Prepare Site-Related Documents Prior to IRS Audit
IRS auditors may flag sites for further review based on state agencies’ noncompliance reports. The owner’s tax returns and IRS Form 8823 noncompliance reports and other information are initially evaluated. If it’s determined that an audit is needed, an IRS auditor will formally notify the owner by mail that an audit has been scheduled.
The letter will include a request for information and documents to be made available for the audit. The IRS uses Form 4564, Information Document Request (IDR), to request this information. To familiarize yourself the IDR process, we’ll list documents you might expect to see on an initial IDR. These documents are necessary for the examination of specific issues related to low-income housing tax credits. Auditors will tailor the request to fit the facts of the case, and there may be subsequent follow-up IDRs.
Recordkeeping and Record Retention
In addition to the general recordkeeping requirements under Internal Revenue Code (IRC) Section 6001, site owners are subject to specific recordkeeping and record retention requirements under Treasury Regulation 1.42-5(b). Records must be retained for at least six years after the due date (with extensions) for filing the federal income tax return for that year. In addition, the records for the first year of the credit period must be retained for at least six years beyond the due date (with extensions) for filing the federal income tax return for the last year of the compliance period of the building.
The following documents will be analyzed early in the audit to assist in setting the scope and depth of the audit:
- Partnership Agreement;
- Prospectus/Offering Memorandum related to the organization or syndication of the partnership;
- Documentation pertaining to the partners’ capital contributions including all notes;
- Credit Allocation Application;
- Market Study;
- Credit Allocation Award/Contract or Carryover Allocation;
- Extended Use Agreement;
- All Forms 8609 issued to the owner;
- Internal audit reports; and
- All Forms 8823.
The following documents will be needed to ensure consistent treatment from year to year:
- Copies of tax returns for the tax year prior to the earliest year under audit and all tax returns for years subsequent to the tax years under audit;
- Trial balance (statement of all debits and credits) and any work papers used to prepare the tax return under audit; and
- Depreciation schedules.
The audit of eligible basis will start with an analysis of the following documents to identify specific costs for in-depth consideration as large, unusual, or questionable items:
- Final cost certification submitted to the state agency with supporting documentation—for example, purchase agreements and construction contracts, or settlement documents if existing buildings were acquired;
- Documentation of all financing sources such as grants, loans, tax-exempt bonds, below market federal loans, and loans payable to the developer or any partner. The owner should provide all debt instruments such as mortgages and promissory notes. The owner will identify outstanding balances and records for all loan repayments;
- Development contracts or agreements for the acquisition, construction, or rehabilitation of the LIHTC site and related payments and/or notes; and
- Documentation of cost allocations among land, land improvements, and depreciable residential rental property included in eligible basis.
Qualifying Low-Income Households
While a review of the household files will be completed during the audit, the starting point will be an analysis of the tenant rolls. For the first document request, the owner should provide:
- For the years under audit, rent rolls identifying the households and family size for each low-income unit; and
- Documentation of internal controls in place to ensure that income-qualified households occupy the low-income units, such as copies of written procedures and owner policies regarding employment requirements and training.
First and Eleventh Year of the Credit Period
If the first year of the compliance period is audited, the special rule for computing the applicable fraction under IRC Section 42(f)(2) is used. The owner should provide:
- Certificates of Occupancy, which will establish when the units were first available for occupancy;
- A schedule indicating when each low-income unit was first occupied by an income-qualified household; and
- Computation of the applicable fraction, including the computation of the applicable fraction for each month.
If the eleventh year of the compliance period is audited and the owner has claimed credit, the owner should provide the information identified above as well as a copy of the tax return for the first year of the credit period.
Additions to Qualified Basis
Units first occupied by qualifying households after the end of the first year of the credit period will result in an increase in qualified basis. The units qualify for the credit, but the applicable percentage applied to the additional qualified basis is two-thirds of the applicable percentage shown on Form 8609, line 2 [IRC §42(f)(3)]. The owner should:
- Provide a list of units first occupied by qualifying tenants after the end of the first year of the credit period and identify when a qualifying household first occupied the unit; or
- Confirm that all units were occupied by qualifying households by the end of the first year of the credit period.
Examination of Income: Rents & Other Sources of Income
Generally, site owners are single-purpose entities and the rents from leasing residential rental units will be the primary source of income. In addition to the records needed to complete the examination of income, the owner should also provide:
- Description of residential rental units, including total number of units, total number of low-income units, size (number of bedrooms), and rents charged for low-income and market-rate units. Also identify units for on-site managers or security personnel;
- Documentation that rents are correctly restricted, including computations of the maximum allowable gross rent based on unit size;
- Sources of rent subsidies;
- Utility allowances and documentation of the computation;
- Fees for services provided to tenants in addition to housing such as providing meals or cleaning services in assisted living housing;
- Other income from related activities such as vending machines, laundry facilities, or charges for cable/satellite television;
- Other income sources such as from the commercial use of a portion of the property such as income for a cell phone tower installed on the roof of a building; and
- Documentation of funds received from other sources such as federal grants or subsidies received during the year, additional capital contributions, or loan proceeds.
If Forms 8823 were filed by the state agency, the taxpayer should provide documentation for corrective actions taken to restore the project to compliance.
If the project was sold, documentation regarding the sale should be provided. Documentation will include the sales contract and settlement documents, computation of the capital gain/loss, how the gain/loss was distributed among the partners, and whether the sale required the new owner to operate the project as a qualified low-income site for the remainder of the 15-year compliance period.