WASHINGTON -- The Office of Management and Budget is proposing to terminate the fledgling housing preservation program, under which 501(c)(3) organizations were expected to issue tax-exempt bonds to purchase low-income housing projects, according to preliminary fiscal 1996 budget documents.

The budget office is also proposing sharp cuts in the so-called Section 8 rent subsidy program, and acknowledges that the cuts may cause some of the federally insured multifamily housing projects supported by the subsidies to default on their loans and underlying bond issues, according to the documents, which were obtained by The Bond Buyer.

The preservation program is slated for elimination because it has "fundamental flaws," the budget documents state. It was designed to provide financial incentives to housing project owners to discourage them from prepaying federally subsidized loans and turn the apartments into more expensive properties.

But the OMB said there is not enough evidence to support the contention by legislators and housing industry officials that a large number of project owners plan to prepay their loans. "Concerns about a decrease in the supply of low-income housing as a result of prepayment may not be justified," the agency said.

The budget documents do not explain the OMB's reasoning for wanting to cut back on the Section 8 program. But the budget office admits that the cutbacks would create financial hardships for many subsidized projects. A large number are insured by the Federal Housing Administration and financed with tax-exempt bonds, and depend on the subsidies to pay debt service.

The proposal "increases the likelihood of defaults on some FHA-insured properties," according to the OMB.

The OMB is now meeting with the Department of Housing and Urban Development and other federal agencies to determine what President Clinton will propose in his fiscal 1996 budget plan, scheduled for release in February. Thus, the final decisions on the two housing programs will be made in the next several weeks.

The preservation program was created by Congress in 1990, when lawmakers discovered that subsidized 40-year loans made by HUD to private developers during the 1960s and 1970s were reaching their 20th year, when they become eligible for prepayment. Once a developer prepays, he is released from restrictions requiring him to rent to low-income tenants.

The 1990 legislation permits HUD to offer incentives to owners either to keep the properties occupied by low-income tenants or to sell to entities -- mainly 501(c)(3) organizations -- that are willing to do so.

Housing industry officials have predicted that nonprofit agencies seeking to acquire properties under the program would finance their purchases using acquisition loans financed with tax-exempt bonds. Earlier this year, officials said they expected the first bond-financed deals to come to market by the end of this year.

The budget office is proposing not only to stop future funding for the program but also to take back or "rescind" money appropriated to the program during fiscal 1994 and 1995. The program has been criticized for its slow spending rate, but industry officials have argued that the program got off the ground only late last year because of long delays by HUD in writing regulations to implement it.

Congress approved $175 million in budget authority for the preservation program in fiscal 1995, and HUD proposed giving it $60 million in fiscal 1996, which starts Oct. 1.

The Section 8 program, meanwhile, encompasses a number of rental assistance programs that were created by Congress in 1974. Since the early 1980s, most Section 8 assistance has been provided through so-called portable certificates, which are issued to tenants who use them in making their rent payments.

But in the early days of the program, rental assistance went directly to the projects. HUD entered into contracts with project owners, guaranteeing that they received a return equal to their areas' fair market rents, as calculated by HUD. Tenants paid a small amount toward their rent, and HUD made up any shortfall with subsidy payments to the owners.

The department also agreed to adjust its subsidy amounts annually to reflect changes in market conditions. In some cases project owners have been receiving increases regularly for years, causing their rents to exceed the fair market rent in their area.

Now many of the contracts are about to expire, and the OMB is proposing that they be renewed for three years, but with the requirement that owners receive no more than the fair market rent. Cutting out the extra payments some owners have been receiving would save the federal government $680 million over five years, the OMB estimates.

The agency said it made the proposal to ensure that the federal government "ceases paying inflated rents in order to prop up properties beyond their market value."

But housing industry officials argue that just because an owner's rent is higher than the area fair-market rent, that does not necessarily mean the owner is reaping a windfall. For example, the owner may be incurring maintenance costs that would make it necessary to charge a rent that is higher than the typical amount charged in other buildings.

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