Affordable Housing Developers Should Consider Tapping into Market Rate HUD Program

Are you aware of the potential tax refunds, accelerated tax deductions, and low equity requirements that U.S. Department of Housing and Urban Development (HUD) insured projects can provide developers? If not, you may be overlooking a lucrative opportunity in the real estate sector. 

Taxes due on developer fees can be significant. As affordable housing developers grow their Low-Income Housing Tax Credit (LITHC) asset base, they receive substantial developer fees that create taxable income. If a developer is not aware of the ways to decrease taxes on that income, they may be unnecessarily and significantly cutting their profits. 

Many affordable housing developers are well-versed in the intricacies of their sector, which include securing project awards, ensuring compliance with LIHTC regulations, and identifying suitable land for tax credit allocations. There has been a recent, noticeable shift toward incorporating HUD-insured deals within the LIHTC framework, which is believed to help developers transition to market-rate projects with greater ease. 

Tax and Non-Tax Benefits 

When considering a HUD-insured market-rate project, there are both tax and non-tax benefits that may not be immediately apparent to those unfamiliar with the advantages of HUD-insured development. Non-tax benefits include an 85% loan-to-cost (LTC) ratio, a 40-year amortizing loan with competitive interest rates, and the status of the debt as qualified non-recourse debt. If the financials of the project erode significantly, this means that the developer can relinquish the project to HUD without further liability; however, this also offers additional risk protection to developers who may be looking for portfolio security. 

Most clients do not encounter such a need to part with their projects and, contrarily, typically have deals that are cash cows. The U.S. Department of HUD will finance a large portion of the project, so the equity requirement, depending on a few factors, can be quite low compared to a typical market-rate product. The equity requirement necessary to complete a HUD deal is open to more sources than a typical tax credit deal, and many HUD developers have built a strong base of investors to help fund the gap, such as friends and family. In addition, developers are becoming savvier and letting the existing landowner contribute to the property and receive a percentage of ownership of the entity. This minimizes the upfront cash outlay. HUD-insured projects can also make for great long-term hold assets that can create significant value inside a larger portfolio should the developer decide to cash out one day. 

Tax Advantages of HUD-Insured Projects 

Cost Segregation 

Cost segregation has become a hot topic when discussing year 15 strategies surrounding tax credit properties in the affordable housing industry. These cost segregations are prime for a market-rate project as they are performed once the project is built. The benefit of this is that the cost segregation can move up to 40% of the depreciable basis into 15- and five-year-life assets. This then impacts the acceleration of depreciation deductions that the developer would have had to otherwise wait much longer than 15 years to offset against taxable income. 

Bonus Depreciation 

There are still bonus depreciation opportunities to increase these tax benefits into the first few years of a project, as bonus depreciation allows developers to deduct 60% of the adjusted basis of the lower life assets right off the bat. This significant depreciation deduction becomes an offset to taxable income, thereby lowering the owners' taxes in the early years of the project. The bonus depreciation percentage decreases to 40% in 2025, 20% in 2026, and then goes away in 2027, so developers will want to move quickly to use this tax benefit. Legislation has been changed regarding bonus depreciation in the past, so it is possible for these percentages to change in the future as well. 

Bonus depreciation can be so significant that it creates excess deductions. Accordingly, if the developer is in a net operating loss position, he/she may qualify to carry these losses back three years and receive tax refunds on their previously paid taxes or use the operating losses going forward to offset taxable developer fees in future years. It is clear why growing a real estate portfolio that generates strong cash flow, creates significant tax savings, and has a lower up-front equity requirement would be undeniably attractive to LIHTC developers. 

45L Tax Credit 

Another tax benefit generated from a HUD-insured deal is the 45L Tax Credit, designed to reward developers building energy-efficient units. The Inflation Reduction Act has expanded the rules around the 45L Tax Credit and now allows qualified projects a credit of up to $5,000 a unit. Under these rules, a 200-unit development could generate $1 million in tax credits, a dollar-for-dollar tax liability reduction. The three-story height restriction previously in place has also been removed under the new rules, so more projects can now access this tax benefit. Developers can use this credit or even sell to an investor in the deal to generate more immediate cash. 

Matching the 45L Tax Credit with the HUD program is mutually beneficial. It makes sense as the $5,000 credit is only available when the construction has been subject to the Davis-Bacon prevailing wage, which the U.S. Department of HUD already mandates. The matching also encourages developers to build projects that are better for the environment and create value for the owners. As a developer, it is critical to work with your architects, engineers, and construction team to make sure you are meeting the requirements to maximize the programs’ benefits. 

Timing and Strategic Planning 

While there is no exact formula for timing the building of a HUD-insured project every three years, there are several factors worth considering. The HUD approval process can be lengthy; however, the U.S. Department of HUD has taken steps to make this process more efficient over recent years. Given that the bulk of tax savings from cost segregation occurs in the early years, developers should plan subsequent projects to continue benefiting from these advantages.  

Additionally, HUD-insured projects are increasingly attractive to Real Estate Investment Trusts (REITs), making them easier to market if developers need to liquidate part of their portfolio. Under circumstances where developers need to liquidate part of their portfolio, it is much more feasible to move one of these projects as opposed to dealing with the exit on a LIHTC deal. 

Key Considerations

Developer-Lender Relationships 

Building a strong relationship with a HUD-approved lender is essential. Many highly qualified lenders in the market will be interested in meeting and discussing the various stages of the process with a developer. These lenders are more than willing to walk the developer through HUD’s sometimes rigorous process. A developer’s decision to engage a CPA who knows and understands not only the upfront HUD rules and regulations but who is also experienced with the long-term rules is critical to achieving the tax and non-tax benefits. A qualified CPA can help to avoid missteps along the way that could preclude or eliminate the tax savings that developers could otherwise benefit from. 

Fluctuating Interest Rates 

Due to higher interest rates, there is a slight decrease in activity in the HUD program. We expect to see rates drop beginning in the third quarter of 2024 and, thus, expect to see more deals come across in 2025. Developers canceled their planned deals when rates more than doubled before they got the deals moving. With the lowering of rates and the pent-up demand, we will see this program continue to flourish and expand. Refinancings, which can usually be closed in 60 days, may also tick up in 2025 by utilizing HUD’s 223(a)(7) program, another added benefit of the HUD-insured program. 

Opportunities for Growth

The tax and non-tax benefits of HUD-insured projects present significant opportunities for developers, and understanding these advantages can lead to substantial rewards in the real estate industry. If you are ready to leverage the advantages of your HUD-insured project but do not know where to start, the EisnerAmper Real Estate team has a depth of resources and knowledge to help our clients. Contact us today to find out how we can assist you.