IRS Helps First-Year Owners Avoid the Two-Thirds Rule
In January, the IRS issued Notice 2021-12 granting relief for various LIHTC requirements. Among the relief provided, the notice extended the deadline for a LIHTC site to meet its first-year occupancy obligations from Dec. 31, 2020, to June 31, 2021, for sites operating on a calendar-year basis. On March 16, the IRS issued Notice 2021-17 clarifying how increases in qualified occupancy six months after year-end affect the ability to claim LIHTCs. We’ll go over what effect the IRS’s recent clarification has on a site’s first-year requirements.
First-Year Occupancy Basics
The LIHTC program requires owners to meet certain occupancy requirements in the first year of the site’s compliance period. If these requirements aren’t met, the site owner may have to forfeit some or even all of the tax credits it was allocated for the site.
There are two occupancy requirements that all tax credit managers must meet in the first year of the compliance period. Because both requirements have to do with making sure the right number of units are occupied by low-income residents, you may mistakenly believe that the two goals are the same. Remember you must meet both of the following. Managers who think in terms of only one number may end up meeting only one of the goals, and their sites may fall into noncompliance.
Goal #1: Meet the minimum set-aside. To qualify for the tax credit program, a site must meet its “minimum set-aside.” This means that you must rent a certain percentage of your units to qualified low-income households.
Since the beginning of the LIHTC program, the two main set-asides were the 20-50 and the 40-60. The first number tells the percentage of units that you must rent to qualified low-income households. The second number tells the highest income a qualified household can earn, expressed as a percentage of area median gross income (AMGI). So if your site’s set-aside is 20-50, you must rent at least 20 percent of your site’s units to households earning no more than 50 percent of AMGI.
As a result of the 2018 Consolidated Appropriations Act, a third set-aside was added. This is the income averaging set-aside in which a minimum of 40 percent of the units must be set aside for low-income households with set-asides that don’t exceed an average of 60 percent AMGI. Individual units may have set-asides of 20 percent, 30 percent, 40 percent, 50 percent, 60 percent, 70 percent, or 80 percent of AMGI.
If you don’t meet the set-aside by the end of the first year of the compliance period, the building or site won’t qualify for the tax credit program. As a result, the owner won’t be entitled to claim any of the tax credits it was allocated.
Goal #2: Meet each building’s target or applicable fraction. The applicable fraction is the percentage of a building that’s treated as low-income use and generally eligible for the tax credits. The applicable fraction is the lesser of the unit fraction (the number of low-income units divided by the building’s total units) or the floor space fraction (the floor space of the low-income units divided by the total floor space of all units). For an owner to be entitled to claim all the tax credits it was allocated for its buildings, you must rent enough units to low-income households to bring each building’s first-year fraction up to the “target fraction.”
Example: If a building has 100 units taking up 78,000 square feet, and the owner’s targeted applicable fraction is 60 percent, you’ll want 60 units taking up no less than 46,800 square feet (78,000 sq. ft. x 60%), occupied by qualified families no later than the end of the first year of the credit period or on Dec. 31 of that year. Owners set the target fraction with the state housing agency during the development phase.
If your first-year fraction falls short of the target fraction, your building will still qualify for the tax credit program (assuming you meet the minimum set-aside). But the owner won’t be able to claim all the credits it was allocated for the building. For instance, if the owner’s target fraction is 90 percent, but you establish a first-year fraction of only 80 percent, the owner will lose credits for the 10 percent shortfall.
It’s important to note that the credits generated by units first occupied by eligible residents during the first year of the credit period are more valuable than the credits generated by units first occupied by eligible residents after the first year of the credit period. For a unit first occupied by an eligible household during the first year of the credit period, the owner may take 1/10th of the total tax credit for the unit each year of the 10-year credit period.
If your first-year fraction falls short of the target, the tax credit law gives owners a chance to make up for this shortfall if they rent more units to qualified low-income households after the first year. But if an owner is entitled to claim additional credits because of an increase in the target fraction after the first year, 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.
In other words, if a tax credit unit hasn’t been occupied by the end of the first year of the credit period, tax credits can’t be claimed on that never-occupied unit in that year. Should the unit become occupied after the end of the first year of the credit period, two-thirds of the credit can be claimed each year for the remaining years of the 15-year compliance period.
More Time to Avoid the Two-Thirds Rule
The recent notice specifically references IRC Section 42(f)(3)(A)(ii) whereas Notice 2021-12 from January cited IRC Section 42(f). The new notice citation clarifies that increases in qualified occupancy six months after year-end help owners avoid two-thirds LIHTCs in the future, but can’t be used to claim additional LIHTCs in the first year.
Remember that if all of the LIHTC units aren’t leased by the close of the first year of the LIHTC period, an owner must choose to either defer the first year of the credit period or take two-thirds LIHTCs on the units leased up in the following years. The notice allows a site that isn’t fully leased up at year-end until June 31, 2021, to avoid 15-year or two-thirds credits on units leased in the following six months.
However, the notice doesn’t give owners more time to meet the minimum set-aside. The notice only modifies IRC Section 42(f)(3)(A), whereas Section 42(g) defines the minimum set-aside. So if a site didn’t meet its minimum set-aside in the first year, it will need to defer the first year of the credit period.