4% LIHTC with Tax-Exempt Bonds: Deal Structure, the 25% Test, and Modeling

Key Takeaways

How 4% Bond Deals Work

The 4% Low-Income Housing Tax Credit paired with tax-exempt bonds is the dominant financing mechanism for large-scale affordable housing production in the United States. According to Novogradac's annual allocation data, 4% bond deals account for the majority of LIHTC units placed in service each year. Unlike the competitively allocated 9% credit, 4% LIHTC credits are generated automatically when a project meets the bond financing threshold under IRC Section 42(h)(4). That makes them the faster, more scalable path for developers who can assemble the rest of the capital stack.

The mechanics. A state or local government entity, typically the state housing finance agency (HFA) or a local housing authority, issues tax-exempt private activity bonds on behalf of a developer. The bond proceeds finance the project's construction or acquisition. When the bond amount is at least 25% of the project's aggregate basis (down from 50% under the OBBBA), the project automatically qualifies for 4% credits on 100% of its eligible basis. The developer sells those credits to an investor for equity.

The critical difference from 9% deals is the capital stack. Because 4% credits generate roughly 30% of eligible basis in equity (compared to about 70% for 9%), the remaining gap must be filled by the bonds themselves (which become permanent debt, or are replaced by permanent debt at conversion), soft debt from state and local programs, deferred developer fee, HOME funds, and other subordinate sources. How these pieces interact, and how the bond tranche drives the whole structure, is the underwriting problem.

The Financed-By Test (25%)

The financed-by test, at IRC §42(h)(4)(B), is the gateway to 4% credits. If the project passes, it receives credits on 100% of its eligible basis. If it fails, it does not receive 4% credits automatically. In practice a failed test kills a 4% deal: the project would have to secure a competitive 9% allocation instead, a different program on a different timeline.

The statute does technically allow a partial credit corresponding to the bond-financed portion of eligible basis when the threshold is not fully met. That mechanism is rarely used in practice because state agencies do not typically structure allocations this way. Treat the test as binary for underwriting purposes.

The formula

The test compares the aggregate face amount of tax-exempt bonds actually used to finance the project's basis, to the project's aggregate basis:

Tax-exempt bonds financing project basis ÷ Aggregate basis ≥ 25%

The 25% threshold applies to buildings placed in service after December 31, 2025, subject to the additional new-bond condition described below. Before OBBBA, the threshold was 50%. The reduction is the largest structural change to 4% LIHTC deal structuring in twenty years.

What counts as aggregate basis

Aggregate basis is the entire depreciable basis of the buildings plus the cost of the land they sit on. In practice it is close to total development cost, but not identical. Items excluded include syndication and partnership costs, certain reserves not tied to the depreciable property, working capital, and other non-basis financing costs. Bond counsel will opine on the specific inclusions and exclusions for each project. In an early-stage model, aggregate basis is typically 90% to 96% of TDC. Do not use TDC as a shortcut in the test itself.

What counts as bond-financed

The numerator is the portion of bond proceeds actually used to fund aggregate basis costs, not the total face amount of bonds outstanding. Bonds sitting in a project account that are never spent on basis do not count. Bonds spent on non-basis uses (issuance costs above the 2% limit, working capital) do not count either. In practice, models often use peak outstanding bond amount as a proxy, but bond counsel will look at proceeds used to finance basis when opining on the test.

The test also has a timing dimension. It must be met at some point during the period from bond issuance through the building being placed in service, not continuously. A project can meet the test at peak construction draw, redeem some bonds, and still qualify for 4% credits. That is what enables short-term construction bond structures.

Why the 25% change matters

The reduction from 50% to 25% has three real consequences for 4% deal structuring:

