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

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 now 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) — making them the faster, more scalable path for developers who can assemble the rest of the capital stack.

The mechanics are straightforward in concept but demanding in execution. 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 exceeds a specified percentage of the project's aggregate basis (now 25%, reduced from 50% by the One Big Beautiful Bill Act), the project automatically qualifies for 4% LIHTC credits on 100% of its eligible basis. The developer then sells those credits to an investor in exchange for equity, just as in a 9% deal.

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

The Financed-By Test (25%)

The financed-by test, established under IRC Section 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 receives no credits at all. There is no partial credit — it is binary.

The formula

The test compares the aggregate face amount of tax-exempt bonds outstanding at any point during construction to the project's aggregate basis:

Tax-exempt bonds outstanding ÷ Aggregate basis of the project ≥ 25%

Prior to the One Big Beautiful Bill Act (effective for projects placed in service after December 31, 2025, with at least 5% of aggregate basis financed by bonds issued after that date), this threshold was 50%. The reduction to 25% is the single largest structural change to 4% LIHTC deals in the program's history.

What counts as aggregate basis

Aggregate basis is broader than eligible basis. It includes the entire depreciable basis of the project — land improvements, building, personal property — plus the cost of land. In practice, aggregate basis is close to total development cost, though certain items (syndication costs, some reserves) may be excluded depending on how the bond counsel interprets the rules. The denominator is deliberately wide, which historically made the 50% test demanding to meet.

What counts as bonds outstanding

The numerator is the face amount of tax-exempt bonds that are outstanding at any point during the period from bond issuance through the project being placed in service. This creates a timing dimension: bonds can be issued, used for construction, and then partially repaid or redeemed before placed-in-service — but the test only requires that the threshold be met at some point, not continuously.

Why the 25% change matters

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

1. Volume cap relief. States allocate private activity bond volume cap from a finite annual pool. With bonds needing to cover only 25% instead of 50% of aggregate basis, the same volume cap can support roughly twice as many projects. States that were previously volume-cap-constrained — California, New York, Massachusetts, Texas — now have meaningful additional capacity, as projected in the ACTION Campaign's 2025 legislative impact analysis.
2. More flexible capital stacks. Developers can now use more conventional permanent debt (Freddie Mac, FHA, bank loans) alongside a smaller bond tranche. This can improve terms and reduce complexity, since the bond tranche no longer needs to be the dominant debt source.
3. Lower minimum deal size. At the 50% threshold, the fixed costs of bond issuance (counsel, trustee, underwriter) made small deals (under 60-80 units) economically impractical. At 25%, smaller projects can clear the threshold with a bond amount that makes the transaction costs proportional.

Bond Volume Cap and Recycling

Private activity bonds — the vehicle that funds 4% LIHTC deals — draw from a finite state allocation governed by IRC Section 146. Each state receives an annual volume cap based on population (currently $130 per capita, adjusted for inflation, with a small-state minimum as published by the IRS in Revenue Procedure 2025-11). The state allocates this 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 a share of the pie.

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. In practice, 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.

Volume cap has been the binding constraint on 4% production in many states. Even when deals are financially feasible, they cannot proceed without a bond allocation. The 25% threshold change effectively doubles the volume cap available for 4% LIHTC by cutting the per-project bond requirement in half.

Bond recycling

Bond recycling is a technique that allows issuers to stretch volume cap further. The mechanics: short-term tax-exempt bonds are issued to finance construction, meeting the financed-by test at the point of maximum draw. As construction progresses and permanent financing closes, the bonds are redeemed using permanent loan proceeds. The redeemed bond cap can then be reallocated to a new project within the same calendar year.

Recycling works because the financed-by test only requires that bonds be outstanding at some point during construction — not at placed-in-service. A project can meet the test during construction, redeem the bonds, and still claim 4% credits. The freed cap is reused for the next deal in the pipeline.

In states with sophisticated recycling programs (California, New York, Massachusetts), a single dollar of volume cap can finance 1.5-2.0x its face value in projects over the course of a year. The 25% threshold makes recycling even more potent — each project consumes less cap, so each recycling cycle frees up more for the next deal.

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 (recycled)

Short-term bonds — typically 24 to 36 months — are issued to finance construction and satisfy the financed-by test. 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:

• Frees volume cap for recycling
• Separates the bond (tax-exempt) and permanent debt (conventional) markets
• Adds conversion risk — the developer must secure permanent financing before bond maturity
• Requires a construction lender willing to fund during the bond period

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 effectively become a Freddie Mac permanent loan with tax-exempt interest.

