LIHTC: The 4% and 9% Credit, Qualified Basis & Compliance

The Low-Income Housing Tax Credit (LIHTC), created by the Tax Reform Act of 1986 and codified at Internal Revenue Code Section 42, is the primary federal subsidy for producing and preserving affordable rental housing in the United States. It does not work like a grant or a direct subsidy paid to a developer. Instead, it is a dollar-for-dollar reduction in federal tax liability that the government allocates to a project and that a developer then sells — more precisely, syndicates — to outside investors in exchange for equity capital. That equity substitutes for a large slice of the debt and cash equity a market-rate deal would otherwise need, which is what allows the resulting property to charge rents well below what the same construction cost would require in an unsubsidized deal.

Two structurally different credit types exist under the same statute — shorthanded as the '9% credit' and the '4% credit' — and confusing them, or their interaction with a project's basis calculation, is one of the more consequential errors an analyst can make when underwriting an affordable housing capital stack.

The 9% credit (formally the 70% present-value credit, though the applicable percentage has been fixed by statute at not less than 9% for most new-construction and substantial-rehabilitation allocations since 2008) is awarded through a competitive process. Each state receives an annual per-capita volume cap of credit authority — a dollar figure set by federal statute and adjusted for inflation, administered by a state or local Housing Finance Agency (HFA) — and developers compete for a slice of that fixed pool by submitting applications scored against the state's Qualified Allocation Plan (QAP), a locally written scoring rubric rewarding factors such as deeper affordability, location, sustainability, and local government support. Because demand for 9% credits routinely exceeds the available volume cap in most states, competitive rounds are oversubscribed and a losing application often must reapply in a later cycle.

The 4% credit (the 30% present-value credit, fixed by statute at a floor of not less than 4% since the Consolidated Appropriations Act, 2021) is not competitively awarded against the per-capita cap. It is available essentially as of right to any project that finances at least 50% of its aggregate basis — land and building — with tax-exempt private activity bonds, generally referred to as the '50% test.' Because the 4% credit rides alongside tax-exempt bond financing rather than competing for capped 9% authority, it has become the primary vehicle for financing affordable housing at scale in high-cost states, even though the per-unit subsidy it generates is roughly half that of a 9% allocation on the same qualified basis.

Not every dollar spent building the project generates a credit. Eligible basis is the subset of total development cost that Section 42 allows to be credit-generating — broadly, the depreciable cost of the building and its improvements, including hard construction costs, contractor overhead and profit, and capitalized soft costs such as architecture, engineering, and construction-period interest. Land is never included in eligible basis, because land is not a depreciable asset. Permanent financing costs, most operating and replacement reserves, and (for new construction) most off-site costs are also excluded.

Where the project sits in a Qualified Census Tract (QCT) or a Difficult Development Area (DDA) — both designated annually by HUD based on poverty rates and the relationship between local rents, incomes, and construction costs — the statute allows eligible basis to be increased by up to 30% before the credit is calculated (the 'basis boost'). This does not change how much the developer actually spent; it changes how much of that spend is allowed to generate credits, directly increasing the annual credit amount and the equity the deal can raise. Which specific census tracts and areas qualify changes from year to year, so current QCT/DDA status must always be verified against the current HUD designation list, not assumed from a prior year's map.

Eligible basis is not yet the number the credit is calculated on. It is multiplied by the applicable fraction — the lesser of the unit fraction (low-income units divided by total residential units) and the floor-space fraction (square footage of low-income units divided by total residential square footage). In a 100% affordable project the applicable fraction is simply 100%; in a mixed-income project it captures only the affordable share of the building. Eligible basis (after any boost) multiplied by the applicable fraction produces qualified basis — the number the annual credit percentage is actually applied to.

To qualify for credits at all, a project must also satisfy a federal minimum set-aside test elected at allocation: at least 20% of units at or below 50% of Area Median Income (AMI), at least 40% at or below 60% of AMI, or, under the average income test, units averaging 60% AMI with individual designations permitted up to 80% AMI. These income limits, and the AMI figures themselves, are published annually by HUD for each metropolitan area and must be verified as of the relevant tax year.

Consider a hypothetical 100-unit new-construction apartment property with a total development cost of $20,000,000, of which $2,000,000 is land and $500,000 is ineligible cost (permanent loan fees and initial reserve deposits). The project is located in a HUD-designated Qualified Census Tract, and 90 of its 100 units (matching 90% of building square footage) are restricted as low-income units under the minimum set-aside election.

Step 1 — Eligible basis. Total development cost, less land and ineligible costs: $20,000,000 minus $2,000,000 minus $500,000 = $17,500,000.

Step 2 — Basis boost. Because the property sits in a Qualified Census Tract, eligible basis is increased by the full statutory 30%: $17,500,000 x 1.30 = $22,750,000.

Step 3 — Applicable fraction. With 90 of 100 units restricted, matching floor-space proportion, the applicable fraction is 90%.

Step 4 — Qualified basis. Boosted eligible basis x applicable fraction: $22,750,000 x 0.90 = $20,475,000.

Step 5 — Annual credit. As a competitively awarded 9% allocation: $20,475,000 x 9% = $1,842,750 per year, claimed for a 10-year credit period, for $18,427,500 in total credits.

Had the same qualified basis instead been financed with tax-exempt bonds at the 4% rate, the annual credit would be $20,475,000 x 4% = $819,000 per year, or $8,190,000 over 10 years — illustrating why 9% allocations, constrained by the state volume cap, generate roughly double the subsidy per dollar of qualified basis.

The developer generally cannot use $18,427,500 of federal tax credits directly — most housing developers do not carry that much annual federal tax liability. Instead, the credits (along with the depreciation losses the project generates) are syndicated: sold to outside corporate investors, often through a syndication fund, who become the (typically) 99.99% limited partner or managing member of the ownership entity in exchange for a capital contribution, while the developer retains a small (often 0.01%) general partner or managing member interest and operational control.

Continuing the example above, suppose the syndicator prices the 9% credit at $0.90 per $1.00 of 10-year credit — a price reflecting investor demand, deal risk, and prevailing capital markets conditions at syndication. Total equity raised: $18,427,500 x 0.90 = $16,584,750. On a $20,000,000 total development cost, that equity alone covers roughly 83% of the capital stack, leaving a comparatively small permanent loan to fill the remainder — the mechanism that lets the project operate at restricted, below-market rents while still covering its costs.