IRS Issues Memo on Eligible Basis Reduction Due to Common Area Noncompliance
The IRS Office of Chief Counsel recently issued a memorandum addressing noncompliance of common areas in LIHTC sites. The memo was issued in response to a clarification request by an IRS Program Manager for Technical Issues. The memo states that its advice may not be used or cited as precedent, but it illuminates how the IRS will approach noncompliance of a common area.
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.
Eligible Basis Issues
When a building’s eligible basis goes down, the credits the owner can claim go down with it. A change in a building’s eligible basis can occur due to an inadvertent conversion of common areas into commercial space. Section 42(d)(4)(B) of the Internal Revenue Code indicates that common areas may be included in eligible basis or credits may be claimed on the cost of the common areas as long as the common area is provided as “comparable amenities to all residential rental units.” This means that you can’t charge anyone for the use of common areas that are included in your building’s eligible basis. If a common area is in the basis, fees may not be charged even to market-rate residents. In other words, if parking, pools, tennis courts, and other types of common areas are included in the eligible basis, no separate fees can be charged.
Treasury Regulation 1.42-5(c)(VII) requires that owners certify annually that “there was no change in the eligible basis (as defined in Section 42(d)) of any building in the project, or if there was a change (e.g., a common area has become commercial space or a fee is charged for a tenant facility formerly provided without charge).”
Another situation involving a change in a building’s eligible basis is when a common area becomes noncompliant under an inspection standard. Here are the three questions the memo resolves:
- Should the noncompliance of a common area in a qualified low-income building, based on a failure of the inspection standards under Section 1.42-5(d) of the income tax regulations or any requirements under Section 42, be treated as a change in the eligible basis of the building in the taxable year in which the noncompliance occurs?
- If recapture is appropriate, is the recapture amount based on the amount of costs attributable to the entire common area and not just the noncompliant portion?
- Should the noncompliance of a common area, based on a failure of the inspection standards, be treated as a change in the applicable fraction of the qualified low-income building in the taxable year in which the noncompliance occurs, as if one of the low-income units located the closest to the noncompliant area was out of compliance?
First issue. The memo makes clear that noncompliance of the common area reduces the eligible basis for the property for the year the noncompliance takes place. It states that if a common area of a LIHTC building is noncompliant under the inspection standards or any other requirements under IRC Section 42 during the compliance period, and if the noncompliance is uncorrected as of the close of the taxable year in which the noncompliance occurs, the noncompliance should be treated, in the taxable year in which the noncompliance occurs, as a change and reduction in the eligible basis of the building.
Second issue. The memo says that the recapture amount is based on the amount of costs attributable to the entire common area, not just the noncompliant section.
For example, a qualified low-income building contains multiple common areas. One of the common areas is a laundry room for use by all tenants of the building without additional charge. The laundry room contains 20 laundry machines. For purposes of the LIHTC under Section 42, the costs of the entire laundry room ($40,000), and those of the 20 laundry machines ($10,000), were included in eligible basis (a total of $50,000) as of the close of the first year of the credit period. In June of Year 3, during the compliance period, the state housing credit agency inspected the building and discovered that 10 of the laundry machines weren’t properly functional, so the common area (the laundry room) was deemed noncompliant. The housing agency gave the owner 90 days to correct the noncompliance, but the noncompliance wasn’t corrected and remained uncorrected at the end of Year 3. Therefore, in Year 3, there’s a reduction in eligible basis in the amount of the total costs of the laundry room that were included in eligible basis ($50,000), because the laundry room was noncompliant. The reduction isn’t limited to the amount of the costs attributable to the nonfunctional laundry machines ($5,000).
Furthermore, if the adjusted basis of the common area is allocated to the eligible basis of one or more buildings in the project for purposes of calculating the credit, such as a carport that’s for use by all of the tenants of a qualified multi-building LIHTC project, the reduction in the eligible basis of the buildings based on the noncompliance of the common area should be allocated among the buildings.
Third issue. According to the memo, treating the noncompliance of a common area instead as if one of the low-income units located closest to a noncompliant common area was out of compliance isn’t a valid alternative to reducing the eligible basis. Doing so wouldn’t properly and accurately account for the change caused by the noncompliance of a common area to the qualified basis of the building.
Reporting the Noncompliance
For reporting purposes, state housing agencies are to check box 11c (Violation(s) of the UPCS or local inspection standards) and 11e (Changes in Eligible Basis or the Applicable Percentage) of Form 8823 if a common area is found to be noncompliant due to an inspection standard violation.