Investment Earnings and the 50 Percent Test

Introduction
For an affordable multifamily housing project to qualify for the maximum allowable amount of four percent Low Income Housing Tax Credits (LIHTCs), at least 50 percent of the project’s aggregate basis (consisting of eligible basis plus land) must be financed with the proceeds of tax-exempt bonds issued pursuant to an allocation of private activity bond volume cap by a state housing authority or another municipal issuer (the 50 percent test).

In recent years, due to increases in development costs and construction delays resulting in cost overruns, projects have found themselves in a position in which the bonds initially issued to meet the 50 percent test were no longer sufficient for that purpose. The failure to meet the 50 percent test significantly reduces the LIHTCs available to a project and generally renders the project unviable, as the equity contributed by investors in exchange for the LIHTCs represents a substantial portion of the overall capital stack.

Typically, to address this concern, additional bonds are issued in an amount necessary to meet the 50 percent test and maintain the project’s access to the full LIHTC allocation. However, Internal Revenue Service guidance allows for certain investment earnings on bond proceeds to be taken into account in determining whether the numerator in the 50 percent test (i.e., bond proceeds spent on qualified project costs) equals or exceeds 50 percent of the denominator in the 50 percent test (i.e., total aggregate basis), which potentially reduces the amount of additional bonds that would need to be issued (or eliminates the need for a supplemental issuance entirely). The implications of such guidance will be the focus of this article.

Investment Earnings on Bond Proceeds
Under Revenue Ruling 2002-21, “amounts received from investing proceeds of tax-exempt bonds are counted toward satisfying the 50 percent aggregate basis test,” as such earnings are deemed themselves to be bond proceeds. Moreover, under the facts of that ruling, such investment earnings do not require a corresponding allocation of private activity volume cap (which is necessary for the underlying bonds themselves). The following paragraph will consider the application of the ruling in the context of a bond financing execution commonly utilized in today’s market.

Cash-Collateralized Bond Structure
Under the “cash-collateralized bond structure,” tax-exempt bonds are sold by a bond underwriting firm to public institutional investors (such as pension funds), and the proceeds of such bonds are delivered to a trustee for deposit into a “project fund” under the bond indenture. At closing, the trustee uses the bond proceeds to purchase investments (such as U.S. Treasury notes), the earnings on which are used to offset the interest cost on the bonds. Over the course of the construction period, draws on another source of funds (such as a bank construction loan) are delivered to the trustee for deposit into a “collateral fund” under the indenture, which allows the trustee to release a corresponding amount of bond proceeds to the project. This collateralization structure ensures that the bonds are always fully secured by cash, allowing for rating agencies to assign them the highest possible rating and investors to provide low interest rates. On the “initial mandatory tender date” (which occurs sometime after the conclusion of the construction period) the investments mature, and the cash received by the trustee in connection therewith is used to repay bondholders.

As part of the “collateral in, bond proceeds out” mechanic described above, the trustee regularly moves portions of the investment from the project fund to the collateral fund and an equal amount of cash from the collateral fund to the project fund. Once the project is completed and ready to be placed in service, the entirety of the investment would have been transferred to the collateral fund, and all bond proceeds would have been disbursed.

In addition to its impact on the 50 percent test calculation, which is discussed below, the cash-collateralized bond structure is frequently employed by developers due to its potential to generate a variety of other benefits for an affordable multifamily housing project.

Investment Earnings on Bond Proceeds in Cash-Collateralized Structure
As described above, earnings received from the investment of bond proceeds count toward the 50 percent test. In the cash-collateralized bond structure, where bond proceeds are continuously disbursed from the project fund and corresponding amounts of the investments initially deposited into the project fund are moved to the collateral fund, earnings are taken into account for purposes of the 50 percent test with respect to the portion of the underlying investment that is located in the project fund. As bond proceeds are drawn down and investments moved to the collateral fund, a steadily declining percentage of the overall earnings are counted toward the 50 percent test, as earnings on the investments that are on deposit in the collateral fund do not constitute earnings on the investment of bond proceeds (but rather, as earnings on the investment of collateral monies). Therefore, at the conclusion of a project’s construction period, an analysis of the draw schedule must be conducted to determine the portion of the earnings that was received while investments were in the project fund and such amount is taken into account in calculating the numerator of the 50 percent test.

As an example, consider a project with $20 million of tax-exempt bonds and $40 million of aggregate basis, in which the interest rate on the investments purchased at closing is four percent. Assuming that bond proceeds are drawn in equal monthly amounts over the project’s 18-month construction period, and that in connection with each draw, an equal portion of the investment is transferred from the project fund to the collateral fund as described above, then earnings on the investments, while they are on deposit in the project fund (i.e., earnings with respect to bond proceeds), would total approximately $566,000. This would increase the numerator from $20 million to approximately $20,566,000, thereby raising the 50 percent test amount from exactly 50 percent to 51.42 percent and creating some cushion that can help the project meet the 50 percent test in the event of cost overruns that result in a higher aggregate basis.

Conclusion
The includability of investment earnings in the 50 percent test analysis can be a useful tool for deals facing delays and cost overruns that may jeopardize the ability to meet the minimum requirement to qualify for the full amount of LIHTCs. Not only does it allow borrowers to decrease (or avoid entirely) the need for additional bonds to help meet the test, but such earnings, while treated as bond proceeds and taken into account for the 50 percent test, do not require a corresponding allocation of private activity bond volume cap, which is increasingly becoming scarce across the country. Developers considering the use of this strategy should consult experienced tax counsel.