Mr. Chairman, thank you for the opportunity of appearing before your Subcommittee today to express the views of the New York Housing Conference (the "NYHC") on this most important piece of legislation. The NYHC, which was founded in 1973 and became an independent affiliate of the National Housing Conference in 1975, is composed of representatives of for-profit and nonprofit developers, owners and managers of low and moderate income housing, financial institutions, housing professionals, community leaders and affordable housing advocates.
As you know, Mr. Chairman, many thousands of affordable housing developments, throughout the country, including more than 600 developments in the City of New York, were financed by HUD using a combination of FHA insurance and project-based Section 8 subsidies. For the most part, at least in New York, these developments were modestly designed, have been well maintained through the years and represent an irreplaceable housing resource for low income families. However, the Section 8 program contained a major flaw which has now placed all of these developments at risk; the Section 8 contracts were not co-terminus with the term of the FBA insured mortgage, thus placing the FHA Insurance Fund, the economic viability of the developments and the very homes of hundreds of thousands of tenants at risk at the end of the Section 8 contract term. In addition, in many cases the cumulative effect of automatic Annual Adjustment Factors ("AAFs"), applied over the years, caused developments to have subsidized rents far above the amounts needed for debt service, operating expenses, required reserves and a reasonable rate of return, thus costing the Federal government more subsidy than necessary to maintain the developments as decent and affordable rental housing.
Commencing early in 1996, 1 was privileged to be one of a group of housing professionals, from both the public and private sectors, which you consulted in your effort to find a solution to both the policy and budgetary implications of the Section 8 contract renewal problem. You and your colleagues are to be commended, Mr. Chairman, for the solutions now embodied in S.513. Given the agreement of the Congress and the Administration to balance the Federal budget by the year 2002, the staggering dimensions of projected Section 8 contract renewal costs and the potentially devastating effects of non-renewal on residents and communities, the bill constitutes an absolutely essential first step in resolving the HUD Section 8 funding crisis. It provides a comprehensive structure and mechanisms through which the spiraling costs of Section 8 assistance can be abated and a majority of assisted developments preserved within the parameters of the bipartisan budget agreement.
The essence and, if you will, the genius of S.513 is the simultaneous restructuring of the FHA-insured mortgage and the Section 8 contract at the time of contract renewal. Through a Mortgage Restructuring and Rental Sufficiency Plan ("Plan") initiated by the owner and implemented by a Participating Administrative Entity ("PAE") pursuant to a contractual agreement with HUD, new lower rents for the development will be set based on the rents of comparable unassisted rental housing in the area. If no such comparables are available, 90% of the HUD Fair Market Rents ("FMRs") for the area will be used as a surrogate. The project-based Section 8 Contract will be renewed, at the reduced rent levels, on a year-to-year basis, with either an FMR adjustment or a budget-based operating cost adjustment on each annual renewal, and the FHA mortgage will be written down to a level where debt service and operating expenses can be met by the lower rents, with a corresponding payment of claim by the FHA Insurance Fund. The Plan will also require the owner or purchaser of the development to maintain use and affordability restrictions, as determined by the PAE, for 20 years.
Coming from New York City, where both the development and operating costs of housing are high and the HUD FMRs are relatively low (because they are based in large part on recent moves into rent regulated housing), we are particularly appreciative of the provisions of the bill allowing the PAE to set budget-based exception rents, up to 120% of FMR, for up to 20% of the rents in its geographic jurisdiction, and the further provision allowing HUD to increase the 20% limitation upon a finding of special need.
Most important, the bill recognizes that the continued availability of FRA insurance, adjusted to market levels, and project-based Section 8 assistance, at levels sufficient to service the restructured debt and legitimate operating expenses, are essential to the continued existence of this absolutely irreplaceable supply of affordable housing. While the Section 8 contract must be renewed annually, the continued presence of FHA insurance makes it likely that such renewals will occur. Replacing project-based Section 8 contracts with tenant-based assistance would, of course, provide even less security for the mortgagee, to say nothing of the myriad tenant problems inherent in any attempt to "voucher out" the current project-based contracts.
The New York Housing Conference also strongly supports the concept of state or local housing finance agencies as the primary restructuring entities. By definition, such entities act in the public interest and are publicly accountable. With two strong and experienced agencies (the New York State Housing Finance Agency ("HFA") and the New York City Housing Development Corporation ("HDC") already servicing large urban mortgage portfolios in New York, there does not seem any need for an "Alternative Administrator". While the "preference" language of 103(a)(4) is somewhat troubling, we are confident that, as in the past, HFA and HDC will divide the work in an appropriate fashion. Certainly, each such agency should have the right to act as the PAE with respect to any development where it is the mortgagee.