• Simpler structure — no conversion event
• Better interest rates (tax-exempt rates are typically 100-200 bps below taxable)
• Does not free volume cap — the bonds remain outstanding for the full term
• 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 two constraints that must be satisfied simultaneously:

1. The financed-by test. The bond amount must exceed 25% of aggregate basis. This sets the minimum bond amount.
2. Debt service coverage. The bond amount (if permanent) or the replacement permanent debt must be supportable by the project's net operating income at a DSCR of 1.15-1.25x, depending on the lender. This sets the maximum debt amount.

In the pre-2026 environment, these two constraints often conflicted. Meeting the 50% test required large bond amounts that generated debt service exceeding what the project's restricted rents could support — especially in lower-rent markets. The 25% threshold substantially relaxes this tension.

The sizing calculation

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

Table 1 — Bond sizing sequence. The bond amount is the greater of the financed-by test minimum and the NOI-supportable debt. In most post-2026 deals, the NOI constraint governs — the 25% test minimum is easily cleared.

When the NOI-supportable debt exceeds the financed-by minimum (as in the example above), the developer can size the bonds to the project's debt capacity, with the 25% test easily satisfied as a byproduct. This is a reversal from the 50% regime, where developers often had to oversize bonds beyond the project's debt capacity just to meet the test, then use short-term bond structures or creative draw schedules to manage the mismatch.

Key variables in bond sizing

• Bond interest rate. Tax-exempt rates are currently 4.25-5.25% for permanent bonds (Freddie Mac TEL, per Freddie Mac's published rate sheets) and 5.00-6.00% for short-term construction bonds. A 50 bps rate change on a $15M bond shifts annual debt service by $75,000 — meaningful in a restricted-rent operating budget.
• DSCR requirement. Most agency lenders (Freddie Mac, FHA) require 1.15-1.20x. State HFAs as direct lenders may require 1.10-1.15x. Higher DSCRs reduce supportable debt.
• Amortization period. Typically 35-40 years for new construction, 30-35 years for rehab. Longer amortization periods increase the supportable loan amount.
• Net operating income. NOI in a LIHTC project is constrained by maximum allowable rents (set by AMI limits) and operating expense levels. There is limited ability to increase NOI above the initial underwriting — you cannot raise rents to market.

Common Mistakes

These are 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 bonds issued after that date), the threshold is 25%. Applying the old threshold oversizes the bond tranche by up to 2x, distorting the capital stack and inflating debt service.
• Confusing aggregate basis with eligible basis. The financed-by test uses aggregate basis (includes land, all depreciable property). The credit calculation uses eligible basis (excludes land, reserves, syndication costs). These are different numbers. Using eligible basis as the denominator in the financed-by test overstates the ratio and may lead you to believe you've cleared the threshold when you haven't.
• Ignoring bond issuance costs. Bond issuance involves counsel fees ($75K-$150K), underwriter fees (0.5-1.0% of par), trustee fees ($5K-$15K/year), and rating agency fees (if rated). These costs reduce net bond proceeds available for construction and must be accounted for in the sources and uses.
• Sizing bonds to the test minimum without checking debt capacity. Meeting the 25% test is necessary but not sufficient. The bond amount must also be supportable by NOI at the required DSCR. A project that clears the 25% test but can only support $8M in permanent debt on a $13M bond will face a conversion gap at placed-in-service.
• Forgetting the timing dimension. The financed-by test measures bonds outstanding at any point during construction, not at placed-in-service. If you plan to recycle bonds, the test must be satisfied during the construction period when bonds are at peak draw — not after redemption. 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. The permanent sources and uses must show the replacement debt (Freddie Mac, FHA, bank loan), not the bonds. The bonds appear only in the construction-period sources and uses.

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: Maximum tax-exempt bonds outstanding at any point during construction. If using a draw schedule, this is the peak draw amount. If issuing the full amount at closing, it's the par amount.
• Denominator: Aggregate basis of the building. Include land, all hard costs, all soft costs, all financing costs. Exclude only items that are clearly not part of the project's basis (non-project costs, working capital).
• Result: Numerator ÷ denominator. Must be ≥ 25% (or ≥ 50% for projects placed in service before January 1, 2026). Show the result as a percentage with two decimal places. Include a pass/fail flag.
• Cushion: Target 27-30% to provide margin for cost increases during construction. A 25.01% result that drops below 25% after a change order is a deal-killer.

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 outstanding amount (this is the numerator for the financed-by test)
• 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

Sources and Uses: Construction Period vs Permanent

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

Table 2 — 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.

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. For 4% deals, the key constraint is that rents are capped by AMI limits. You cannot 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 have 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 isn't 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