housing deals. 

Yet, Layser points out practical and legal barriers as a hurdle for such LIHTC-OZ strategy. She points out to the requirement to substantially improve distressed property (and its adjusted basis) that disincentivizes light rehabilitation projects. The zero-basis rules crowds out new construction and prevents partners in Opportunity Funds partnership from claiming loss deductions unless they borrow capital. Timing and asset holding rules are not in accordance with practical realities of developing affordable housing transaction, thus disincentive undertaking such projects. Lastly, the identity and motivations of investors that usually undertake low-income housing projects such as commercial community banks that need to satisfy regulatory requirements to invest in their local low-income communities do not match the lower-risk and higher-profit motivations of opportunity zones investors such as high-net-worth individuals, managed investment funds, life insurance companies, and mutual funds.

Layser proposes to amend the law as follows: First, reduce the “substantial improvement” threshold solely for the purpose of affordable housing rehabilitation. Second, relax the basis rules by providing a basis equal to contribution in the partnership of Opportunity Funds that develops affordable housing. Third, provide remedial opportunities for investors who violate timing rules due to permit and other common development delays via documentation sent to Treasury proving the reason for the delay. Lastly, Layser suggests raising the nonqualified financial property threshold in the context of affordable housing deals to include residential rental property for low-income taxpayers.   

Nevertheless, Layser warns there are policy considerations that may prevent Congress from adopting reform proposals for creating the LIHTC-OZ. Reducing the supply of current affordable housing development driven by the LIHTC alone is an undesirable outcome. It will harm economic efficiency by subsidizing an activity in which taxpayers would have engaged without that subsidy. Seems like it is doubtful whether and how much an LIHTC-OZ pairing will drive additional investors in Opportunity Zones to be involved in affordable housing supply. Consequently, now is the time to retract the Opportunity Zone tax experiment for failing to alleviate affordable housing needs before it is too late and legislative inertia catches on.

Here's the rest of this week's SSRN Tax Roundup:

https://taxprof.typepad.com/taxprof_blog/2022/01/weekly-ssrn-tax-article-review-and-roundup-eyal-cohen-reviews-laysers-financing-affordable-housing-t.html

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