Cost Segregation and Low-Income Housing Tax Credit
The Low-Income Housing Tax Credit (LIHTC) represents the federal government's primary program for encouraging private investment in affordable rental housing. Established under Section 42 of the Internal Revenue Code, LIHTC provides tax credits to developers and investors who build or rehabilitate properties serving low-income tenants.
For affordable housing developers and investors, LIHTC creates substantial tax benefits through annual credits over a 10 year period. When coordinated with cost segregation, cost segregation lihtc strategies can optimize total tax benefits by adding accelerated depreciation to the LIHTC credit stream, improving overall project returns and cash flow.
TL;DR – Key Takeaway
LIHTC Program Overview
The Low-Income Housing Tax Credit was created by the Tax Reform Act of 1986 and has become the most important resource for creating affordable housing in the United States. The program provides federal tax credits to private developers and investors who agree to maintain properties as affordable housing for specified periods.
LIHTC credits are allocated by state housing finance agencies based on Qualified Allocation Plans that prioritize projects meeting state affordable housing goals. Developers apply for credit allocations, and successful applicants receive credits that can be claimed annually for 10 years once the property is placed in service and meets compliance requirements.
Key program features
- Credits claimed annually over 10 year credit period
- Minimum 15 year compliance period with extended use agreement
- Income and rent restrictions on qualifying units
- Two credit rates: approximately 9% and 4% annually
- Credits can be syndicated to investors through partnership structures
The low income housing tax credit has financed over 3 million affordable housing units since inception and represents a substantial portion of all new multifamily rental construction in many markets.
Eligible Basis and Credit Calculation
LIHTC credits are calculated based on eligible basis, which includes the depreciable costs of constructing or rehabilitating residential rental units. Land costs, permanent financing costs, developer fees above certain limits, and costs of non qualifying amenities are excluded from eligible basis.
The credit calculation multiplies eligible basis by the applicable fraction (percentage of units that are rent restricted and occupied by qualifying tenants) and the applicable credit rate. The credit rate varies monthly based on federal rates but approximates 9% annually for new construction without other federal subsidies and 4% for acquisition or federally subsidized projects.
Table 1: LIHTC Credit Calculation Example
| Component | Amount | Notes |
|---|---|---|
| Total development cost | $15,000,000 | Including land and all costs |
| Less: Land and ineligible costs | ($3,000,000) | Land, financing, excess fees |
| Eligible basis | $12,000,000 | Depreciable residential costs |
| Applicable fraction | 100% | All units qualify |
| Qualified basis | $12,000,000 | Eligible basis × applicable fraction |
| Annual credit (9% rate) | $1,080,000 | Claimed annually for 10 years |
The total credits over 10 years approximate 90% or 40% of qualified basis depending on which rate applies. This substantial benefit makes LIHTC highly valuable for affordable housing projects, and adding cost segregation benefits enhances total returns further.
Compliance and Affordability Requirements
LIHTC properties must comply with strict affordability and operational requirements to maintain eligibility for credits. The primary requirements are the set aside election (minimum percentage of units that must be affordable) and rent and income restrictions that ensure units serve the target population.
The most common set aside is 40/60, requiring at least 40% of units be rented to households earning no more than 60% of area median income. Alternative set asides include 20/50 (20% of units to households at 50% of median income) and various other configurations including deeper targeting and average income elections.
Ongoing compliance requirements
- Annual certifications of tenant income and rent restrictions
- Physical inspections by state housing agencies
- File reviews verifying income certifications and rent calculations
- Maintenance of property in suitable condition for occupancy
- Extended use agreement restricting affordability for minimum 30 years total
Noncompliance can result in credit recapture, with substantial penalties including interest and potential loss of future credits. Professional asset management and compliance monitoring are essential for LIHTC properties, which affects operational costs that should be considered alongside tax benefits from both LIHTC and cost segregation.
Cost Segregation on LIHTC Properties
Cost segregation can be performed on LIHTC properties to identify components eligible for accelerated depreciation beyond the straight line depreciation over 27.5 years for residential rental property. The lihtc and cost seg interaction operates independently, with LIHTC credits based on eligible basis calculations and cost segregation affecting depreciation schedules.
