How to Use the Averaging Convention to Determine First-Year Tax Credits
If you're managing a tax credit site in the first year of its credit period, it's important to know that the owner may not be able to claim all the credits it expects to for that year. According to IRC Section 42(f)(2), an owner isn't allowed to take the entire credit a building is expected to produce each year in the tax credit program on his tax return for the first year of the tax credit period.
The number of credits an owner can claim in the first year depends on the percentage of a building's units rented to low-income households during each month of that year, says management expert Roxie Munn. This percentage is known as the prorated fraction. The owner must use the prorated fraction rather than the first-year applicable fraction to calculate how many credits it's entitled to claim in the first year. It's important for an owner to obtain the right prorated fraction and claim the correct number of credits. If the owner claims too many, it can get into trouble with the IRS. And if the owner doesn't claim all the credits it's entitled to because calculations were off, the owner may hold you responsible.
We'll tell you how to calculate the prorated fraction to determine how many credits the owner can claim in the first year after the owner places a building in service. We'll also give you a Model Form: Calculate Prorated Fraction to Determine First-Year Credits, which you can adapt and use to help you make your calculations accurately.
Applicable Fraction vs. Prorated Fraction
The applicable fraction is that portion of a building occupied by qualified, low-income residents. It's the portion of a building qualified to generate a tax credit. According to IRC Section 42(c)(1)(B), a building's applicable fraction is always calculated as the lesser of:
The unit applicable fraction—The percentage of units in a building occupied by qualified, low-income residents; or
The floor space application fraction—The percentage of floor space in a building occupied by qualified, low-income residents.
An owner has a targeted applicable fraction for each building. The targeted applicable fraction is that portion of a building covered by its credit allocation. To generate the maximum possible tax credit, a building's applicable fraction must be at least equal to the owner's targeted applicable fraction by the end of the first year of the credit period. The applicable fraction an owner calculates at the end of the first year of the credit period is called the first-year applicable fraction. This fraction becomes the lower limit that each following year's applicable fractions must meet to avoid putting the owner's credits in jeopardy. But it isn't used to calculate credits.
On the other hand, the prorated fraction is used to calculate credits for the first year. It takes into account the percentage of your building's units rented to low-income households during each month of the first year. It's called the prorated fraction because each month that the building wasn't in service for the full month is averaged in as zero, reducing the fraction.
Following the First-Year Averaging Convention
Calculating the prorated fraction involves two steps:
1. Calculate applicable fraction for each full month following placed-in-service date. First, you must calculate your building's applicable fraction on the last day of each full calendar month after the building was placed in service. For example, if the placed-in-service date is Oct. 17, start calculating the applicable fraction on Nov. 30 and repeat the calculation on the last day of each month for the rest of the calendar year. If the placed-in-service date is the first of the month, start calculating the applicable fraction on the last day of that month. The applicable fraction for a given month is the percentage of a building's units that were rented to low-income households on the last day of that month.
2. Average applicable fractions over entire year. Next, take the average of your monthly applicable fractions over the full calendar year. When adding your applicable fractions, enter “0 percent” for any months when you didn't calculate the applicable fraction because your building wasn't in service for the full month. For example, if your building was placed in service on Feb. 12, 2011, you would enter “0 percent” for January and February. The resulting average is your building's prorated fraction.
If your building's prorated fraction is less than its first-year applicable fraction, the owner can claim credits based only on the prorated fraction in the first year. But the owner can claim the difference between the prorated fraction and the first-year fraction in the year after the credit period ends or Year 11 of the compliance period.
How to Complete Worksheet
Use a separate worksheet for each building, since the prorated fraction must be calculated on a per-building basis. Complete a copy of part 1 of the worksheet on the last day of each full calendar month after a building's placed-in-service date. If the placed-in-service date is the first of the month, complete a copy of part 1 on the last day of that month.
Write down building number and month. Start by writing the identification number for the building at the top of each worksheet. Below it, write the month the worksheet covers.
List units and fill in and total chart. In column 1, list the units in your building by number. If a unit is low income, mark it as such with a checkmark 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 or empty units, leave column 4 blank. Finally, add up each column. This will give you the total number of units (col. 1), the total number of low-income units (col. 2), the total floor space (col. 3), and the floor space for your low-income units (col. 4). Write the totals in the final row.
Calculate unit fraction. To calculate the unit fraction, divide the number of low-income units (col. 2 total) by the total number of units (col. 1 total). Change any fractions to percentages, because that's how the unit fraction is expressed. On our worksheet, the unit fraction is 5/8 or 62.50 percent.
Calculate floor space fraction. Next, calculate the floor space fraction, which is the total floor space for your low-income units (col. 4 total) divided by the total floor space in your building (col. 3 total). Change any fractions to percentages, as you did with the unit fraction. On our worksheet, the floor space fraction becomes 4,500/8,000, or 56.25 percent.
Determine applicable fraction for month. The applicable fraction for the month is the lesser of the unit fraction and the floor space fraction. On our worksheet, since the floor space fraction (56.25 percent) is lower than the unit fraction (62.50 percent), the applicable fraction for April is 56.25 percent.
After you've calculated the applicable fraction for December, you should proceed to part 2 of the Model Worksheet and calculate the prorated fraction.
Fill in applicable fraction for each month. Next, fill in the chart. Insert the applicable fraction you calculated on each of your part 1 worksheets into the space next to the corresponding month. For any months when you didn't complete part 1 because your building wasn't in service for the full month, just write “0 percent.”
Calculate 12-month average. Take the average of all 12 applicable fractions to calculate your building's prorated fraction. This is what the owner must use to calculate its tax credits in the first year of the credit period.
Be sure that the applicable fraction you calculated in part 1 for December is the same as your first-year fraction, says Munn. Since both fractions are calculated on Dec. 31 of the first year, they should be identical.
After you make this calculation, you should tell the owner what the prorated fraction is so that it can prepare its tax return accurately. If the prorated fraction is less than the first-year fraction, let the owner know that it can claim the difference in credits in the year after the credit period is over. Once you've finished both parts of the worksheet, file them together in a separate folder with the household files for the building.
Roxie Munn, HCCP: President, Roxie Munn, Inc., 117 Kingsland Way, Piedmont, SC 29673; www.roxiemunn.com.
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