Follow Three Rules on Unit Size to Avoid Noncompliance
To comply with many key tax credit requirements, it is important to take into account unit size, that is, either a unit's square footage or its number of bedrooms. If you don't take unit size into account where required, your site is likely to fall into noncompliance, which could put the owner's tax credits in jeopardy. Many managers who have experience with other housing programs, but are new to the low income housing tax credit (LIHTC) program, make mistakes because they don't realize that unit size plays a key role in tax credit compliance.
To help you avoid making costly mistakes, we will give you three rules to follow to properly consider a unit's size when the tax credit program requires you to do so.
Rule #1: Calculate Floor Space Fraction to Determine Applicable Fraction, First-Year Partial Fraction
You must take unit size into account each year when you calculate the applicable fraction for each building at your site, says tax credit consultant Karen A. Graham. And because you must perform similar calculations when determining each building's first-year partial fraction, unit size also matters for that first-year's calculation.
Don't confuse applicable fraction and minimum set aside. Some managers don't take unit size into consideration for the applicable fraction requirement, because they confuse it with the minimum set-aside requirement, Graham notes. That requirement also involves renting enough units to qualified low-income households. But the size of those units does not play any role in meeting and maintaining the set aside.
For background information on set-asides, see “Avoid Six Common Mistakes When Complying with the minimum Set-Aside Requirement,” in the February 2006 issue of the Insider, p. 1.
To calculate a building's applicable fraction, determine the unit fraction (the number of low-income units divided by the building's total units)and the floor space fraction (the floor space of the low-income units divided by the total floor space of all units). The lesser of these two fractions is the building's applicable fraction, Graham explains.
Getting the applicable fraction right is crucial, Graham says. During the first year of the compliance period, you must be concerned about establishing an application fraction (known as the “first-year fraction”) that is high enough so the owner can claim all the credits it was allocated. And you must maintain this applicable fraction for each remaining year of the compliance period so the owner stays entitled to claim its credits.
Calculating credits for the first year. Because calculating the credits for the first year is tied to the applicable fraction, you must consider both the unit fraction and the floor space fraction of your buildings’ units. This first-year calculation lets the owner know how many credits it is entitled to claim in the first year of the credit period. It represents the percentage of units in each building that you have rented to low-income households during each month of the first year.
To calculate the credits for the first year of the credit period, you must calculate each building's applicable fraction on the last day of each FULL calendar month after the building was placed in service, explains Graham.
For example, suppose a building's placed-in-service (PIS) date is April 4, 2008. You first calculate the applicable fraction on May 30, 2008, and repeat the calculation on the last day of each month for the rest of the calendar year. (If the building's PIS date is the first of the month, calculate the application fraction on the last day of that month.) Average your building's monthly applicable fractions over the full calendar year to get your building's first-year credit calculation, Graham advises.
PRACTICAL POINTER: Bear in mind that variables make it difficult to make a general statement applicable to every possible situation, Graham advises. For example, when units gradually begin to be occupied in a “lease-up,” the credits for the first year of the credit period are calculated based on the average low-income occupancy for the year, says Graham. However, in all other years of the credit period, the applicable fraction is determined on the last day of the year, she notes.
If the owner chooses to defer and not take these partial credits, then the second year is actually considered the first year, she adds. Any annual credit not taken in the first year as a result of this “first-year calculation” is taken in year 11 of the compliance period, she says. It is not taken in the credit period, because the credit period is the 10-year period in which credits are claimed, she advises.
Rule #2: Convert Number of Bedrooms to Imputed Household Size to Correctly Calculate Rent
If your site was allocated credits in 1990 or later, or was allocated credits before 1990 and made a “cross-over election,” the tax credit law requires your site to use the number-of-bedrooms method to calculate rents. If you manage this type of site, you must take into account your low-income units’ size (number of bedrooms) to correctly calculate their rent, Graham says.
This involves a special calculation, she notes. The tax credit rent is always based on 30 percent of the income limits for your area. But these limits are based on the number of persons—not bedrooms—per household, Graham says. To calculate rent using the number-of-bedrooms method, first convert the number of bedrooms to an “imputed” household size by multiplying the number of bedrooms by 1.5. (Treat a studio, which has no bedrooms, as a one-person household.) Then apply the appropriate income limits to calculate the household rent.
If you skip this step because you think you must use the one-person limit for one-bedroom units, the two-person limit for two-bedroom units, and so on, you are likely to charge households too little for your units, which will cost the owner rent revenue. If you don't realize that you must use the number-of-bedrooms method, and instead calculate the rent based on the number of persons occupying the unit, you may charge households too much and bring your site into noncompliance, Graham warns.
For background information on handling changes in household size, see “Prevent Available Unit Rule Violations Triggered by Changes in Household Size,” in the December 2006 issue of the Insider, p. 6.
Rule #3: Rent Comparables or Smaller Units to Comply with Available Unit and Vacant Unit Rules
You must take unit size into account to comply with the available unit rule and the vacant unit rule. With each rule, you must determine which units are comparable to or smaller than the unit that triggered the rule.
Household exceeds income limits. When a household's income exceeds the limits by 40 percent (or 70 percent in the case of “deep rent-skewed” units), you must comply with the available unit rule. This rule says that over-income households stay eligible to occupy their low-income units and the owner can continue to claim credits for them. But in return, you must rent the next available unit of comparable or smaller size in the building to a new, qualified low-income household.
Available unit larger than household's current unit. If a household goes over income and the next available unit is larger than that household's unit, you may rent it to a qualified low-income household, says Graham. But doing so won't satisfy the available unit rule, she adds.
The available unit rule also states that when a household goes over income, the household still qualifies as long as all current and subsequent available units of comparable size or smaller are rented to tax credit qualified households in that building, until the percentage of low-income units or square footage in the building (excluding the over-income units) is equal to the required applicable fraction.
To comply with this rule, you would still need to rent the next unit of comparable or smaller size that becomes available to a qualified low-income household, Graham says.
PRACTICAL POINTER: Bear in mind that unit size also plays a key role in the occupancy standards you set for your site. You may legally set standards that limit the number of people who can live in your low-income and market rate units.
The LIHTC program does not have its own occupancy standards, but your state or local law may have certain requirements that you must follow. And federal guidelines, with some exceptions, recommend limiting occupancy to two persons per bedroom. If you remain unsure what occupancy standard you should set for your site, consult your attorney, recommends Graham.
Karen A. Graham: President, Karen A. Graham Consulting, LLC; Liberty Township, OH