Since the cancellation of all or a portion of a mortgage debt is generally treated as taxable ordinary income under the Internal Revenue Code (the "Tax Code"), in order to encourage owners to participate in the restructuring process the bill bifurcates the existing mortgage into two obligations; a new FHA-insured first mortgage in an amount that can be supported by the reduced rents and a soft second mortgage held by the PAE as agent for HUD. Because we strongly believe that for-profit owners must have at least some potential of a cash return if they are to be held responsible for maintaining their developments in compliance with housing quality standards, the New York Housing Conference recommends that 25% of any cash flow in excess of debt service on the insured first mortgage, operating expenses of the development and required reserves be made available to the owner. The remaining 75% should be applied to the payment, first of accrued interest and then to principal, on the second mortgage.
In the absence of an express amendment to the Code, which I am told is extremely unlikely, from both a jurisdictional and scheduling point of view, there can be no guarantee that such a bifurcation will avoid adverse tax consequences to the owner. However, a very similar bifurcated structure was used, with the blessing of the Internal Revenue Service, in connection with a series of Section 223(f) refinancings of Mitchell-Lama projects in New York in the mid-1970s. Admittedly, the tax law has changed since then (i.e. the OID and "material modification" rules adopted in the mid-80s) but we would urge that, where the reduction in the amount of federally-insured debt is directly proportionate to the reduction in federal subsidy supporting that debt, such debt reduction should not be considered a "cancellation of indebtedness" nor should the terms of the soft second mortgage be construed as an "original issue discount" for federal income tax purposes. If it is not possible to amend the Tax Code to make this clear, then we urge that precatory language to this effect be included in the report accompanying this legislation.
We are aware that the Administration's Housing Opportunity Act of 1997 (HR 1433) would amend the Tax Code to allow deferral and amortization of tax liabilities for up to ten years for owners whose debt is restructured by more than 30% and less than 75% of the unpaid principal balance.' Frankly, we doubt that the opportunity to pay taxes, for ten years, on phantom income resulting from a debt and subsidy restructuring designed to save federal dollars will incentivize many owners. More fundamentally, however, the Administration bill completely fails to recognize the owners' lack of economic return since enactment of the Tax Reform Act of 1986. In most cases the tax benefits that the owners initially expected to receive have been suspended for the past ten years. To be effective, any legislation intended to encourage owners to participate in a restructuring program must make some attempt to compensate the owners for the "passive losses" that they have not been able to use.
Instead, the Administration bill actually penalizes owners who participate. It not only takes away the "step-up in basis on death" that has been in the law for many years but actually places owners in a worse economic position than the status quo. If past inequities cannot be addressed, any amendment of the Tax Code should at least leave owners in the same position they would have been in had they not participated in the program; they should pay no more and no less tax over the remaining term of the development's underlying mortgage than they would have if the mortgage had not been restructured. By any fair measure, this approach should be revenue neutral to the Federal government. In addition, owners participating in a restructuring should be permitted to use their suspended losses to offset any tax liability resulting from the restructuring.
S.513 recognizes that some of the developments whose mortgages are to be restructured suffer from deferred maintenance due to a lack of positive cash flow under the present mortgage structure. The bill allows up to $5,000 per unit to be included in the restructuring budget to correct such conditions, provided that the owner contributes at least 25% of the cost of the work done. The New York Housing Conference would hope that this 25% contribution requirement could be waived for nonprofits with good track records. Also, where more significant rehabilitation is necessary, the bill should authorize payment out of available project reserves or residual receipts, or financing by a further write down of the FHA-insured mortgage or restructuring of Section 236 interest reduction payments.
The New York Housing Conference has not yet developed a final position on Title 11 of the bill. While effective enforcement of laws and regulations designed to prevent fraud and abuse in HUD-assisted programs is clearly desirable, and new enforcement tools and sanctions may be necessary, it is not at all clear that HUD, at least until very recently, has made effective use of the enforcement tools and sanctions that it now possesses or that Title II contains (directly or incorporated by reference) all of the due process safeguards that we would want to see in criminal or civil penalty statute. It is our experience that enforcement mechanisms that appear to be strong, but lack due process safeguards, such as written notice. opportunity to cure, materiality, judicial review, etc., may in the end prove to be unenforceable.
Mr. Chairman and members of the Subcommittee, I want to thank you again for the
opportunity to appear before you today and assure you of the continued cooperation and support of
the New York Housing Conference in moving this important legislation forward as expeditiously
as possible. We simply cannot afford to let another year go by with the critical problem of expiring
project-based Section 8 contracts unresolved.
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