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Implementation of LIHTC Income Averaging

Published by Mark Shelburne and Thomas Stagg on Tuesday, April 3, 2018 - 12:00AM

On Oct. 7, 2022, the Internal Revenue Service released final and temporary regulations for the average income test. Based on this updated guidance, this blog post is now partially obsolete. Stay up to date on these regulations by reading this blog post.

The Consolidated Appropriations Act, 2018, also known as the omnibus spending bill, made two changes to the low-income housing tax credit (LIHTC). In addition to increasing the amount of LIHTC volume cap by 12.5 percent over the next four years, Congress created a new occupancy set-aside option known as “income averaging” (IA).

IA is one of two dozen provisions in the Affordable Housing Credit Improvement Act (AHCIA). Sens. Maria Cantwell, D-Wash., and Orrin Hatch, R-Utah, introduced the AHCIA in May 2016 during the 114th Congress, then again last year in the 115th Congress.

Although IA has been under consideration for several years, now that it has been enacted, there are a number of issues and questions to consider regarding its implementation. The following discussion, despite its length, is a summary and does not touch on all of IA’s nuances. As with any new or complex LIHTC matter, affordable housing participants should contact a knowledgeable professional before making decisions.

Background and Clarifications

Income Averaging–A New Minimum Set-Aside

Under prior law, to qualify for low-income housing tax credits (LIHTCs), rental properties had to meet one of two set-aside tests. Specifically,

(A)  at least 20 percent of the units had to be both rent restricted and occupied by households with incomes at or below 50 percent of area median income (AMI), or

(B)  at least 40 percent of the units had to be both rent restricted and occupied by households with incomes at or below 60 percent of AMI.

The majority of owners elect to operate their tax credit properties under the latter test. Complying with this requirement is described as meeting the minimum set-aside.

The omnibus spending bill added a new third minimum set-aside–the Average Income test as follows:

  • At least 40 percent of the units have to be both rent-restricted and occupied by individuals whose incomes do not exceed the imputed income limitation designated by the taxpayer.
  • The average of the imputed income limitations designated cannot exceed 60 percent of AMI.
  • The designated imputed income limitations must be in 10 percent increments as follows:
    • 20 percent
    • 30 percent
    • 40 percent
    • 50 percent
    • 60 percent
    • 70 percent
    • 80 percent

For example, if a unit is designated as a 40 percent unit it must be occupied by a household who at initial occupancy has an income equal to or less than 40 percent of AMI and who is continuously charged rent that is equal to or less than 30 percent of 40 percent of AMI.

Novogradac has prepared a document showing how the new law revised Internal Revenue Code Section 42 (Section 42) (note the rules vary for “deep rent skewed” developments in New York City).

Considerations and Misconceptions

Contrary to the understandable concerns of some practitioners, the income average is not based on individual households’ incomes. Instead, developers designate unit income limits, and compliance with the IA provision is based on the designation for the unit and not the household’s actual income. For example, a family with an income at 68 percent of the area median could move into a unit designated as a 70 (or 80) percent AMI unit.

Only the 70 percent designation (or 80) counts in determining compliance with the 60 percent IA test. The actual income of the households is not tracked and averaged on an annual basis for purposes of the IA test.

As it relates to meeting the minimum set-aside, an owner would have to ensure that at least 40 percent of the units have rents and incomes at the various designated unit income limits to achieve an average affordability of 60 percent.

Another area owners will have to consider is how the IA is affected by the multiple-building election. The minimum set-aside test is applied on a building basis unless the owner elects to have a multi-building property counted as one development. The election to treat multiple buildings as one project is made on IRS Form 8609 and is often called the 8b election. There are many things to consider when making this election, and IA adds to the list.

Another common misconception is thinking (perhaps hoping) IA will be an option for existing LIHTC properties not undergoing resyndication (more on this later). Unfortunately, once a minimum set-aside election is made, it is irrevocable and therefore properties that have already made their minimum set-aside election on IRS Form 8609 would not generally be able to change to the IA minimum set-aside.

Unit Mix Possibilities and QAP Incentives

The law specifies the available income limit increments: 20, 30, 40, 50, 60, 70 and 80 percent. Units cannot be designated below 20 percent or over 80 percent and must be in the aforementioned 10 percent increments. The Novogradac Rent & Income Limit Calculator © has the limits at these levels for all counties. The IA rent and income calculation is similar to the calculation used by many qualified allocation plans (QAPs) that encourage serving households with incomes well below the federal LIHTC maximums.

