How to Track Applicable Fraction to Help Avoid Tax Credit Loss
Keeping each building’s applicable fraction on target is an essential part of a tax credit manager’s job. The applicable fraction is the percentage of a building’s units rented to low-income households. It comes into play when you calculate the building’s qualified basis, which affects whether the owner can claim all its tax credits. The qualified basis is the eligible basis (which rarely changes but can’t go up) times the applicable fraction (which often goes up or down). That means a change in a building’s qualified basis typically occurs because of a change in the applicable fraction.
So you need to keep track of changes in the applicable fraction each year to determine the qualified basis accurately and avoid tax credit problems. If the applicable fraction isn’t high enough, your building may fall into noncompliance. And if the qualified basis increases, you may need to alert the owner so that it won’t lose the chance to claim any tax credits it couldn’t claim in the first year.
We’ll explain how to calculate the applicable fraction correctly and what the consequences are if you don’t. We’ll also give you a Model Worksheet: Use Worksheet to Stay on Top of Applicable Fraction Changes, which you can adapt and use to help you track changes to the applicable fraction during each year of the compliance period.
What’s the Applicable Fraction?
The applicable fraction for a given year is the percentage of a building’s units that were rented to low-income households on Dec. 31 of that year. To calculate the applicable fraction, take the lesser of 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). If your site has more than one building, you must make this calculation for each building. The applicable fraction for the first year of the compliance period is known as the first-year fraction.
What’s at Stake?
During the first year of the compliance period, your goal is to create the first-year fraction by meeting the owner’s target. Owners must set a target for the first-year fraction in the applications for credits they send to the state housing agency. If you fail to bring the first-year fraction up to that target, the owner won’t be able to claim all its credits during the first year.
After the first-year fraction is established, changes in the applicable fraction throughout the remainder of the compliance period will cause the qualified basis to go up or down. So it’s important, as you calculate and track the applicable fraction, that you aim to meet the first-year fraction. If you end the year by falling short of the first-year fraction without letting the owner know, the owner may lose a chance to claim additional tax credits. Here’s what can happen.
Applicable fraction lower than first-year fraction. If, on Dec. 31 of any year, the applicable fraction for one of your buildings is below the first-year fraction, the building’s qualified basis will drop, causing the entire building to fall into noncompliance. This means that the owner won’t be able to claim credits for the noncomplying units in the building for that year. On top of this, the IRS will recapture one third of the credits the owner got for those units in previous years when the building was in compliance.
If you don’t meet the first-year fraction in a given year but do meet it the following year, the owner may resume claiming credits (assuming no other reason for noncompliance exists). But the owner can’t recoup the credits it lost.
Applicable fraction greater than first-year fraction. If the applicable fraction exceeds the first-year fraction, your building won’t fall into noncompliance. In fact, the owner may be able to begin claiming credits it couldn’t claim in the first year if the first-year fraction didn’t meet the target. But if an owner is entitled to claim additional credits because of an increase in the applicable fraction, it can claim only two-thirds of these credits during each year of the 15-year compliance period rather than the usual 100 percent over the 10-year credit period.
If you aren’t aware of this rule or don’t keep track of the applicable fraction for all your buildings, the owner will lose its chance to claim all the credits allocated to it. If this happens and the owner believes the loss was due to the management company’s incompetence, it may consider replacing its management company.
How Worksheet Helps
Using an applicable fraction worksheet to calculate and keep track of the applicable fraction can benefit you in four ways:
Helps you predict whether building will reach owner’s first-year target. If the owner expects you to establish your building’s first-year fraction at a specific level, you can use the worksheet to monitor your progress in achieving this goal. Because some owners don’t understand the marketing difficulties involved in renting enough low-income units to meet their targets, they don’t realize that their targets may not be achievable in the first year. By using a worksheet to track the applicable fraction during rent-up, you can see what’s needed to achieve the target. And, if you determine the target can’t be achieved, you can discuss this with the owner. Telling the owner in advance that you’re likely to fall short of the target gives the owner more time to adjust to the situation and plan for it. If you don’t let the owner know until after the fact that the first-year fraction didn’t meet the target, you’ll look unprofessional, and it may be harder to convince the owner that its target wasn’t achievable.
Shows first-year fraction. You’ll want the first-year fraction for your building in front of you as you perform your calculations each year, so you can compare the current applicable fraction to the first-year fraction. The worksheet does this, showing the first-year fraction on the same piece of paper you’re using for your calculations. This way, there’s no chance you’ll refer to the first-year fraction for the wrong building or remember it incorrectly.
