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Good Financing Strategies Worth Exploring

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By Lowell L. Kalapa

(Released on 8/3/08)

Well, it seems that state leaders have finally admitted that the economy is headed for, if not already in, a slump, and the outlook for tax revenues gets more bleak by the day as visitor arrivals struggle, occupancies fall, and residential construction becomes but a memory.

So what is state and county government to do? The last downturn’s gimmicks of tax incentives and tax credits are just not feasible as there are barely enough resources to keep government running let alone trying to hand out goodies to stimulate the economy.

As it was pointed out in an earlier commentary, state and county government still have the ability to access the credit markets by selling bonds or debt. With interest rates once again at historic lows, this is an opportune time for government to go to the credit markets to finance much-needed public infrastructure. With investors looking for safe and secure opportunities to place their funds, public debt or bonds become attractive as a secure investment.

Because public debt pays tax-exempt interest, investors are willing to settle for lower interest rates. In most markets, tax-exempt rates are much lower than taxable rates at a given rating level and maturity. Often, tax- exempt rates are a full percentage point or more lower for 30 or 40-year triple A rated notes.

Thus, an investor who is in a 36% tax bracket actually could take home more with a tax exempt bond than he would with a taxable note. For example, if the investor invested $10,000 in a tax exempt state bond paying 5% interest and another $10,000 in a taxable note paying 7% interest, he would actually realize more on the state bond because he would owe taxes on the taxable bond interest. Thus, although the taxable bond would yield $700 in annual interest payments, after deducting 36% for taxes, the investor would take home only $448 while he would take home the entire $500 earned from his 5% tax exempt bond. Thus, it becomes attractive to investors in this turbulent time in the market to seek safe and secure investments that will give them reasonable returns. Because state and local government bonds are tax exempt, the actual return on investment has the equivalent of a higher interest rate of say 8% or 9% depending on the tax bracket of the investor.

To sweeten the deal even more, if the state or local government utilizes “private activity bonds” allocated under Section 142(d) of the Internal Revenue Code for affordable or low-income housing, the proceeds become eligible for the federal and state low-income housing tax credits. While there are federal low-income housing credits that are always over solicited, those are the 9% tax credits. But there are also 4% low-income housing tax credits that are usually never claimed because they hardly seem worthwhile in making the numbers pencil out.

The developer of the affordable or low-income housing project claims the credits and turns around and sells them to investors who use the credits as a dollar-for-dollar offset against federal and state income tax liability equal to roughly 4% of the “qualified basis” of the affordable housing units for a period of ten years after the credits are claimed. “Qualified basis” excludes the land and any commercial components; in other words, the qualified basis is the residential units.

In the past, Investors generally paid 90 to 95 cents for each dollar of tax credits, but under current conditions, those tax credits are being purchased for about 84 cents on the dollar. The amount they pay for those credits thus becomes additional moneys to finance the development of the affordable housing project. So, for example, on a $10 million affordable or low-income housing project, $1.5 million is for the land and the commercial component leaving a qualified basis of $8.5 million. This would produce roughly $290,000 a year in tax credits which if sold for 95 cents on the dollar would produce approximately $2.75 million more in proceeds to help finance the project.

There are rules governing the use of the 4% tax credit equity such as the ten-year holding period which requires the project to have been owned by the prior owner for at least 10 years to be eligible for the tax credits and at least 50% of the aggregate basis of the building and land must be financed with tax-exempt bond proceeds.

With the use of tax-exempt bond financing and the low-income tax credits, such affordable housing projects could experience nearly 40% in additional proceeds to help pay for the project. This is a financing strategy worth exploring as the economy begins to slow.

Lowell L. Kalapa is the president of the Tax Foundation of Hawaii. Mr. Kalapa’s commentary is printed each week in the Maui News, West Hawaii Today, Garden Isle News, and the HawaiiReporter.com.

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