Mixed-Finance Section 202 and Section
By Ruth Sparrow
On December 1, 2003, HUD issued an interim rule effective December 31, 2003, providing
for mixed-finance and for-profit participation in the development and operation
of Section 202 and Section 811 supportive housing for the elderly and persons with
disabilities (24 C.F.R. Part 891, 68 Fed. Reg. 67,316 -Dec. 1, 2003). The interim
rule implements changes made to these programs by the American Homeownership and
Economic Opportunity Act of 2000 (the Act), Pub. L. 106-569. The intent of the mixed-finance
program is to leverage the expertise of the private developer community and private
capital in order to increase the development of attractive and affordable housing
for the elderly and persons with disabilities. The interim rule is structured to
allow the use of low-income housing tax credits (LIHTC) with Section 202 and 811
assistance, subject to resolution of certain issues discussed below. Existing Section
202 and 811 regulations apply to the mixed-finance program to the extent not revised
by the interim rule.
Under Sections 202 and 811, HUD provides capital advances and rental assistance
for supportive housing for very low-income elderly and disabled persons, subject
to a forty-year use restriction. The Act provides for the ownership of Section 202
and Section 811 housing by for-profit limited partnerships with a single-purpose
nonprofit organization as the sole general partner.
Single-Purpose Nonprofit Organization
The single-purpose nonprofit organization is formed by the sponsor, a nonprofit
entity, that has received a fund reservation under section 202 or 811. The single-purpose
nonprofit is required to be tax-exempt under either Section 501 (c)(3) or (4) of
the Internal Revenue Code (IRC) for Section 202 projects and must be tax-exempt
under Section 501 (c)(3) with respect to Section 811 projects. It has been more
difficult recently to obtain Section 501 (c)(3) tax exemptions for general partners
of tax credit partnerships. The Treasury Department is anticipated to issue guidance
in 2004 that should facilitate the process. Until such guidance is issued, it is
important to take into account the time involved in obtaining the tax exemption
and to work with an investor that understands the potential issues.
Other requirements include mandates that the nonprofit's governing board represent
the views of the community in which the housing is located, assume responsibility
for operating the development, and receive HUD approval as to administrative and
financial responsibility. If the project is financed with LIHTC equity, IRC Section
42(h)(5) applies to the partnership, including the requirement that the nonprofit
general partner must materially participate in the project and not be affiliated
with or controlled by a for-profit entity.
Capital Advance Funds
The capital advance fund reservation granted by HUD is transferred from the sponsor
to the nonprofit general partner. HUD provides the capital advance funds to the
nonprofit general partner. Repayment is not required by HUD if the project remains
available for very low-income elderly or disabled persons for forty years in compliance
with applicable requirements..
Under the interim rule, the nonprofit makes a nonamortizing loan to the partnership
of such funds upon HUD approval of the drawdown. The loan is to be repaid within
forty years and bears interest at the Section 202 or 811 rate in effect at closing
of the capital advance. If the project is financed with tax-exempt bonds and 4 percent
LIHTC, then the rule provides that the capital advance funds may be provided as
a pass-through to the partnership. If the project is financed with 9 percent LIHTC,
the rule provides that the funds may be loaned to the partnership. In order to obtain
9 percent LIHTC, the interest rate on the loan will have to be at least equal to
the applicable federal rate as determined under Section 1274(d)(1) of the Code.
Under the LIHTC program, the eligible basis for purposes of determining the amount
of credits available is reduced by federal grants. If the HUD funds are provided
by the nonprofit as a grant to either a 9 percent or 4 percent LIHTC project, then
such funds would not be included in eligible basis. Generally, a loan that provides
for forgiveness of the debt if the project complies with the program requirements
would be treated as a grant for this purpose. The rule provides that the funds may
be advanced as a pass-through to the owner of a 4 percent tax-exempt bond-financed
project. The term pass-through implies that the advance would be treated as a grant
for federal tax purposes. This is inconsistent with HUD's intent to make the program
compatible with the LIHTC. Since the rule provides that the funds may be provided
as a pass-through, the nonprofit will have the option to structure the advance as
a loan that requires repayment in order to include the advance in eligible basis
for LIHTC purposes. Capital advances may be used to finance construction, rehabilitation,
or acquisition of facilities; site acquisition and improvement; demolition; and
relocation. The funds cannot be used for excess amenities, such as balconies, dishwashers,
or washers and dryers in individual units. Excess amenities may be included in a
mixed-finance project if the amenities are financed by other sources of funds, the
amenities are designed with appropriate safeguards, and the assisted residents are
not required to use or pay for their use or maintenance. Capital advances are not
available for acquisition of facilities currently owned and operated by the sponsor,
except with rehabilitation, or for the refinancing of federally assisted or insured
Mixed-finance developments may include market rate units provided that the number
of Section 202 or 811 units funded with the capital advance is not less than the
number of units that could have been developed without other sources of funding.
