IRS Publishes Final Average-Income Regulations
The IRS recently published a final rule to implement Congress’s 2018 authorization of a third set-aside option for LIHTC sites. Under the LIHTC program, all tax credit owners must formally notify the IRS of their minimum set-aside election for their building or site when they file IRS Form 8609. Meeting your site’s minimum set-aside is the most important goal you have as a tax credit manager. If you meet the set-aside, the owner of your site will be entitled to claim its tax credits. If you don’t meet the set-aside, your site won’t qualify for the tax credit program, which means the owner won’t be able to claim any of the credits it was allocated.
In 2018, as part of the Consolidated Appropriations Act of 2018, the Internal Revenue Code was amended to include an average-income minimum set-aside. The provision allows sites to take LIHTCs on units that have designated an imputed income limitation that allows tenants with incomes at 70 percent or even 80 percent of area median income (AMI) as long as there are additional units with designated imputed income limitations at 30 percent, 40 percent, 50 percent, or 60 percent of AMI so that the overall average for all units doesn’t exceed 60 percent of AMI.
Previously, tax credit units were restricted to households earning no more than 60 percent of AMI. The prior minimum set-asides called for having 20 percent of the units targeted to no more than 50 percent of the AMI or 40 percent of the units at no more than 60 percent of the AMI, and these options remain part of the federal program.
In 2020, the IRS issued proposed regulations providing its interpretation of the average-income test, and these proposed regulations were criticized. For example, under the proposed regulations, the loss of even one below-60 percent unit could potentially cause the entire building to no longer qualify for credits. Also, once a unit was designated at a certain income level, there was no change to that designation allowed. If the income designation was removed, the unit would then cease to be a low-income unit, regardless of tenant needs or applicable law. In addition, the designation and correction deadlines under the proposed regulations meant that owners might discover that they had failed the law’s requirements, but be unable correct the failure in time.
These inflexibilities and concerns made owners and developers reluctant to choose this minimum set-aside option when the option was intended to expand the LIHTC program to serve more families. Before, families earning 80 percent of the AMI didn’t qualify for a LIHTC unit and were likely to be living in market-rate housing. Also, income averaging could help a site’s bottom line and allow for deeper income targeting. Higher rents that households at the upper range could pay would have the potential to offset the lower rents for extremely low- and very low-income households.
After nearly two years, the IRS and Treasury released final regulations that provide clarity to LIHTC program participants. The regulations address the major criticisms to its proposed rules. We’ll discuss the key provisions of the final regulations and the practical changes it makes for LIHTC projects.
New Terms, Definitions
The proposed regulations from 2020 relied on the definition of “low-income unit” in Section 42(i)(3)(A), as it’s applied throughout the section. Because a low-income unit in an income-averaging site isn’t subject to one site-wide income ceiling, but instead to an individual unit designation that interacts with a site-wide average, the IRS clarified its definition.
Low-income unit. Low-income unit, specific to the average-income test, will now take into account if a unit is part of a group of units with a compliant average limitation. According to the final regulations, in the case of average-income projects, a low-income unit refers to a residential unit that meets four criteria:
- The unit is rent-restricted;
- It’s occupied by a household that satisfies the imputed income limitation;
- No other provision of Section 42 would otherwise deny low-income status to the unit; and
- The unit is part of a qualified group of units or a group of units whose average income is 60 percent of AMI or less.
Over-income unit. As a result of the new definition of low-income unit as it relates to the average-income test, an over-income unit is a residential unit whose occupant’s income grows to more than 140 percent of the greater of 60 percent AMI or the income designation of the unit and that meets the first three criteria of a low-income unit.
Qualified group of units. This is a new concept introduced by the final regulations. It is a group of residential units composed of individual units that satisfy the new definition of low-income unit and, when taken as a group, have an average imputed income limitation of 60 percent AMI or less. With the final regulations, the term is used for the minimum set-aside test and for the applicable fraction determination
The biggest change in the final regulations is related to the minimum set-aside. In 2020, the proposed regulations created an unnecessarily high minimum set-aside standard. The proposed rule required all low-income units in a project to average no more than 60 percent of AMI. This last requirement established what was known as the “cliff test,” in which one over-income unit would cause an otherwise compliant project to lose all credits.
This requirement was seen as inconsistent with the other minimum set-asides. For example, if a unit is out of compliance in a 40-60 site, as long as 40 percent of the units in the development are in compliance, the project does not fail the minimum set-aside. But under the proposed rule, a single unit out of compliance in an AIT property could jeopardize the minimum set-aside, even if 40 percent of the low-income units still have an average of 60 percent or less of AMI.