1. Volume cap relief on cap-constrained deals. States allocate private activity bond volume cap from a finite annual pool. Where the 50% test forced projects to consume cap up to their debt capacity ceiling, the 25% federal floor lets projects size bonds to NOI capacity instead of the test minimum. On low-NOI deals in weak markets that were cap-consumers, the reduction can meaningfully lower cap consumption per project. On high-NOI deals in strong markets, cap consumption barely changes because NOI-supportable debt already exceeded the old 50% requirement in most cases.
2. More flexible capital stacks. Developers can now blend a smaller tax-exempt bond tranche with taxable permanent debt (Freddie Mac conventional, agency, or bank). The tradeoff is that taxable debt sits at a higher rate than tax-exempt, so the blended cost of capital rises. In the typical yield curve environment the substitution effect offsets a meaningful share of the volume cap benefit. Do not model the savings from moving to 25% without pricing the taxable replacement debt.
3. Higher fixed costs per bond dollar on smaller issuances. Counsel, trustee, underwriter, and rating agency fees do not scale down with bond size. A $15M issuance carries roughly the same fixed cost as a $25M issuance, so a smaller bond tranche pushes the fixed-cost-per-dollar-of-proceeds up, not down. This makes very small deals harder to justify economically, not easier. Deals under about 60 to 80 units still struggle to spread the fixed cost.

The 5% New-Bond Rule

OBBBA does not simply drop the threshold. It adds a second condition specific to the transition. For any building placed in service after December 31, 2025:

1. The aggregate face amount of tax-exempt bonds financing the project must equal at least 25% of aggregate basis (the reduced threshold); AND
2. At least 5% of aggregate basis must be financed by tax-exempt bonds issued after December 31, 2025 (the new-bond condition).

Older, pre-2026 bond issuances count toward the 25% total, but no project can satisfy the test purely by drawing on pre-2026 cap. At least a new post-2025 tranche sized to 5% of aggregate basis must be part of the stack.

This is a modeling trap on any deal structuring across the 2025-2026 transition. If a developer sizes the 2026 tranche at exactly 5% of estimated aggregate basis, and construction cost inflation grows actual basis by 1% between application and cost certification, the tranche no longer satisfies the 5% requirement. The remedy is a supplemental issuance, which carries its own transaction costs. Tiber Hudson and others have advised sizing the post-2025 tranche at a minimum of 10% of aggregate basis, with the combined issuance at 30% or more, to leave cushion for cost drift.

State Agency Implementation

The federal 25% number is a floor, not the operative threshold in most jurisdictions. State housing finance agencies routinely require higher effective bond-to-basis ratios through their private activity bond allocation policies. A pro forma sized to 25% of aggregate basis will fail underwriting at most state HFAs.

Illustrative state thresholds for the 2026 allocation cycle:

Table 1. Representative state HFA thresholds. Numbers change annually and by allocation round. Always pull the current QAP and PAB allocation manual for the specific state before sizing.

Two implications for modeling. First, the operative sizing constraint is usually the state threshold, not the federal floor. If a state requires 30%, the whole discussion of the federal 25% is academic. Second, the state threshold interacts with NOI capacity. In stronger markets, NOI-supportable debt still exceeds both the federal and state thresholds, so DSCR binds. In weaker markets, the state threshold binds and the deal may need additional soft sources to close the gap between what NOI supports and what the state requires.

Bond Volume Cap and Recycling

Private activity bonds draw from a finite state allocation governed by IRC Section 146. Each state receives an annual volume cap based on population, adjusted annually by the IRS for inflation. For calendar year 2026, the cap is the greater of $135 per resident or $397,625,000 (per Rev. Proc. 2025-32, IRB 2025-45). The IRS releases the annual inflation adjustment in the fall of the prior year; check for the current-year procedure before locking assumptions.

The state allocates its cap across all private activity bond uses: multifamily housing, single-family mortgage revenue bonds, manufacturing facilities, airports, and other permitted purposes. Housing competes with other uses for its share. Volume cap has historically been the binding constraint on 4% production in California, New York, Massachusetts, and Texas.

How volume cap works

When a state HFA or local issuer authorizes bonds for a LIHTC project, the bond amount counts against the state's annual volume cap. Unused cap can be carried forward for up to three years. Most states allocate their housing bond cap through a separate application process, often administered by the same HFA that runs the QAP for 9% credits.

Bond recycling

Bond recycling is a technique that lets issuers stretch tax-exempt financing capacity further. The mechanics: short-term tax-exempt bonds are issued to finance construction and meet the financed-by test at peak draw. When the bonds are redeemed with permanent loan proceeds, the freed proceeds can be reissued to finance another qualified residential rental project without a new volume cap allocation.

What recycling does not do is generate 4% LIHTC credits for the second project. This is the point most commonly misunderstood in 4% deal structuring.

