The Average Income Minimum Set-Aside Election: Understanding the Proposed Regs

The new option would allow for deeper income targeting and could help your bottom line.

On Oct. 30, the IRS published proposed regulations related to the Average Income Minimum Set-Aside Test under the LIHTC program. Every tax credit site must meet and maintain a minimum set-aside throughout a 15-year compliance period to qualify for the tax credit program. A minimum set-aside is the federally required minimum level of tax credit units at a site. To meet the set-aside, you must rent a certain percentage of the units in your building or site to qualified low-income households.

The proposed regulations address a new option for the minimum set-aside election that was created in 2018 with the passage of the Consolidated Appropriations Act. This income-averaging option allows LIHTC-qualified units to serve households earning as much as 80 percent of the area median gross income (AMI) as long as the average income limit at the property is no more than 60 percent of the AMI.

We’ll go into greater detail about what it means to choose an average income minimum set-aside and what the proposed changes will mean for the Next Available Unit rule and unit designations with this option.

What Is Income Averaging?

All tax credit owners must formally notify the IRS of their minimum set-aside election for their building or site when they file IRS Form 8609. If an owner doesn’t elect a set-aside on this form, all the tax credits the owner was allocated for its site may be lost. The IRS has published a revised Form 8609 that includes the income-averaging option as a minimum set-aside.

Meeting your site’s minimum set-aside is the most important goal you have as a tax credit manager. If you meet the set-aside, the owner of your site will be entitled to claim its tax credits. If you don’t meet the set-aside, your site won’t qualify for the tax credit program, which means the owner won’t be able to claim any of the credits it was allocated.

The average income minimum set-aside was added to Section 42 in 2018 as part of the Consolidated Appropriations Act of 2018. The provision allows sites to take LIHTCs on units that have designated an imputed income limitation that allows tenants with incomes at 70 percent or even 80 percent of AMI as long as there are additional units with designated imputed income limitations at 30 percent, 40 percent, 50 percent, or 60 percent of AMI so that the overall average for all units doesn’t exceed 60 percent of AMI. The designated low-income units must comprise at least 40 percent of all residential rental units in the building. Once a site elects the average income minimum set-aside, the choice is irrevocable.

Previously, tax credit units were restricted to households earning no more than 60 percent of the area median income (AMI). The prior minimum set-asides called for having 20 percent of the units targeted to no more than 50 percent of the AMI or 40 percent of the units at no more than 60 percent of the AMI, and these options remain part of the federal program.

The income-averaging option is intended to expand the program to serve more families. Before, families earning 80 percent of the AMI didn’t qualify for a LIHTC unit and were likely to be living in market-rate housing. Also, income averaging could help a site’s bottom line and allow for deeper income targeting. Higher rents that households at the upper range could pay would have the potential to offset the lower rents for extremely low- and very low-income households.

Here’s an example of how income averaging might work. Suppose you manage a 20-unit building with 11 market-rate units and the rest are low-income units. The designated income limitations for each unit are as follows:

The overall average income computation for the building is 56.67 percent. This is calculated by adding all the imputed income limitations (30% + 30% + 30% + 40% + 70% + 70% + 80% + 80% + 80% = 510%) and dividing that figure by the total number of low-income units in the building (9 units). The minimum set-aside calculation is 45 percent (9 LIHTC units ÷ 20 total units). Therefore, the minimum set-aside is met.

If this building had used the more traditional 40-60 minimum set-aside, which means renting at least 40 percent of its units to households earning no more than 60 percent of AMI, the given example would be in noncompliance because only four units out of 20 units (25 percent) are at 60 percent or less of AMI. The average income minimum set-aside option allows for deeper income targeting and could help a site’s bottom line.

IRS’s Proposed Average Income Regs

The IRS issued the proposed regulations in two parts. It’s planning to amend Treasury Regulation §1.42-15, which concerns to the Next Available Unit rule, and is proposing a brand new Treasury Regulation, 1.42-19, which deals with unit designations and addresses noncompliance for sites that have elected the average income minimum set-aside.

Treasury Reg. §1.42-19: Average Income Test

The proposed regulations say the owner must designate the imputed income limit of each low-income unit no later than the close of the first taxable year of the LIHTC period. Once the income level of a unit is designated, no change to that designation is allowed. If the income designation is removed, the unit then ceases to be a low-income unit. A single out-of-compliance unit could cause a 100 percent project to fail the minimum set-aside unless mitigating action is taken within 60 days after the end of the owner’s taxable year.

In other words, the IRS requires that all low-income units average 60 percent of AMI or less in order to meet the minimum set-aside requirement. If a unit goes out of compliance for any reason, the proposed rule would give the taxpayer up to 60 days after the end of the year in which the average was violated to take a mitigating action to prevent the site from violating the minimum set-aside and being disqualified from receiving LIHTCs for that year—or ever, if the violation occurs in year one. The rule allows two types of mitigating actions to avoid the 60 percent test failures:

Conversion of market-rate units. If a site isn’t a 100 percent low-income project, the owner can convert one or more market-rate units to low-income units, as long as the market-rate unit(s) is either vacant or occupied by an otherwise qualified tenant; or

Designate a removed unit. An owner may designate one or more otherwise qualified low-income units as “removed units” and not count those units in the average income computation, thus re-establishing an average of 60 percent or less of AMI.

However, owners can’t count removed units in their credit calculation until compliance has been restored. The proposed regulations state that while a removed unit wouldn’t be included as a low-income unit when determining the applicable fraction to calculate the owner’s annual credit, removed units don’t trigger the recapture of previously claimed credits. If removing the units causes the total number of qualified low-income units to fall below 40 percent of the units in the project, then the project fails the minimum set-aside.

Treasury Reg. §1.42-15: Next Available Unit Rule

The proposed rule provides guidance on how the Next Available Unit rule would work in sites with market-rate units if multiple low-income tenants in units with different imputed income designations exceed 140 percent of their unit’s income designation at the same time.

In such an instance, the regulation doesn’t require the owner to apply the Next Available Unit rule in any specific order. Renting “any available comparable or smaller vacant unit to a qualified tenant maintains the status of all over-income units” as low-income units until the next comparable or smaller unit becomes available (or, in the case of a deep rent-skewed project, the next low-income unit becomes available).

Deadline for Comments

A copy of the proposed regulations can be found at https://public-inspection.federalregister.gov/2020-20221.pdf. The amendments to the Next Available Unit regulations in Treasury Regulation §1.42-15 are proposed to apply to occupancy beginning 60 or more days after the date those regulations are published as final regulations in the Federal Register. The IRS proposes the Average Income Test regulations in Treasury Regulation §1.42-19 apply to taxable years beginning after the date those regulations are published as final regulations in the Federal Register.

Currently, the IRS is seeking comments before these proposed amendments to the regulations are adopted as final regulations. The IRS must receive comments on the proposed regulations by Dec. 29, 2020. The IRS strongly encourages electronic submissions via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-104591-18).