LOW-INCOME HOUSING PROVIDES TAX BREAKS FOR INVESTORS

Interested in a tax shelter that provides steady-if unspectacular-returns, and at the same time benefits the community? Consider an overlooked but increasingly popular investment called the low-income housing tax credit.

Created in 1987 by the federal government, this program provides dollar-for-dollar federal tax credits for ten years. The government makes around $400 million available in tax credits each year. C corporations consume the bulk of the credits, but individuals can qualify as long as they meet income and net worth minimums established by their state. A typical minimum might be $35,000 annual gross income and a $75,000 net worth excluding the home, car, and furnishings, though they vary state to state. However, a broker sponsoring a partnership might require higher limits, and many investment experts recommend higher limits because of the riskiness of the investment. Investors can qualify for the credits by directly building, buying, or renovating property to rent to lower-income people, but most find it easier to invest through limited partnerships.

Understand that this is not public housing. These apartment properties typically are built in suburbs or smaller towns for tenants earning no more than 60 percent of the local median income. In turn, the rents must be at least 10 to 15 percent below local market rates. The housing must remain as low-income housing for at least 15 years; otherwise, the government will recapture some of the tax credits.

Calculating the maximum tax credit you can take each year is pretty complicated, and you'll want to work with a financial planner or tax specialist familiar with this type of investment. In general, you multiply your marginal tax bracket by what's called the "tax-credit equivalent." The maximum tax-credit equivalent is $25,000, but that could be less if you are also deducting passive losses from actively managed property.

Suppose you are in the 31 percent tax bracket. That means the maximum tax credits you can take in a single year is $7,750 (married filing singly may not claim any tax credits). The tax credits may be carried forward if necessary. Unlike other passive loss investments, the low-income tax credit does not phase out as your income rises.

What kind of typical return will your investment make? First, don't count on any cash flow. Rents will likely barely cover debt and operating expenses. The return due to the tax credit will obviously depend in part on your tax bracket. An article in the May 2000 Journal of Financial Planning estimated that an investor in the 31 percent tax bracket investing $50,000 might see an annual after-tax return of 10 to 11 percent. How much additional you might earn from capital gains after a dozen years is the unknown, since the program isn't old enough to have established any track record.

On the plus side, the tax credits provide a fairly steady stream of benefits regardless of the state of the economy, real estate and stock markets, or interest rates. With a shortage of low-income housing, occupancy rates should remain high regardless of the local housing market.

On the risk side, it's clear that this is a highly illiquid, long-term investment. It may take a couple of years for the tax credits to fully kick in while the property is being built or renovated. Because the tax credits can be claimed only for ten years, and the property must be held at least 15 years, some years the investment won't return anything. Furthermore, any capital gains payoff is over a decade away and not guaranteed, and there is always the risk that not all or any of your principal will be returned. The constraints on rental rates may be a problem if expenses rise dramatically.

Assuming you invest through a partnership, you'll want to be very careful whom you choose. They should have a track record for bringing properties to market quickly, and you need to be assured they'll comply with the complicated federal rules so that the property remains qualified as low-income property.

You also should have your financial planner run the numbers to determine whether the potential return is worth the risk. Some of these deals can be excellent, while others can be poor.