Avoid Recapture and Noncompliance with Understanding of Eligible Basis Calculations
The low-income housing tax credit program is administered at the state level by state housing finance agencies with each state getting a fixed allocation of credits based on its population. The state housing agency has wide discretion in determining which projects to award credits, and applications are considered under the state’s “Qualified Allocation Plan.”
Tax credits are taken over a 10-year period and are calculated according to the eligible basis of the site, which includes the cost of new construction/rehabilitation or the cost of acquisition of an existing building. The concept of “eligible basis” is unique to the low-income housing tax credit program because it’s tied to the credits that can be claimed. Typical market-rate apartment developers mainly are concerned with total construction costs, and they don’t consider the eligible basis of a site. For a tax credit site, however, total cost of construction doesn’t equal eligible basis.
As a tax credit site manager, you have the important responsibility of maintaining a site’s eligible basis to preserve the owner’s tax credits. The eligible basis of a building is determined at the end of the first year of the credit period, and as long as there’s no reduction in the eligible basis amount upon which the credit is based, the site is in compliance.
Although you’re not responsible for calculating eligible basis, knowing what it entails and how tax credits are calculated may help you maintain the eligible basis of a site and keep your site in compliance. As you face decisions that affect eligible basis, such as decisions relating to common areas and employee units, you should know exactly how your decisions may affect your site’s eligible basis and be able to point to statutory and regulatory provisions directly affecting your site compliance.
Calculating Annual Allowable Credit
The amount of tax credit the owner can claim each year can be calculated with a three-step process. First, determine the eligible basis: the amount of development cost that would be eligible for generating tax credits if all the site’s units are used for low-income housing.
Second, calculate the applicable fraction (the percentage of a site that’s dedicated to serving low-income residents) and qualified basis (eligible basis x applicable fraction). A site with all of its units used for low-income housing will have an applicable fraction of 100 percent, and its qualified basis will be equal to its eligible basis. A mixed-income site will have an applicable fraction of less than 100 percent, and a qualified basis below its eligible basis.
Finally, calculate the annual tax credit amount by multiplying the qualified basis by the applicable percentage. The applicable percentage is based upon the appropriate tax credit rates (9 percent and/or 4 percent), with adjustments made for the applicable federal rate. A 9 percent annual credit rate is applied to eligible construction and “substantial rehabilitation” costs. A 4 percent annual credit is applied to the acquisition cost of existing buildings to be rehabilitated. And if a site uses tax-exempt bond financing, a 4 percent annual credit is used for all of its eligible costs, including eligible construction and substantial rehabilitation costs.
Typically, the 9 percent and 4 percent annual credits are subject to adjustment based upon the applicable federal rate. The federal rate is based on interest rates and is reported monthly by the IRS for both the 9 percent and 4 percent credits. Various acts of legislation have fixed the 9 percent tax credit at a rate of 9 percent since July 2008. In December 2015, Congress voted to permanently replace the variable federal rate for the 9 percent development credit with a fixed rate of 9 percent. However, the variable federal rate for the 4 percent acquisition and tax-exempt bond credit remain in place.
Identifying Costs Included in Eligible Basis
We’ll go over the characteristics of costs that can be included in a site’s eligible basis calculations. Internal Revenue Code (IRC) Sections 103 and 168 and supplemental definitions and requirements provided by Section 42 cover the characteristics of the costs that can be included in a site’s eligible basis.
Related to residential housing. To be eligible for eligible basis, a cost must be for residential housing. Eligible basis does not include commercial space. Residential rental property may qualify for the credit even though a portion of the building in which the residential rental units are located is used for a commercial use such as commercial office space. However, no portion of the cost of such nonresidential rental property may be included in eligible basis.
If you do happen to use residential space commercially, that space is no longer part of the eligible basis. Therefore, when a building’s eligible basis goes down, the credits the owner can claim go down with it.
Costs associated with residential housing include the costs of personal property for use by the households, such as appliances. It can also include the cost of facilities, such as garages, swimming pools and parking lots, as long as there isn’t a separate fee charged for the use of the facility and the facility is available to all households. For example, if a site consists of 100 units, but there are only 30 garages available, the garages are not considered residential housing and cannot be included in eligible basis.
Suppose an owner included the cost of a building housing a laundry facility in the eligible basis. For security reasons, the room is kept locked, but every household has a key and has access at any time. And the owner installed coin-operated washers and dryers.
