Read about the Qualified Contract process and why the pricing calculation can help determine whether or not to seek early release from IRC Section 42 compliance.
Is Qualified Contract Right for Me? Let’s Do the Math
Multi-family housing values continue to rise along with demand in many parts of the country. This poses a new challenge for owners and buyers of properties that seek an early release from rent and income restrictions under Section 42 of the Internal Revenue Code (IRC).
Under IRC Section 42, properties are subject to a minimum 30-year affordability commitment: a 15-year Initial Compliance Period, plus a minimum 15-year Extended Use Period by way of a Land Use Restriction Agreement placed on the property. This commitment puts restrictions on the tenant’s income and limits the amount of rent that can be charged. There is, however, a provision in IRC Section 42 that allows owners to be released from the Extended Use Period through the Qualified Contract option.
The Qualified Contract option involves submitting an application to the State Housing Finance Agency (HFA) any time after the 14th year of the Initial Compliance Period. Once the application is submitted, the HFA has a one-year period to procure a Qualified Buyer who will maintain the affordability restrictions through the Extended Use Period. If after the one-year period, the HFA is not able to secure a Qualified Buyer, then the owner is relieved of the affordability restrictions, and those restrictions are phased out over three years.
Before submitting a request for a Qualified Contract, it’s important to evaluate the value of your property by calculating the price in accordance with IRC Section 42. Owners may discover that the Qualified Contract purchase price is lower than the property’s Fair Market Value (FMV). This is rare, but it could happen in some markets with high housing demands and low supply.
In consideration of these potential risks, we encourage owners to take time to understand the Qualified Contract option to determine if it helps them to achieve their goals. Tidwell Group helps owners consider their options within the guidelines of each state. We can also provide the Qualified Contract price calculation, which will help you determine if the price is higher or lower than the FMV.
How a Qualified Contract Application Works
As an important first step, owners should review original applications and the Tax Credit Land Use Restriction Agreements to note any waivers or other restrictions on the property. Sometimes the developers or property owners of IRC Section 42 properties have elected to waive their right to request a Qualified Contract, usually to achieve more favorable tax credit application scoring.
If no waivers exist, then applicants will need to determine the status of the building’s Initial Compliance Period and/or the Extended Use Period. To request a Qualified Contract, applicants can submit the request in the last year of the Initial Compliance Period or any time within the Extended Use Period.
As part of the application, owners must provide a calculation of the Qualified Contract purchase price. This calculation would ideally be determined by a CPA with specific knowledge of the formula laid out in IRC Section 42 related to calculating the Qualified Contract purchase price. This pricing formula is complex but is designed to give the property owner an inflation-adjusted return on the original equity contribution related to the purchase of tax credits.
The formula calculates the price as a function of the income-restricted portion of the building(s) and takes into account the FMV of the land (as-is, income-restricted) and any unrestricted housing units. The calculation is broken down into five sections:
- Outstanding debt on the property (limited to the original debt placed on the property used to pay for “Qualifying Building Costs”);
- Original equity used to purchase tax credits increased by the Cost of Living Adjustment from the first year tax credits were claimed;
- Additional capital contributions not reflected in items (1) or (2) above;
- Cash distributions from or available from the property (reduction to price); and
- FMV of land and the non-low-income portion of the property (an appraisal is used to determine the FMV of the land and any unrestricted housing units and is based on the as-is value).
The acceptance of the application triggers the start of the one-year period during which the HFA must work to secure a Qualified Buyer who will maintain the affordability restrictions. In some states with high demand for housing, we have seen an increase in Qualified Buyers identified to purchase properties.
A Qualified Buyer is a buyer that will acquire the property for the Qualified Contract price and will continue to operate the property under the affordability restrictions for the remainder of the Extended Use Period. As it relates to Qualified Contracts, the HFA’s sole responsibility is to present the owner with a Qualified Buyer. If the HFA presents the owner with a Qualified Buyer, and the sale does not close due to a default by the owner or other matters within the control of the owner, the one-year period ends, and the owner is required to continue operating the property with the affordability restrictions in place for the life of the Extended Use Period.