The typical approach is to perform cost segregation after the property is placed in service and LIHTC credits begin. The engineering study identifies building components that qualify for 5, 7, or 15 year recovery periods, creating accelerated depreciation deductions alongside the annual LIHTC credit claims.
Table 2: LIHTC Property Cost Segregation Benefits
| Tax Benefit | Timing | Value Source |
|---|---|---|
| LIHTC credits | Annual for 10 years | Based on qualified basis and credit rate |
| Straight line depreciation | 27.5 years | Components not reclassified by cost seg |
| Accelerated depreciation | 5, 7, 15 years | Components identified by cost segregation |
| Combined benefit | Layered over project life | LIHTC credits plus total depreciation |
For investors in LIHTC partnerships, the allocation of both credits and depreciation follows the partnership agreement. Typically, tax credit investors receive the majority of LIHTC credits and depreciation in exchange for their equity investment, while the developer retains ownership and operational control.
Affordable Housing Depreciation Strategies
Affordable housing depreciation strategies for LIHTC properties should optimize the combination of credits and depreciation to maximize investor returns and project feasibility. Cost segregation enhances depreciation benefits without affecting LIHTC credit amounts, making it a valuable addition to LIHTC project structures.
The accelerated depreciation from cost segregation provides particular value in the early years of LIHTC projects when investors have the largest capital at risk. Enhanced depreciation deductions in years 1 through 10 alongside the LIHTC credits improve investor internal rates of return and can make marginal projects financially feasible.
For developers who maintain ownership interests in LIHTC properties, cost segregation provides ongoing benefit through accelerated deductions that can offset other income. The section 42 cost segregation benefits continue beyond the 10 year credit period, providing value throughout the compliance period and beyond.
To understand broader approaches to tax planning across multiple strategies, see Cost Segregation and New Markets Tax Credit for coordination strategies in community development contexts.
New Construction vs Rehabilitation
LIHTC applies to both new construction and substantial rehabilitation of existing properties, with different credit rates and basis calculation rules for each. Cost segregation strategies vary slightly depending on whether the project is new construction or rehabilitation.
For new construction LIHTC projects, the full building is eligible for cost segregation analysis. The engineering study examines all components and identifies those eligible for shortened recovery periods. The typical reclassification percentage for multifamily properties ranges from 20% to 30% of total building costs.
For rehabilitation projects, the LIHTC acquisition credit applies to the existing building basis (at the 4% rate) while rehabilitation expenditures can qualify for the 9% credit if requirements are met. Cost segregation on rehabilitation projects focuses on the improvement costs and can identify substantial components eligible for acceleration, particularly when renovations include mechanical systems, site work, and unit upgrades.
Investor and Developer Considerations
LIHTC projects typically involve complex partnership structures with tax credit investors providing equity capital in exchange for credits and depreciation, while developers retain operational control and receive developer fees and residual interests. Cost segregation benefits are allocated through the partnership agreement.
For tax credit investors, cost segregation enhances the value proposition by increasing total tax benefits beyond LIHTC credits alone. The incremental depreciation from cost segregation can improve investor returns by 50 to 100 basis points or more, making projects more attractive and potentially allowing developers to raise equity at better pricing.
Developers should evaluate cost segregation during the project planning phase and include expected benefits in investor presentations and financial projections. The cost segregation study expense is typically nominal compared to the incremental benefits and can be included in project costs or funded from operations.
Combining LIHTC With Other Incentives
LIHTC can be combined with other tax incentives to create comprehensive benefit structures for affordable housing development. Common combinations include LIHTC with historic rehabilitation credits, Section 45L energy credits, state affordable housing credits, and various grant programs.
For properties incorporating energy efficient design, the Section 45L credit can provide additional benefits. LIHTC developers building energy efficient units can claim 45L credits of up to $5,000 per unit while also receiving LIHTC credits and cost segregation benefits. The programs operate independently with different qualification requirements.
Historic rehabilitation projects may qualify for both LIHTC and the historic tax credit when rehabilitating qualified historic buildings for affordable housing. Coordination is required because both credits affect basis and have specific qualification rules, but the combination can make challenging adaptive reuse projects feasible.