There are many possible permutations of how to use IA, below are a few of the innumerable possibilities:

Blog Chart Income Averaging Version 2.1

These are just examples; each developer will need to decide what unit mix best suits their prospective tenant population. Allocating agencies, local funding sources and lenders will all likely have comments on the unit mix as well.

Many properties already have units with various income designations below 60 percent of AMI due to incentives in QAPs. However, violating the deeper designations has historically been a state matter as long as the household’s income and rent was at or below the federal limits. In those cases, the IRS 8823 Guide instructs agencies that they should not notify the Internal Revenue Service (IRS) about exceeding the deeper designated rent or income limits. By contrast, under the IA election, such violations will be reportable to the IRS on IRS Form 8823, putting a property’s LIHTC at risk of credit reduction or recapture.

The Need for Additional Guidance

Which Properties are Eligible: When is the Effective Date?

The IA set-aside option is available for “elections made” after the law’s enactment (March 23, 2018). Section 42 does not specifically designate when the minimum set-aside election is to be made, however, a common interpretation is upon filing a Form 8609.

Although the IRS is not formally notified of the election until the taxpayer files IRS Forms 8609, for all practical purposes the minimum set-aside is selected by the taxpayer as early as the initial tax credit application, when a unit mix for a property is established and the allocating agency determines the project is financially feasible under IRC Section 42(m). Allocating agencies will need to examine how to incorporate IA into their QAPs. This will include updating existing policies related to deeper rent targets, updating underwriting criteria and adding requirements that market studies substantiate there is sufficient market demand for the various designated income limits.

There are many interesting questions regarding the ability to make an IA election for properties that have already been awarded or allocated credits but have not yet made the minimum set-aside election by filing Form 8609. Allocating agencies will need to determine if they will allow these properties to use IA and will want to develop a formal process outlining how IA will be applied to these properties. The California Tax Credit Allocation Committee is an example of an allocating agency that has already released emergency regulations to address how IA will be applied to these type of properties.

The IRS will need to update Form 8609 to include the IA set-aside election option. Until the form is updated, it’s unclear how to make the election. The IRS routinely updates tax forms, but it is unknown when Form 8609 will be updated. We do know that the IRS is aware that Form 8609 needs to be updated for this issue.

Which Properties are Eligible: What about Resyndicated Properties?

The law’s effective date clearly precludes use of IA by existing properties that have already filed IRS Form 8609, but what about those receiving a subsequent LIHTC allocation? Even though the process known as resyndicating involves making a new minimum set-aside election, there are technical hurdles that may make it impossible for the property to be able to change to the IA minimum set-aside.

All LIHTC properties must record an extended use agreement (EUA). A required provision of the EUA gives tenants the right to enforce the affordability requirements. Because of these third-party rights, a court in Oregon held the agency and owner could not terminate an existing EUA. The logic used also limits the owners’ ability to make amendments. Therefore, unless the prior EUA has ended through one of the ways allowed the terms of the agreement and state law, it at least arguably remains in effect even after resyndication.

An obligation also found in all existing EUAs is a 60 percent limit on rents (or 50 percent if using the other original minimum set-aside). While there are legal issues as to who qualified as a third-party beneficiary of the contract, at least some individuals could go to court to stop an increase in the maximum rent.

Unit Mix Intricacies–How Would Applicable Fraction be Calculated?

A property’s maximum allowable LIHTC allocation is reduced by the share of residential space in unrestricted, market-rate apartments. This reduction is calculated using the greater of the number of market-rate units or market-rate residential floor space (resulting in a calculation referred to as the applicable fraction). If the market rate apartments have on average greater square footage than the LIHTC apartments, on average, then the property will generate fewer LIHTC than if the LIHTC units and market rate units had the same square footage.

Some may think the same applicable fraction math applies to determining the 60 percent average for the IA minimum set-aside test. In fact, IA, consistent with the other two minimum set-aside tests, does not consider floor space. Under Section 42, owners may opt to designate the larger LIHTC units for higher-income households (still at or below 80 percent AMI).

For example, with respect to LIHTC units, the following set-up would comply with Section 42:

Blog Chart Income Averaging Version 2.2

(Keep in mind the applicable fraction’s floor space ratio still impacts the amount of LIHTC generated if the IA property also has market-rate units.)

Although this type of unit mix is possible under Section 42, other restrictions may apply requiring a more even distribution of the units, such as limitations imposed by an allocating agency through its QAP or a soft financing funding source.

Unit Mix Intricacies–Can Unit Designations Change Over Time?