The owner can include the cost of the building in eligible basis because all households have access to the facility. However, because households must pay an additional fee to use the washers and dryers, the appliances should not be included in eligible basis.
Model units. Model units are considered rental units under IRC Section 42; PLR 9330013, Issue #3, July 30, 1993. Model units are maintained primarily during a project’s rent-up period to show prospective tenants the desirability of the site’s units. If the site maintains full occupancy thereafter, the model can be dismantled and the unit rented. This makes economic sense because model units don’t generate rental income for a project owner. However, at a large apartment site, it’s standard industry practice to continuously maintain a model unit for marketing purposes and to be competitive. The unit can be shown immediately to prospective tenants at any time without disturbing tenants in occupied units. By increasing competitiveness, model units contribute to the economic viability of the LIHTC site.
A model unit’s cost is included in the building’s eligible basis and in the denominator of the applicable fraction when determining a building’s qualified basis. For example, an owner included the cost of a model unit in the eligible basis for a 100 percent LIHTC building with 49 units (other than the model unit). The owner anticipates that the model unit will be maintained throughout the compliance period and will never be rented to an income-qualified household. The cost of the unit should be included in the building’s eligible basis. But the maximum applicable fraction that the owner can claim is 49/50, or 98 percent.
Depreciable costs. To be eligible for LIHTC, the cost must be depreciable. Costs includable in eligible basis must be depreciable property under IRC Section 168. IRC Section 168(e)(2)(A) defines “residential rental property” to mean any building or structure if 80 percent or more of the gross rental income from such building or structure for the taxable year is rental income from dwelling units.
So, for example, land costs are not included in eligible basis. Neither are expenses related to permanent financing (loans) for the site, syndication fees, nor costs related to the selling of an equity interest in a site.
However, if a cost is directly attributable to the depreciable, residential rental property, then it is included in eligible basis. For example, costs such as engineering studies, architectural specifications, pertinent legal and accounting fees, construction period interest and taxes, and general contractor fees are most often found to be directly attributable to building costs.
Developer fees are generally included in eligible basis provided that the fee is reasonable. Most of the state agencies have set limits on the amount of developer fee that can be included. The developer fee should represent debt and payment and it should not depend upon the performance of the site over time. If payment is contingent on performance and the developer is also the managing partner, then the fee is really for successfully managing the site and is characterized as an operational cost. Most likely, developer fee should be associated with activities such as buying the land, syndicating the credit, and putting together the partnership.
Costs incurred within appropriate time frames. Under IRC Section 42, the buildings qualifying for the credit are:
- New buildings, the original use of which begins with the taxpayer [IRC §42(i)(4)];
- Existing buildings, which means any buildings that are not new buildings [IRC §42(i)(5)]; and
- Rehabilitated buildings—i.e., the expenditures connected with rehabilitating an existing building are treated as a separate new building and don’t include the cost of acquiring the building [IRC §42(e)(1) and (2)].
The main thing to be aware of here is the timing difference between these two types of buildings. The timing of when a cost is paid or incurred affects its inclusion in the eligible basis. Under IRC Section 42(f)(1), the credit period starts with the taxable year in which the building is placed in service, or at the election of the taxpayer, the succeeding taxable year. The election is documented on Form 8609, line 10a. For new building owners, their eligible basis costs must be incurred by the close of the taxable year so elected. As a result, certain costs that may have been incurred after the close of the year (e.g., landscaping and common areas) cannot be considered part of eligible basis.
For existing buildings with substantial rehabilitation, the owner elects a 24-month period, during which to incur and perform the substantial rehabilitation, and these eligible basis costs end on the last day of the 24-month period elected.
Federal grants. Under IRC Section 42(d)(5)(A), the eligible basis must be reduced if a federal grant is made to fund the cost of a building. Federal grants are funds that originate from a federal source and don’t require repayment.
The IRS will consider a building to be out of compliance as of the date the federal grant is made if the eligible basis isn’t reduced and the reduction would’ve resulted in a decrease in qualified basis. For example, suppose an owner constructed a building that was placed in service on Sept. 1, 2003, and 2003 is the first year of the credit period. The owner included the cost of kitchen appliances installed in the low-income units’ kitchens—that is, the dishwashers, refrigerators, and stoves.
During 2010, the owner replaces the worn-out appliances using funds received from a federally sourced grant. Here, the eligible basis must be reduced for the amount of grant money used to purchase and install the new appliances.