Warns you when applicable fraction slips below first-year fraction. You won’t be unpleasantly surprised when the applicable fraction is determined on Dec. 31 of each year of the compliance period if you use the worksheet to track the applicable fraction throughout the year. For example, you may discover on Sept. 30 that your building is one unit or 250 square feet away from meeting the first-year fraction. If that happens, you’ll know what you must do over the next three months to meet the first-year fraction. And you’ll be able to update the worksheet as you make progress.
Alerts you when applicable fraction is too far above first-year fraction. You need to know whether you’re renting too many units to low-income households. That’s because if the first-year fraction was on target, you don’t want to go too far above it. Otherwise, the owner will lose money in rent, assuming your charge a higher rent for your market-rate units than for your low-income units. Of course, the owner may want you to aim slightly higher than the first-year fraction to leave room for error. And, if the first-year fraction wasn’t on target, going above the first-year fraction may benefit the owner by entitling it to claim more credits. Whatever the owner’s strategy, using the worksheet will allow you to track the applicable fraction throughout the year. So, if you see that the applicable fraction for the current year may exceed the first-year fraction, you can tell the owner before it’s too late to make any changes.
How to Use Worksheet
Because the applicable fraction is a building-by-building computation, you’ll need to maintain a separate worksheet for each building. The definition of a building in IRS Code Section 42 is based on the Building Identification Number the state housing finance agency assigns. Start a new worksheet in the beginning of each calendar year during the compliance period. Then, whenever one of your low-income units becomes a market-rate unit or vice versa, update the worksheet right away to reflect this change.
Keep the worksheet for each building handy, so you can update it or refer to it when needed. And, when you’re done with a worksheet at the end of the year, file it in a separate folder with the household files for that building.
Here’s how to use the worksheet:
Write down building number, first-year fraction, and owner’s target. Start by writing the identification number for the building at the top of each worksheet. Then, at the bottom, fill in the first-year fraction unless this is the first year of the compliance period. If this is the first year of the compliance period or if the owner wants the applicable fraction to be higher than the first-year fraction, write down the owner’s target.
List units and total up chart. Next, fill in the chart. In Column 1, list the units in your building by number. If there aren’t enough rows, you’ll need to add rows. Indicate if a unit is low-income in column 2. In column 3, write in the unit’s floor space in square feet. If the unit is low-income, copy its floor space into column 4, but for market-rate units, leave column 4 blank. Finally, add up each column and write the totals in the final row.
Calculate unit fraction. With the date you need to determine the applicable fraction handy, you can begin your calculations. The first step is to calculate the unit fraction, which is simply the number of low-income units (column 2 total) divided by the total number of units (column 1 total). Change any fractions to percentages, because that’s how the unit fraction is expressed.
Calculate floor space fraction. The second step is to calculate the floor space fraction. The floor space fraction is the total floor space for your low-income units (column 4 total) divided by the total floor space in your building (column 3 total). Change any fractions to percentages, as you did with the unit fraction.
Determine applicable fraction. Now that you’ve calculated the unit fraction and the floor space fraction, decide which is the lesser of the two, and that’s the applicable fraction.
Compare to first-year fraction and owner’s target. If this is the first year of your building’s compliance period, then the answer you get in step 3 is the first-year fraction. If it’s not, you must compare the applicable fraction to your building’s first-year fraction and to the owner’s target, if the owner wants you to aim above the first-year fraction. This way, you can tell whether you’re on track for meeting the first-year fraction and the owner’s target on Dec. 31. If you determine early enough that the applicable fraction is too low, you may have time to fix the problem by renting more of your units to low-income households. Or, if the applicable fraction is higher than the first-year fraction, you can ask the owner how much leeway it wants to allow.
Editor’s Note: For a site’s first year of its credit period, owners must calculate a “prorated fraction” for each building to determine how many credits the owner may claim in the first year. It’s called the prorated fraction because it takes into account the percentage of a building’s units that were rented to low-income households during each month of the first year. Each month that the building wasn’t in service for the full month is averaged in as a zero, reducing the fraction.
Don’t confuse the prorated fraction with the “first-year fraction.” The first-year fraction only establishes the lower limit that each following year’s applicable fractions must meet to avoid putting the owner’s credits at risk. It’s not used to calculate credits.
Note date of update. Finally, write down the date, so the next person to refer to or update the worksheet will know how up-to-date it is.
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