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Mixed-Finance Section 202 and Section 811 Housing
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 projects.

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 of funds.

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.

Developer's Fee

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.

Reserves

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.

Approval Process

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 these transactions.

Conclusion

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.