On the last day of the one-year period, if the HFA is unable to find a Qualified Buyer, the owner is released from the Extended Use Period and its affordability restrictions.
There is, however, another potential wrinkle to consider. Once the property is released from the affordability restrictions, the clock starts again. Existing tenants are grandfathered in for three years, during which time their rent should not increase more than the annual increase allowed by the state HFA.
It is important to note that the Qualified Contract option only releases owners from the affordability restrictions associated with the Low Income Housing Tax Credits. If there are other restrictions on the property from a debt instrument (HOME Loan, Tax-Exempt Bonds, etc.), those restrictions may remain on the property even if the property is released from the Tax Credit Land Use Restriction Agreement. In other words, when loans are paid off, some restrictions will expire. However, depending on the terms of the individual Restrictive Covenants provided for in the specific debt instrument used, other restrictions will persist for a set period.
Is Qualified Contract Right for Me?
If you are a potential buyer and plan to use the Qualified Contract option to remove affordability restrictions on an IRC Section 42 designated property, there are some very important pricing considerations. You will want to ensure that the FMV of the property does not exceed the Qualified Contract price. In such cases, the property is much more likely to be purchased during the one-year period. In areas of high property values, you’ll want to have a contingency plan in place in the event that someone does offer to purchase the property. In addition, carefully read the affordability restrictions within the Land Use Restriction Agreement to confirm that the property has not waived its right to a Qualified Contract.
As part of their due diligence, potential buyers should request the following documents from the seller in order for a CPA to calculate the Qualified Contract price:
- Audited financial statements from the placed in service date through most recent year-end
- Tax returns from inception through most recent year-end
- Final Cost Certification prepared when the property was placed in service
- Partnership Agreement with all amendments
- Original Loan Documents
- Land Use Restriction Agreement / Covenants
- 8609s with Part II completed
If you are an owner of an IRC Section 42 property and want an early release from the affordability restrictions, you should conduct a price calculation to determine if the Qualified Contract price is higher than FMV. The price calculation process can also compare the price per unit to other properties in your state currently exercising their right to Qualified Contract. If the Qualified Contract price per unit is lower than comparable properties and the total price is lower than FMV, Qualified Contract may not be the best option for you, as there has been an increase in Qualified Buyers purchasing properties through the Qualified Contract process.
Although the Qualified Contract option is outlined in IRC Section 42, the IRS has never issued final regulations detailing the process. As a result, each HFA has the authority to design its own regulations for implementing the Qualified Contract option. As a result, the process is different for every state. Differences from state to state include, but are not limited to, variations in the Qualified Contract price formula, documents required for submission and application fees. For instance, some states require all audited financial statements and tax returns for the entire Initial Compliance Period and will not accept an application if the owner does not submit information for one of the 15 years. Also, some states have required developers to waive their rights during the tax credit application process, which has resulted in no properties being eligible for Qualified Contract in those states.
The team at Tidwell Group has extensive knowledge of the application process for each state and a thorough understanding of IRC Section 42 and calculating the Qualified Contract price. We can use our experience and understanding of the program to assist in evaluating whether or not Qualified Contract is right for you — and the likelihood of your property being released from the affordability restrictions. Contact Amie Gray or Jeremy Densmore to discuss your goals.
- IRC Section 42(h)(6)(F) through (H)
- Treasury Regulation Section 1.42-18(c)(1) through (6)
About Tidwell Group LLC
Tidwell Group is a full-service accounting and consulting firm that specializes in the real estate and construction industries and is a Best of the Best Firm according to the 2019 INSIDE Public Accounting National Benchmarking Report. Their experienced professionals serve all asset classes within the affordable housing, conventional real estate, and not-for-profit industries. Within the affordable housing industry, Tidwell Group’s expertise ranges from low-income housing tax credits, bond and conventional financing, HUD compliance and reporting and USDA-Rural Development compliance and reporting. Their focus is on developing long term client relationships through value-driven results. For more information on Tidwell Group, contact their firm on their website at www.TidwellGroup.com, on Twitter @TidwellGroupLLC, or by telephone at (866) 442-7090.