Another question is whether the unit mix can change over time. Regarding IA, Section 42 as amended by the omnibus spending bill says owners designate the “income limitation of each unit.” It is unclear if this clause requires the unit mix to be fixed at designation or allows for modification. If the designation is changeable, this would allow a development to be adaptable to the needs of new potential tenants or a change in tenant demand for certain income level designations.

Unit Mix Intricacies–Next Available Unit Rule

Under Section 42, a unit may continue to be LIHTC-eligible even if, after moving in, the household’s income increases beyond the applicable limit. Continuing to qualify depends on complying with what’s known as the next-available-unit (NAU) rule.

Because IA is such a shift from current practice, the new law adds a separate NAU requirement for IA properties. If a household’s income increases above 140 percent of the greater of

  • 60 percent of AMI, or
  • the applicable designated income limit (i.e., 20, 30, 40, 50, 70 or 80 percent of AMI),

the unit will remain LIHTC-eligible if the owner rents another smaller or comparable unit to a household whose income is within its imputed income limit. As mentioned before, the rules vary for “deep rent skewed” properties in New York City.

However, due to the intricacies of IA, determining what income designation should be applied to the vacant comparable unit will depend on if the vacant unit was previously a LIHTC unit or if it is a vacant market-rate unit.

The updated language in Section 42(g)(2)(D)(v) states that an available vacant unit of comparable size or smaller must be rented to a household that meets the imputed income limitations outlined below (emphasis added):

(I) the imputed income limitation designated with respect to such unit under paragraph (1)(C)(ii)(I), in the case of a unit which was taken into account as a low-income unit prior to becoming vacant, and

(II) the imputed income limitation which would have to be designated with respect to such unit under such paragraph in order for the project to continue to meet the requirements of paragraph (1)(C)(ii)(II), in the case of any other unit.

To say this again in layman’s terms the NAU rule would be applied as follows:

If the comparable or smaller vacant unit is a LIHTC unit, rent the unit based on the income designation of the vacant unit.

If the comparable or smaller vacant unit is market rate, rent the unit based on the income designation of the over-income unit.

The flow chart below shows how to apply the NAU rule on an IA property:

Blog Chart Income Averaging Version 7.4

As the chart illustrates, applying the NAU rule for 100 percent LIHTC property should be fairly straightforward. For a vacant income-restricted unit, managers would move in a tenant who is income-qualified based on the IA designation for the vacant unit. The IA designation of the over-income unit is not pertinent. Thus, in a 100 percent LIHTC property there would be no need to track NAU compliance since regardless of how many over-income tenants are in the building, an owner would always rent an available unit to a tenant that meets the IA income designation of the vacant unit. Essentially, the NAU rule for 100 percent affordable IA properties should be implemented similar to how the NAU rule is being applied to current 100 percent LIHTC properties.

Unfortunately, there are many questions relating to properties with market-rate units, such as:

  • What happens when there are multiple over-income units at different IA designations, but only one vacant market-rate unit? For example, there are two over-income tenants, one at 40 percent and one at 80 percent, and there is one vacant market-rate unit. Is the vacant market-rate unit rented to a 40 percent or 80 percent tenant? Will owners need to track which unit was over-income first? What if they both have the same effective date?
  • Once the over-income unit is replaced and the property meets its minimum set-aside test and IA test, can the rent on the over-income tenant be increased? Treasury Regulation 1.42-15(c) appears to indicate it can be, but clear guidance would be helpful.

As a reminder, Treasury Regulation 1.42-15 states the following about violating the NAU rule (emphasis added):

If any comparable unit that is available or that subsequently becomes available is rented to a nonqualified resident, all over-income units for which the available unit was a comparable unit within the same building lose their status as low-income units; thus, comparably sized or larger over-income units would lose their status as low-income units.

Therefore, developers should take care, including consulting with compliance experts, before incorporating IA. Following all of the federal expectations will be unusually challenging.

How Do You Apply IA to a 4 Percent LIHTC Project?

In order to generate the 4 percent LIHTC, the proceeds from issuing a tax-exempt private activity bond (PAB) must finance at least half of the aggregate basis of a property. The federal PAB tax exemption statute has its own separate requirements for rental occupancy and affordability. The original Section 42 LIHTC minimum set-asides essentially copy those requirements, thereby simplifying compliance for properties utilizing both programs.

Moreover, a property receives LIHTC based on the percentage of the development that is restricted, whereas the PAB tax exemption applies for the whole bond issue as long as the minimum set-aside is met. For example, having 40 units at 20 percent and the remaining 60 units at 80 percent meets the PAB test even if 60 percent of the units are not income or rent qualified.

