IRS Proposes LIHTC Average Income Regulation

Published by Mark Shelburne on Monday, November 2, 2020 - 12:00am

On Oct. 30 the Internal Revenue Service (IRS) issued a notice of proposed rulemaking for the low-income housing tax credit (LIHTC) average income (AI) minimum set-aside. There are three overall conclusions to draw at this point:

  1. Interested parties should focus on submitting comments. As much as possible, the input should be unified regarding potential problems.
  2. Taking further action is premature because the guidance may change.
  3. Even if the IRS finalizes the regulation exactly as written,
  • any benefit of market rate units is very likely outweighed by the increased challenges;
  • some amount of cushion below 60 percent might make sense, but only to a certain extent;
  • agencies and LIHTC property owners should wait to formally finalize unit designations until the end of the first year of LIHTCs.

Average Income Background

AI has been a widely discussed hot topic since being enacted in March 2018. Explanations of what the law says, and outstanding issues, are available on Novogradac’s website. (Earlier this year the IRS resolved how to set area median income (AMI) limits.)

A reminder of the Internal Revenue Code Section 42(g)(1)(C) language is helpful in understanding the context:

The project meets the minimum [set-aside] requirements … if 40 percent or more … of the residential units in such project are both rent-restricted and occupied by individuals whose income does not exceed the imputed income limitation designated by the taxpayer with respect to the respective unit.

The taxpayer shall designate the imputed income limitation of each unit …

The average of the imputed income limitations designated … shall not exceed 60 percent of area median gross income.

Rulemaking Notice in General

The IRS is proposing to revise Regulation 1.42-15 on the available unit rule and add a new 1.42-19 on AI’s other aspects, in particular designations and noncompliance. The discussion herein explains how the regulation would operate and is not a substitute for reading the text itself.

Making and Not Changing Designations

The IRS answers a couple of questions by saying owners must designate the imputed income limit of each low-income unit

  • according to LIHTC allocating agency procedures (plus any future IRS guidance),
  • not later than the close of the first taxable year of the LIHTC period.

In what would be a very problematic constraint, the IRS is seeking to prevent any subsequent changes in designations, regardless of what an agency may allow. Restricting the ability to make changes is not required under Section 42, which just states that the taxpayer shall designate the imputed income limitation of each unit.

This prohibition would run counter to what many practitioners have planned. Permanently fixing the AMI limits for each unit at a federal level (as opposed to state policies or in partnership agreements) does not accomplish any discernable program purpose and could

  • preclude necessary responses to market conditions,
  • prevent the best approach to serving households, and
  • risk creating fair housing issues.

Mitigating Noncompliance

Section 42 requires that the “average of the imputed income limitations designated … shall not exceed 60 percent of area median gross income.” The law does not mandate recalculating the average of the designations to account for noncompliant units. Noncompliance should result in the unit losing LIHTCs, not its designation. By strictly following the Internal Revenue Code in this manner, AI would operate the same as the other two minimum set-asides.

Unfortunately, the IRS is proposing a different interpretation that invents a need (again, where none exists) to revisit the 60 percent average upon certain instances of noncompliance. The proposed regulations differ from the Internal Revenue Code by stating the “average of the imputed income limit of the low-income units in the project does not exceed 60 percent.” The IRS appears to say that in order to include a designation in the average calculation, the unit must be in compliance with all program rules. In so doing it is establishing a new, additional test to meet the minimum set-aside.

The following is a summary of how the IRS would implement its interpretation.

  1. A property’s income limit designations average 60 percent of AMI. As of Dec. 31, one or more unit(s) designated at 20, 30, 40, or 50 percent will not qualify as low-income. The example mentions habitability as the reason, but the regulation text is broader (e.g., maximum housing expense).
  2. Not counting the designation of that unit would result in the project average being above 60 percent. Presumably the recalculation would take into account any 70 or 80 percent units also not qualifying as low-income at year-end.
  3. If the property has non-low-income residential units, the owner can convert any that are either vacant or occupied by a LIHTC eligible household with an income below the owner-chosen designation.
  4. In the likely event the property does not contain such a unit, the owner may identify enough LIHTC units as “removed” to bring the property average to at or below 60 percent. The removed units must be in LIHTC compliance at the time.

The above steps may be unnecessary if the property is in the first year of the LIHTC period and the designations are not yet final. A LIHTC property owner may be able to shift the AMI limits between units to maintain an average of the designations that are less than 60 percent. Naturally, the ability to do so would be restricted by several factors, including the agency’s policies and the income of the qualified tenants.

Timing and Result of Mitigation

Taking mitigating steps within 60 days of year-end avoids the catastrophic result of a property failing the minimum set-aside. Meeting this expectation (which stems from the unnecessary IRS interpretation) would be in addition to the actual Section 42(g)(1)(C) minimum set-aside test requirement for AI that 40 percent of the units comply with their designations.

A LIHTC property owner cannot claim LIHTCs on removed units for that calendar year, but recapture of accelerated LIHTCs will not apply to the removed units.

Structuring Considerations

Bottom line is action would be necessary only in specific circumstances of noncompliance, and even then, the consequences may not be dire.

Therefore, if the regulation is enacted as written, it would be important to not set a property’s unit mix based on an overreaction to the risks.

  1. Incorporating market rate units does give an option to mitigate. However, a property being less than 100 percent LIHTC
  • adds substantial complexity to compliance responsibilities,
  • can result in higher rents for LIHTC households, and
  • diminishes interest from equity providers.

Remember market-rate units help only if vacant or occupied by tenants that would be LIHTC income qualified at the close of the year.

  1. Keeping the property average below 60 percent (known as a cushion or buffer) could reduce the need to remove units in the future. The tradeoff in potential revenue has various effects, such as increased deferred developer fee and greater risk of operating deficits. Since removed units do not result in recapture, the calculus is how many buffer units make sense before the benefit outweighs the cost.

Next Available Unit Rule

The guidance has a helpful take on the next available unit rule (NAUR). If multiple units are over-income at the same time in a building with market-rate units, property owners need not comply with NAUR in a specific order. Renting “any available comparable or smaller vacant unit to a qualified tenant maintains the status of all over-income units” as LIHTC qualified.

Submitting Comments

Anyone who has read this far should submit input as an individual and/or as part of a trade association. The best way to do so is the Federal eRulemaking Portal at (indicate IRS and REG-104591-18). Note that earlier this year the IRS responded to practitioners and did a nearly complete reversal on other LIHTC compliance mandates. Novogradac is available to help with drafting.


Not allowing changes in designations is a serious concern. While agencies and LIHTC property owners may not have anticipated doing so, a federal prohibition means it would be forever impossible. Similarly problematic is the interpretation of unit noncompliance leading to an additional minimum set-aside risk. Ideally, the IRS will reconsider both before finalizing the regulation. The best chance of that happening is from receiving a flood of unified comments.

This regulation will be the subject of Novogradac’s Effects of Proposed Average Income Test Regulations Webinar, Nov. 13 and further addressed during the 2020 Tax Credit Housing Finance Virtual Conference, Dec. 3-4. Novogradac’s LIHTC Working Group will submit comments; click here for more information on how to join.