The reason is the statutory plumbing. §42(h)(4)(A) exempts a project's credits from the housing credit ceiling only when the building is financed by "any obligation the interest on which is exempt from tax under section 103 and which is subject to a volume cap under section 146." Recycled bond proceeds are, by design, not subject to a new volume cap allocation. Because they are outside the volume cap regime, they fall outside the §42(h)(4) trigger. They provide low-cost tax-exempt financing to the second project, but they do not automatically produce 4% credits for that project. The second project still needs its own new bond allocation, sized to meet the financed-by test, in order to qualify for 4% credits.

Real value of recycling in a 4% pipeline. Recycled bonds lower the blended cost of capital by extending tax-exempt interest rates to deals that would otherwise use taxable debt in the same tranche. In a typical yield curve environment, this reduces interest cost by 75 to 150 bps versus taxable comparable debt. It increases NOI-supportable debt on constrained deals and improves cash flow on well-covered ones. What it does not do is multiply the state's effective 4% credit output. That multiplier comes from the 25% threshold itself (each new deal consumes less new cap), not from recycling.

Constraints on recycling. Recycled proceeds must be used within 6 months of the refunded bond's redemption, and within 4 years of the original bond issue date. Proceeds can only be recycled once. Reissuance must be for a qualified residential rental project meeting §142(d) requirements. States that run active recycling programs (California, New York, Massachusetts) have detailed procedural rules for pairing redeemed cap with pipeline projects.

Short-Term vs Permanent Bonds

The choice of bond structure affects the capital stack, the financing timeline, and the deal's risk profile. There are two primary approaches.

Short-term construction bonds

Short-term bonds, typically 24 to 36 months, are issued to finance construction and satisfy the financed-by test at peak draw. At or before placed-in-service, the bonds are redeemed with permanent loan proceeds (a Freddie Mac Tax-Exempt Loan, FHA 221(d)(4) financing, or a conventional bank loan). This structure:

• Enables recycling of the bond proceeds into another qualified project
• Separates the bond (tax-exempt) and permanent debt (either tax-exempt or taxable) markets
• Adds conversion risk: the developer must secure permanent financing before bond maturity
• Requires a construction lender willing to fund alongside the bond issuance

Long-term permanent bonds

Permanent bonds, typically 15 to 40 years, serve as both the construction and permanent financing vehicle. The bonds are issued at closing, draw during construction, and convert to a permanent fixed-rate obligation. Freddie Mac's Tax-Exempt Loan (TEL) product, offered through the Freddie Mac Multifamily Seller/Servicer network, is the dominant vehicle. Freddie Mac purchases the bonds from the issuer, and the bonds function as a Freddie Mac permanent loan with tax-exempt interest.

• Simpler structure with no conversion event
• Tax-exempt rates typically trade at a spread advantage to comparable taxable debt, though the size of the spread varies with yield curve shape
• Bonds remain outstanding, so cap is not recycled
• Preferred by larger, well-capitalized developers who can secure Freddie Mac or FHA terms

Sizing the Bond Tranche

Bond sizing in a 4% deal is driven by three constraints that must be satisfied simultaneously:

1. The federal financed-by test. The bond amount must exceed 25% of aggregate basis (with at least 5% financed by post-2025 bonds). This is the statutory floor.
2. The state HFA threshold. The state's PAB allocation policy typically requires 28% to 35% of aggregate basis. This is the operative minimum.
3. Debt service coverage. The bond amount (if permanent) or the replacement permanent debt (if short-term) must be supportable by the project's net operating income at a DSCR of 1.15 to 1.25x, depending on the lender. This is the maximum.

In the pre-OBBBA environment, the federal 50% test frequently required bond amounts that exceeded what restricted rents could support, and developers had to bridge the mismatch with short-term structures or unusual draw schedules. Under the 25% federal floor and typical 28% to 30% state thresholds, the tension eases substantially. In most markets NOI capacity now exceeds both federal and state minimums, so DSCR governs sizing and the state threshold clears as a byproduct.

The sizing calculation

For a permanent bond deal, the sizing follows this sequence:

Table 2. Bond sizing sequence for a permanent bond deal. In most post-2026 markets, NOI capacity governs and both federal and state thresholds clear as a byproduct. In lower-rent markets, the state threshold binds and additional soft sources are needed to close the gap.

