Understanding Possible NAU Violations in 100 Percent LIHTC Buildings
The tax credit law allows low-income units to remain qualified even when a household goes over-income. But to maintain the unit’s low-income status, when a household’s income exceeds 140 percent of the income limit (or 170 percent in deep rent-skewed units), you must follow the next available unit (NAU) rule. To do this, you must rent the next available unit of comparable or smaller size in the same building to a qualified low-income household.
As part of the Housing Assistance Tax Act of 2008, Congress amended IRC §142(d)(3)(A) to read “…The determination of whether the income of a resident of a unit in a project exceeds the applicable income limit shall be made at least annually on the basis of the current income of the resident. The preceding sentence shall not apply with respect to any project for any year if during such year no residential unit in the project is occupied by a new resident whose income exceeds the applicable income limit.”
So, in theory, owners of 100 percent LIHTC buildings, where all the residential units are low-income units, shouldn’t have to worry about violating the NAU rule and don’t have to complete annual tenant income recertifications. However, when Congress said annual income recertifications are not “relevant” to 100 percent LIHTC sites because the next available unit is always rented to an income-qualified household, it didn’t specifically carve out an exception for 100 percent LIHTC sites from the application of the NAU rule.
We’ll discuss what happens when an owner unintentionally rents a unit to a nonqualified household. And how the NAU rule is applied if an owner doesn’t know which units are over-income units.
Applying the NAU Rule to 100 Percent Sites
If an owner rents a unit to a nonqualified household, the unit ceases to be a low-income unit and does not qualify for the credit. The error is accounted for when determining the applicable fraction at the end of the taxable year. For purposes of applying the NAU rule only, the IRS will treat all households documented as initially income-qualified households as income-qualified as long as the owner demonstrates due diligence when completing the initial income certification. Therefore, the owner doesn’t violate the NAU rule when a unit is unintentionally rented to a nonqualified household.
Due Diligence Analysis
The most important aspect to compliance with the NAU rule when an owner unintentionally rents a unit to a nonqualified household is being able to show the IRS that “ordinary business care and prudence” was exercised when income qualifying new tenants.
Specifically, initial tenant income certifications should be timely, accurate, and complete. Here are some basic questions an IRS examiner might ask when considering whether the owner’s tenants are income-qualified:
- Have all the potential sources of income been identified?
- Was income verified with third parties?
- Are the methods for estimating income reasonable based on the facts?
- Was the correct income limit used?
- Was the computation correct?
- Is the documentation sufficient?
Also, can you show that you have procedures in place to safeguard business operations to minimize the chances of treating an applicant as eligible when, in fact, he’s ineligible? Here are some of the questions an IRS examiner might ask:
- What oversight does an owner provide a property manager? Is the property manager trained?
- Are written procedures in place for qualifying households? Who makes sure the procedures are followed? Is there a review process?
- Does the owner use standardized forms?
- Does the owner conduct independent internal audits?
- What happens if noncompliance occurs?
- Are households monitored for changes in family size?
- How are the files maintained?
Red Flags for IRS Audit
Beyond the basic questions that may be asked to indicate that a unit has unintentionally been rented to a nonqualified household, the existence of some fact patterns may alert the IRS that there could be intentional renting of low-income units to nonqualified households and further scrutiny is required. Here are three examples of fact patterns that may be challenged during an IRS audit:
Renting units larger than required for the household’s size. By itself, this is not noncompliance, but is of particular concern when the household size increases soon after the initial move in and the combined income of the new household is over the income limit.
Household has insufficient income to pay the rent. Why would an owner rent a unit to someone who cannot pay the rent? Is there a source of income that hasn’t been disclosed?
Renting units to household with income from a sole proprietorship, but household doesn’t file tax returns. Keep in mind that tax returns can be used to document income, but you’re not required to use them for that. However, if an individual is operating a business that should be reported on Schedule C, the taxpayer must file a tax return even if the business activity doesn’t generate a tax liability.
Household has less income when reapplying for housing. The income limits are a bright line test for determining whether a household is income-qualified. If a household has been denied housing because the anticipated income is just a little more than the limit, the household may try to manipulate that determination by slightly altering the facts–fewer overtime hours, for example. Although the income limits can seem arbitrary and the stories sympathetic, owners need to carefully consider the underlying facts before renting a low-income unit to a household under these circumstances.
The NAU rule is also violated if an owner of a 100 percent LIHTC site deliberately rents a unit for market-rate rent. In such cases of egregious noncompliance, the IRS concludes that the owner disregarded the NAU rule and that the building’s qualified basis is zero. In other words, the building isn’t part of a qualified low-income project at all times during the 15-year compliance period under IRC §42(c)(2). No credit is allowable until the owner can establish compliance with the NAU rule.
For example, an owner of a 100 percent site failed to rent a vacant unit as a rent-restricted unit, but rather rented it as a market-rate unit. The unit ceases being a low-income unit, and since the owner disregarded the NAU rule, the building’s qualified basis is reduced to zero unless the owner can document continuous compliance with the NAU rule. The owner is also subject to the credit recapture rules under IRC §42(j).
However, in situations in which an owner of a 100 percent LIHTC site can demonstrate due diligence and the tenant file provides sufficient documentation, but it is later determined during an IRS audit that one household wasn’t income-qualified at the time the household moved into the unit, the applicable fraction will be recomputed and the allowable credit for the year will be less. The owner is also subject to the credit recapture rules under IRC 42(j). But, more important, the IRS will not make a determination that the taxpayer violated the NAU rule.