However, the omnibus spending bill only added IA to Section 42, not the laws governing PABs. Technically, it is possible to structure a unit mix with an average affordability of 60 percent that does not comply with the tax-exemption statute. Although there are very few such permutations, agencies and owners will need to check for compliance with both Section 42 and Section 142 requirements.

Interactions with Other Programs

Extremely Low-Income vs. 30 Percent AMI

Several gap-funding sources paired with LIHTCs require some units to be targeted to extremely low-income (ELI) households. Most notable among these is the Housing Trust Fund (HTF). ELI nominally means 30 percent AMI, but the reality is more complicated.

The main difference is that ELI incorporates the U.S. Department of Health and Human Service’s poverty level (for other specifics see this post about income limits). As a result, in 2018, ELI is greater than 30 percent AMI in almost all of the nation’s counties. ELI even exceeds the 40 percent limit in more than half of counties. The variation also depends on unit sizes.

Therefore, a 30 percent LIHTC unit and an HTF unit may have very different income limit qualifications. Practitioners should not automatically assume HTF units will qualify as 30 percent LIHTC units. In other words, an HTF-eligible household may be over-income for a 30 or 40 percent LIHTC unit.

As noted above, an over-income violation for an IA property will trigger IRS noncompliance (as opposed to state-level-only reprimands). Agencies will need to be careful in designing policies and owners will need to be careful in leasing units.

Section 8 Payments

The omnibus spending bill did not change the LIHTC definition of rent, which does not count Section 8 Housing Assistance Payments paid for by HUD or any comparable rent subsidy collected. The limit applies to what tenants pay out of pocket (which includes the utility allowance and mandatory fees).

There has historically been the ability to increase revenue by accepting Section 8 voucher holders into LIHTC properties. As shown in the following hypothetical, using IA makes the benefit of the incentive more pronounced.

Blog Chart Income Averaging Version 8.3

The ability to collect the 80 percent AMI rents materially increases revenue compared to what was possible before. Additional monthly income of $21,600 could support $3 million of additional debt (depending on the terms), which could be used to generate additional LIHTC units or make bond transactions financially feasible while keeping the same average affordability. This increased feasibility is particularly important given the decrease in tax credit equity investment resulting from the corporate tax rate reduction from 35 to 21 percent.

Benefits to Households and Properties

The most readily apparent outcomes of IA are:

  • greater property-level income diversity, and
  • rents from higher-income units making the deeper income designations possible.

IA is conducive to integrated permanent supportive housing. By allowing owners to offset the deeper rent designations generally used for permanent supportive housing (i.e. units set aside at 20 percent or 30 percent of AMI) with units designated at 70 percent or 80 percent of AMI, owners may find it easier to pencil deals that have permanent supportive housing units.

The following household types may also be most benefited by IA:

  • Those renters at 60 to 80 percent AMI have difficulty affording any kind of rental housing in many markets. Currently, there is an unusual circumstance where there are options for those who have very low or very high incomes, but not those in between, and
  • In certain very low-income rural areas, families with two minimum-wage incomes sometimes can earn more than 60 percent AMI. In addition, certain rural areas do not have the population to fill a LIHTC project at 60 percent.

IA should help alleviate their housing predicaments by allowing a project to serve a greater portion of the population.

Also, anyone who’s been involved in LIHTC rehabilitation knows sometimes at acquisition, there are current residents with incomes between 60 and 80 percent AMI who would not have been able to qualify for LIHTC. Terminating the tenancies is usually not a desired option (especially for properties with rent assistance), and as noted above, having a smaller applicable fraction means less LIHTC. In these circumstances, IA will make a significant difference. The tenants with income over 60 percent but under 80 percent will be able to stay in their units and the owner will be able to receive LIHTC on these units. This could be especially helpful on HUD Rental Assistance Demonstration transactions.

The IA provision may also be especially beneficial to scattered-site developments. Section 42(g)(7) states that noncontiguous tracts must be 100 percent rent-restricted, yet the IRS Section 42 Audit Technique Guide states that units need to be income and rent restricted. This has caused some developers and investors to have concerns about undertaking scattered site properties with over-income tenants. The higher income limits may help mitigate the number of over-income households.


The LIHTC program needs to adapt and evolve over time. Even though the learning curve will be steep, improvements such as IA are valuable to enable the LIHTC to reach more populations and communities. Readers are encouraged to contact a Novogradac professional for assistance with any issues or problems.

These questions about IA and much more will be addressed during Novogradac’s 25th Annual Affordable Housing Conference and in an upcoming webinar.

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