'Commercial facilities may also be included on-site for the benefit of residents
of the project and the community if funded from other sources.
Upon approval by HUD of the executed evidentiaries discussed below, the capital
advance funds may be drawn down in an approved ratio to other funds, pursuant to
the schedule approved by HUD. The interim rule provides that capital advance funds
can only be drawn down when payment is due and after inspection and acceptance of
work covered by the draw.'~
Project Rental Assistance Contracts
Project rental assistance contracts (PRAC) fund operating costs approved by HUD
with respect to the Section 202 or 811 units to the extent not covered by tenant
rents. Project rental assistance can not be used to pay for debt service on financing,
cash flow distributions to owners, or the creation of reserves for nonassisted units.
HUD-approved operating costs for common areas or the development as a whole, such
as groundskeeping and administrative costs, may be paid from project rental assistance
on a pro rata basis based upon the percentage of assisted units in the development.
PRACs are provided for up to five years and are renewable based upon availability
HUD has asked the Treasury Department to issue a ruling excluding project rental
assistance from treatment as a federal grant for LIHTC purposes. This ruling is
critical to the Section 202 and 811 mixed-finance program will likely be issued
during the first quarter of 2004.
The developer's fee is capped at 9 percent of total project replacement costs, and
no more than 8 percent of the capital advance may be used to pay the fee. The fee
can be used to pay development costs, including reasonable profit and overhead up
to 6 percent of the total construction cost. Two percent of the fee is withheld
to pay for project contingencies. The fee can not be used to pay for excess amenities,
fees to architects or attorneys in excess of contract amounts, and other ineligible
costs. Amounts set for the fee from capital advance funds that remain unused upon
construction completion are deposited in the replacement reserve account.
The interim rule provides that the mixed-finance owner is required to establish
and maintain a replacement reserve in accordance with existing regulations. Disbursements
may be made for capital replacement costs in accordance with the terms of a regulatory
and operating agreement. In the event of a disposition of the development or dissolution
of the owner, Section 202 or 811 funds remaining in the replacement reserve account
must remain dedicated to the assisted units to ensure their long-term viability,
unless HUD agrees otherwise. The interim rule also provides that, with HUD's approval,
replacement reserves may be used to reduce the number of dwelling units in order
to retrofit or combine units that are obsolete or unmarketable.
An operating reserve is required at least equal to three months of operating expenses.
Project income and tax credit equity may be used to fund the operating reserve account.
To obtain HUD approval, the mixed-finance owner (the partnership) and the nonprofit
general partner submit a firm commitment application including the information set
forth in detail in the regulations. The sponsor, mixed-finance owner, or the nonprofit
must have site control. In addition, the mixed-finance owner submits a mixed-finance
proposal that includes a description of the development and the financing, including
official confirmation of the tax credit award and other information required under
the regulations. The regulations also set forth the criteria for HUD's review of
the application and proposal.
As in the HOPE VI program, evidentiaries are to be submitted to HUD for review and
approval prior to drawdown of funds. Evidentiaries include organizational, development,
financing, and management documents; a mixed-finance amendment to the capital advance
agreement; a regulatory and operating agreement; deed or ground lease to the partnership;
declaration of restrictive covenants; and a pro forma title policy. HUD is in the
process of drafting the forms to be used for this program; they should be available
by the fall of 2004.
HUD has informally indicated that its field offices will conduct the review and
approval of the application, proposal, and evidentiaries to facilitate closing of
With the issuance of the interim rule, the sponsors that received fund reservations
for mixed-finance projects can move forward. HUD's prior experience with HOPE VI
mixed-finance transactions, including tax credits, will facilitate implementation
of the Section 202 and 811 mixed-finance program. It is anticipated that Treasury
will issue a favorable ruling regarding treatment of the PRAC as this is essential
to leveraging tax credit equity with the Section 202 and 811 programs. In addition,
guidance from Treasury is expected to provide a safe harbor for obtaining tax-exempt
status for a nonprofit general partner of a tax credit partnership. This guidance
will be critical to structuring the investment of the limited partner and streamlining
the exemption approval process. HUD, Treasury, and the sponsors will have to work
together to make this program a reality.