When NOI-supportable debt exceeds the state threshold, size to NOI. When the state threshold exceeds NOI-supportable debt, either add soft sources (state HFA soft loan, HOME, deferred fee) to bridge the operating shortfall, or reduce the aggregate basis by trimming scope. Do not solve the gap by oversizing the bond above NOI capacity, because you cannot service debt from rents you are not allowed to charge.

Key variables in bond sizing

• Bond interest rate. Tax-exempt permanent rates are set by the Seller/Servicer or issuer based on term, DSCR, LTV, and prevailing benchmark spreads. Freddie Mac does not publish a public TEL rate sheet. Assumptions in the 4.5% to 5.5% range for permanent tax-exempt bonds are typical in current environments, with short-term construction pricing higher; verify against a live quote before locking underwriting assumptions.
• DSCR requirement. Most agency lenders (Freddie Mac, FHA) require 1.15 to 1.20x. State HFAs acting as direct lenders may require 1.10 to 1.15x. Higher DSCRs reduce supportable debt.
• Amortization period. Typically 35 to 40 years for new construction, 30 to 35 years for rehab. Longer amortization increases supportable loan amount.
• Net operating income. NOI in a LIHTC project is constrained by AMI-based rent limits and operating expense levels. Rents cannot be raised to market. There is limited upside to NOI above initial underwriting.

The 42(m) Determination Letter

Every 4% bond deal, whether it competes for state credit allocation or not, requires a determination letter from the state housing credit agency under IRC §42(m)(1)(D). The letter certifies that the credit amount does not exceed what the project needs to be financially feasible and viable throughout the compliance period. Without the letter, no credits are allowed. The letter is a hard prerequisite for the IRS Form 8609 that unlocks the credits.

The determination is a subsidy-layering review. The agency evaluates all sources of funds (bonds, soft debt, HOME, deferred developer fee, tax credit equity, GP equity) and confirms that the requested credit is the minimum needed to close the gap. If equity from tax credits plus other sources exceeds what the project reasonably needs, the agency reduces the credit amount.

Three practical consequences for modeling:

• The final credit amount is set by the state agency at the 42(m) review, not by the developer's spreadsheet
• Late-stage changes to costs or other sources can trigger a re-review and credit reduction
• Size the credit request with a small cushion, not to the exact number that closes the gap in the model. Agencies have discretion to reduce, not to increase

Common Mistakes

The errors that derail 4% bond deal underwriting most frequently:

• Using the old 50% threshold. Any pro forma built before mid-2025 likely uses the 50% test. For projects placed in service after December 31, 2025 with post-2025 bond issuance, the threshold is 25% federally (with the additional 5% new-bond condition). Applying the old threshold oversizes the bond tranche by up to 2x, distorts the capital stack, and inflates debt service.
• Sizing to the federal floor and ignoring the state HFA threshold. The federal 25% is the statutory minimum. The state's PAB allocation policy is the operative minimum. In most jurisdictions the state threshold is 28% or higher. Model to the state number, not the federal number.
• Confusing aggregate basis with eligible basis, or with TDC. The financed-by test uses aggregate basis (land plus depreciable property, less certain non-basis items). The credit calculation uses eligible basis (excludes land, certain reserves, syndication costs). TDC is broader than either. Using the wrong denominator can overstate the ratio and produce a false pass.
• Ignoring the 2% cap on bond issuance costs. IRC §147(g) limits the use of tax-exempt bond proceeds for issuance costs (counsel, underwriter, trustee, rating agency) to 2% of proceeds. On a $15M issuance the cap is $300K. Issuance costs above 2% must be paid from other sources, typically developer fee or equity. Related rule: 95% of proceeds must finance qualified project costs (§142(a)); non-qualified uses (working capital, unrelated fees) must stay under 5%.
• Assuming recycled bonds generate 4% credits for the next project. Recycled proceeds provide low-cost financing to the next project, but they do not qualify that project for 4% credits under §42(h)(4). The next project still needs its own new bond allocation sized to meet the financed-by test.
• Sizing bonds to the test minimum without checking debt capacity. Clearing the state threshold is necessary but not sufficient. The bond amount must also be supportable by NOI at the required DSCR. A project that clears the threshold but can only support $8M in permanent debt on a $13M bond faces a conversion gap at placed-in-service.
• Forgetting the timing dimension. The financed-by test looks at bond proceeds financing basis at some point during construction, not at placed-in-service. If you plan to recycle, the test must be met during the construction period when bond proceeds are at peak deployment. Model the draw schedule to confirm the test is met at the right moment.
• Double-counting the bonds as a permanent source. In a recycled bond structure, the bonds are redeemed at placed-in-service. They are not a permanent source of capital. Permanent sources and uses must show the replacement debt (Freddie Mac, FHA, bank loan). The bonds appear only in the construction-period sources and uses.
• Modeling the tax-exempt rate advantage as a fixed 100 to 200 bps. The spread between tax-exempt and comparable taxable debt varies with the shape of the yield curve and with the specific benchmark. In flatter-curve environments the advantage compresses. Do not lock a fixed spread into a long-horizon model; use a live benchmark.