Eligible basis is not reduced if the proceeds of a federal grant are used as a rental assistance payment under Section 8 of the United States Housing Act of 1937. Under Revenue Ruling 2002-65, rental assistance payments made to a building owner on behalf or in respect of a tenant under the Rent Supplement Payment program [12 U.S.C. §1701s] or the Rental Assistance Payments program [12 U.S.C. §1715z-1(f)(2)] are not grants made with respect to a building or its operation under IRC Section 42(d)(5). Thus, proceeds from these programs don’t require a reduction of eligible basis.
For buildings placed in service after July 30, 2008, IRC Section 42(d)(5)(A) was amended as part of the Housing Assistance Tax Act of 2008. It currently provides that the eligible basis of a building shall not include any costs financed with the proceeds of a federally funded grants. Federally sourced grants used for the operation of an LIHTC building don’t require a reduction of the eligible basis for these buildings.
For example, an owner constructed an LIHTC building that was placed in service on Sept. 1, 2008, and 2008 is the first year of the credit period. On June 25, 2009, the owner received a grant funded with federal funds to buy computers that will be used by the office staff to operate the LIHTC building. Here, no reduction of the building’s eligible basis is required.
Facility costs reasonably required for site. Cost for units for managers, maintenance personnel, and security officers are allowed in the eligible basis. Residential rental property, for low-income housing credit purposes, includes residential rental units, facilities for use by the tenants, and other facilities reasonably required by the project. Under Treasury Regulation Section 1.103-8(b)(4), facilities that are functionally related and subordinate to residential rental projects are considered residential rental property. Treasury Regulation Section 1.103-8(b)(4)(iii) provides that facilities functionally related and subordinate to residential rental projects include facilities for use by the tenants, such as swimming pools and similar recreational facilities, parking areas, and other facilities reasonably required for the project. The examples included in Treasury Regulation Section 1.103-8(b)(4)(iii) of facilities reasonably required by a project specifically include units for resident managers or maintenance personnel.
IRS Revenue Ruling 92-61 holds that the adjusted basis of a unit occupied by a full-time resident manager is included in the eligible basis of a qualified low-income building under IRC Section 42(d)(1), but the unit is excluded from the applicable fraction under IRC Section 42(c)(1)(B) for purposes of determining the building’s qualified basis.
A staff unit is considered a facility reasonably required for the benefit of the project and the resident manager and/or maintenance personnel are not required to be income qualified. If the owner is charging rent for the unit, the IRS may determine that the unit is not reasonably required by the site, because the owner is not requiring the manager to occupy the unit as a condition of employment. And later conversion of the unit into a residential rental unit won’t change the eligible basis.
The same logic applies to units for security officers. For deterring crime in and around an LIHTC site, it may be necessary and reasonably required by the project for the owner to provide a security presence by leasing a residential rental unit to a security officer, who may be an off-duty law enforcement officer, security person in private industry, or other qualified person. In return for performing safety and security services that contribute to the management and control of the site, the security officer may be provided an on-site unit.
Typically, a security officer provides on-site presence during the evening and nighttime hours to respond to any emergencies and disturbances, and to respond to residents’ requests for assistance, including complaints, unauthorized visitors, improper parking, and unauthorized use of community facilities. Other encouraged activities may include conducting resident criminal background investigations, neighborhood watch programs, and educational activities for primary school-age residents.
The adjusted basis of the unit occupied by a security officer is includable in the eligible basis of the building under IRC Section 42(d)(1) as a facility reasonably required for the benefit of the project. However, the unit is excluded from the applicable fraction of the building under IRC Section 42(c)(1)(B).
Community service facility costs. As part of the Community Renewal Tax Relief Act of 2000, IRC Section 42(d)(4)(C) was added to include property used to provide services to non-tenants as part of the eligible basis used for determining the LIHTC amount. The facility must be located on the same tract of land as one of the buildings that comprises the qualified low-income housing project. And examples of such facilities include day care, career counseling, literacy training, education (including tutorial services), recreation, and out-patient clinical health care. These are specific requirements:
- The property must be located in a qualified census tract. (See former IRC Section 42(d)(5)(C)(ii) for buildings placed in service prior to July 31, 2008, and IRC Section 42(d)(5)(B)(ii) for buildings placed in service after July 30, 2008.)
- The property must be subject to the allowance for depreciation and not otherwise accounted for.
- The property must be used throughout the taxable year in providing any community service facility.
- Under IRC Section 42(d)(4)(C)(iii), a community service facility must be designed to service primarily individuals whose income is 60 percent or less of the area median income.