The final regulations eliminated the cliff test and note that if a project contains a qualified group of units that constitutes at least 40 percent or more of residential units, it will meet the minimum set-aside test. This means that an income-averaging project will maintain compliance with the minimum set-aside if at least 40 percent of its units are low-income units with an average AMI of 60 percent or less.
The final regulations say the project may designate another qualified group of units to determine the applicable fraction. The applicable fraction qualified group of units must contain the minimum set-aside qualified group of units. It may also include additional units so long as the entire group maintains an average AMI of 60 percent or less.
The final regulations also clarify the calculation of the applicable fraction for any building in a multiple-building project. A building’s applicable fraction is determined by the units in the building that are also included in the qualified group of units for the overall project. The building itself, unless it elects to be treated as a separate project, does not require a qualified group of units of its own.
As was the case before the final regulations, when a residential unit loses its designation as a low-income unit due to over-income tenants or some other disqualifying factor, an otherwise qualified low-income unit may lose its designation as a low-income unit and need to be excluded from the applicable fraction and calculation of qualified basis, as illustrated in an example in the final regs:
Example: A 100 percent low-income project with a 60 percent average AMI had a 40 percent AMI unit become uninhabitable. Because the loss of the 40 percent unit caused the overall AMI to exceed 60 percent, the owner was required to remove an otherwise qualified 80 percent AMI unit (removed unit) from the applicable fraction qualified group of units to maintain compliance with Section 42.
The loss of the uninhabitable 40 percent AMI unit and the removal of the 80 percent AMI unit from the applicable fraction qualified group of units reduced the qualified basis and results in tax credit recapture.
In this case, the proposed regulations would have allowed a mitigating factor and allowed an owner to ignore the 80 percent AMI removed unit for the purposes of calculating tax credit recapture. However, the final regulations eliminated the cliff test and, with it, the mitigating actions included in the proposed regulations.
Recordkeeping. The IRS’ temporary regulations, which were issued with the final regulations, require that each year the project identify a qualified group of units for the minimum set-aside test and a qualified group of units for the applicable fraction. The selected groups must be recorded and maintained in the taxpayer’s records and communicated to the appropriate housing agency. These agencies have the flexibility to determine when and how owners must communicate this information to the agencies and have discretion on a case-by-case basis to waive compliance with these temporary regulations related to recordkeeping and reporting.
The proposed regulations required that a unit’s income designation be selected before the close of the first taxable year of the credit period. This would have been an issue for projects where units were being placed in service over multiple taxable years. Now, the final regulations allow a unit’s designation to be in place when the unit is first occupied as a low-income unit, or, in the case of a changed designation, before the unit is first occupied under the changed income limitation. This change gives owners flexibility in assigning income designations to units as local demand allows.
Income designation changes. The proposed regulations disallowed the changing of a low-income unit’s designation after it was initially set. Market-rate units were allowed to be converted to low-income units, and the income designation was required within 60 days of the unit’s first treatment as a low-income unit.
While the final regulations state that a unit’s designation generally doesn’t change, the regulations provided much more flexibility. They identify five scenarios in which changes to a unit’s designation may be made. The final regulations allow for a change in a unit’s income designation if the IRS publishes guidance or a housing agency’s publishes a policy that applies to all projects. Otherwise, unit income designation changes are allowed if: (1) the ADA, VAWA, FHA, the Rehabilitation Act of 1973, or any other state, federal, or local law or program that protects tenants requires a unit transfer; (2) a tenant relocates and the income designations of the units are swapped; or (3) the owner redesignates units to restore compliance with the average-income test percentage requirement. The final regulations give an example:
Example: A 100 percent low-income project with a 60 percent AMI average had a 40 percent AMI unit become uninhabitable. The loss of the 40 percent AMI unit caused the overall AMI to exceed 60 percent, so the owner was required to take action to maintain compliance with Section 42. Because an 80 percent AMI unit was occupied by a household whose income did not exceed 60 percent AMI, the project could change its income designation to 60 percent AMI and preserve its status as a low-income unit.
In contrast to the prior example, in this one, the project was able to minimize the impact to the applicable fraction (and qualified basis) to only the one uninhabitable 40 percent AMI unit.
Next Available Unit Rule
The final regulations don’t introduce significant changes to the next available unit rule. They amend the rule to be consistent with the new definition of an over-income unit. So if you have an over-income unit, and the next available unit is a market-rate unit, it must be designated with an income limit that won’t cause the average of all imputed income designations of residential units in the project to exceed 60 percent of AMGI.
The final regulations also added a requirement that in instances where more than one unit is over-income at any given time, the owner need not comply with the next available unit rule in a specific order with respect to occupancy. Instead, renting any available comparable or smaller vacant unit to a qualified tenant maintains all over-income units' status as low-income units until the next comparable or smaller unit becomes available (or, in the case of a deep rent-skewed project, the next low-income unit becomes available).