For projects in designated community development areas, review Stacking Tax Strategies for Maximum Savings to understand comprehensive approaches to multiple incentive programs.
Exit Strategies and Disposition
LIHTC investments have defined holding periods due to compliance requirements and partnership structures. The typical exit involves the tax credit investor exiting after the 15 year compliance period, with the developer or a related party acquiring the investor's interest at a negotiated price.
Cost segregation affects exit strategies through its impact on adjusted basis and depreciation recapture. Accelerated depreciation reduces the property's adjusted basis more quickly than straight line depreciation, which can increase gain on sale and create Section 1250 depreciation recapture exposure.
However, the time value benefit from accelerated deductions typically outweighs the deferred recapture cost. A dollar of tax benefit today is worth more than a dollar of tax cost 15 years in the future, even accounting for recapture rates. Additionally, strategies like 1031 exchanges can defer gain recognition if the investor acquires replacement property.
Frequently Asked Questions
What is the Low-Income Housing Tax Credit (LIHTC)?
The Low-Income Housing Tax Credit, also known as Section 42, is a federal program that provides tax credits to developers who build or rehabilitate affordable rental housing. The credit is allocated by state housing agencies and provides a dollar for dollar reduction in federal tax liability over a 10 year period.
Can I use cost segregation on LIHTC properties?
Yes, cost segregation can be performed on LIHTC properties, but careful coordination is required because LIHTC calculations are based on eligible basis and building costs. The interaction between accelerated depreciation from cost segregation and the LIHTC credit calculation must be evaluated to ensure both benefits are properly captured.
Does cost segregation affect my LIHTC credit amount?
Cost segregation does not directly affect the LIHTC credit amount, which is calculated based on eligible basis and applicable rates at the time credits are allocated. However, the accelerated depreciation from cost segregation affects your ongoing tax position and cash flow alongside the LIHTC credits.
What is eligible basis for LIHTC?
Eligible basis is the portion of building costs that qualifies for LIHTC credits, generally including construction costs for residential rental units but excluding land, non qualifying amenities, commercial space, and certain other costs. The eligible basis is multiplied by the applicable fraction and credit rate to determine annual credits.
How much are LIHTC credits worth?
LIHTC credits provide approximately 9% of eligible basis annually for 10 years for new construction without federal subsidies (about 70% present value), or approximately 4% annually for acquisitions or projects with federal subsidies (about 30% present value). The exact rates are set monthly by the IRS.
Can I combine LIHTC with other tax incentives?
Yes, LIHTC can be combined with other tax incentives including Section 45L energy credits for efficient units, historic rehabilitation credits for qualifying buildings, and state level affordable housing incentives. Each program has interaction rules that must be followed, and basis adjustments may apply.
What are the compliance requirements for LIHTC?
LIHTC properties must maintain affordability and income restrictions for a minimum 15 year compliance period, with an additional 15 year extended use period. Owners must certify annually that income and rent restrictions are met, and state agencies perform physical inspections and file reviews to verify compliance.
Does cost segregation help with LIHTC cash flow?
Yes, cost segregation can improve cash flow on LIHTC properties by accelerating depreciation deductions beyond the straight line depreciation already claimed. The LIHTC credits provide substantial benefits, and cost segregation adds incremental depreciation acceleration that can offset other income and improve project returns.
How does affordable housing depreciation work with LIHTC?
LIHTC properties use straight line depreciation over 27.5 years for residential rental property. Cost segregation identifies components that can be depreciated over 5, 7, or 15 years instead. This accelerates deductions while the LIHTC credits continue on their 10 year schedule, creating layered tax benefits.
Should I do cost segregation before or after LIHTC allocation?
Cost segregation is typically performed after construction is complete and the property is placed in service, which occurs after LIHTC credits are allocated. The cost segregation analysis identifies components for accelerated depreciation while LIHTC credits are claimed over their 10 year credit period.
Next step: For community development tax credit coordination, see Cost Segregation and New Markets Tax Credit to understand NMTC structures. For comprehensive multi strategy planning, review Stacking Tax Strategies for Maximum Savings.