How to Model It

A 4% bond deal pro forma is more complex than a 9% model because it must integrate the bond structure, the financed-by test, and the construction-to-permanent conversion. Here is what each tab should contain.

Financed-By Test tab

This is the tab reviewers look at first. Build it as a standalone calculation:

• Numerator: Bond proceeds used to finance aggregate basis at peak deployment. If issuing the full amount at closing, this is par less issuance costs (subject to the 2% cap) and any non-basis uses.
• Denominator: Aggregate basis of the buildings and land. Include land, all hard costs, all soft costs that are basis-eligible, all basis-eligible financing costs. Exclude syndication costs, working capital, and non-basis reserves.
• Result: Numerator divided by denominator. Must be at least the state HFA threshold (typically 28% or higher). Show the result as a percentage with two decimal places. Include federal-pass, state-pass, and 5%-new-bond-pass flags.
• Cushion: Target 2 to 3 percentage points above the state threshold to provide margin for cost increases during construction. A result that drops below the state threshold after a change order can force a supplemental issuance or credit reduction.

Bond Draw Schedule tab

For recycled bond structures, model the monthly draw and repayment schedule:

• Month-by-month bond draws tied to the construction budget
• Peak deployed amount (this is what feeds the financed-by test numerator)
• Bond interest accrual (construction-period interest, typically funded from bond proceeds or a separate interest reserve)
• Redemption date and amount
• Permanent loan funding date and amount
• Transition tranche split (if applicable). For deals structuring across 2025-2026, model the pre-2025 and post-2025 bond tranches separately so you can confirm the 5% post-2025 requirement is met even after basis inflation.

Sources and Uses: Construction Period vs Permanent

Unlike a 9% deal where sources and uses are typically shown as a single permanent statement, a 4% bond deal needs two versions:

Table 3. Construction vs permanent sources. In a recycled bond deal, the tax-exempt bonds appear as a construction source and are replaced by permanent debt. The remaining sources carry through to the permanent statement.

Credit Calculation tab

The credit calculation for a 4% deal follows the same formula as any LIHTC deal, but with one important distinction: the credit rate is 4% (floored), not 9%. The calculation: eligible basis × basis boost (if QCT/DDA) × applicable fraction = qualified basis × 4% = annual credit × 10 years = total credits × credit pricing = tax credit equity.

Link the tax credit equity output directly to the sources and uses. When credit pricing changes, the equity changes, and the gap (filled by deferred developer fee, additional soft debt, or sponsor equity) should adjust automatically. Also account for deferred developer fee limits: most state QAPs cap deferred fee at 50% to 75% of the total fee and require repayment from cash flow within 15 years.

Operating Pro Forma and Debt Service

The operating pro forma must demonstrate that the project's NOI supports the permanent debt service at the required DSCR. Rents are capped by AMI limits. Do not model rent growth above the HUD-published maximum rents for the applicable income tiers (typically 50% and 60% AMI). Operating expenses should be benchmarked against comparable LIHTC properties in the same market, not market-rate comparables, which carry different expense profiles.

The test of a good 4% bond model. Change the bond interest rate by 50 bps and see if the supportable debt amount, the sources and uses gap, and the DSCR all update automatically. If any cell requires a manual override, the model is not properly linked.

Related Articles

This article is part of the LIHTC underwriting series. Each article covers a specific aspect of tax credit deal structuring:

• LIHTC 101: 4% vs 9%
• 9% LIHTC Competitive Allocation
• Investor Returns
• The LIHTC Capital Stack
• Year 15 Exit Strategies
• Rent and Income Limits