Non-Compliance in LIHTC Income Averaging Properties
As more and more developers and state agencies explore income averaging, one of the biggest questions is what happens if a unit goes out of compliance. Unfortunately, this is a difficult question to answer without knowing the details of the low-income housing tax credit (LIHTC) project, and in some cases without more information from the IRS. This discussion will examine some of the most hotly discussed topics around non-compliance in LIHTC projects that have elected the average income minimum set-aside.
Impact of the Minimum Set-Aside
It is important to understand the difference between the applicable fraction and the minimum set-aside. The applicable fraction determines how many credits a project can generate and is generally reduced any time a unit goes out of compliance. The minimum set-aside is the minimum amount of units a project must income and rent qualify in order to claim any LIHTC. In other words, when a single unit goes out of compliance, the applicable fraction is reduced and credits can be reduced. However, as long as the project can substantiate that after excluding the out of compliance unit, it can satisfy the minimum set-aside, the project can continue to claim credits on the qualified units. On the other hand, when a project fails to meet its minimum set-aside the project loses credits on all units.
At the heart of the discussion is the lack of clarity in how to evidence that a project meets its minimum set-aside under the average income test. Unfortunately, there is no clear answer from the IRS or the Internal Revenue Code (IRC). In addition, there is a lack of consensus amongst industry professionals. The three most common approaches can be overly simplified as follows:
- Code Literalist – The project only loses credits on out of compliance units, assuming at least 40 percent of the units in the project are in compliance with their designation.
- Minimum Set-Aside Loyalist – The project loses credits on all units if the project’s LIHTC unit’s average income is above 60 percent.
- Compromiser – The project loses credits on units that put the project’s LIHTC units average income above 60 percent, but can claim credits on the remaining units as long as the remaining units are greater than 40 percent of the project.
By presenting all three interpretations, Novogradac is not endorsing any approach. Owners should work with their investors, state agencies and tax counsel in determining if a project satisfies its minimum set-aside.
1. Code Literalist
A Code Literalist sees no other requirements beyond the plain reading of the language in IRC §42(g)(1)(C)(i) that 40 percent or more of the residential units in the project are occupied individuals whose income and rent does not exceed the imputed income limitation designated by the taxpayer with respect to the unit.
Under the IRC, the owner is required to designate a unit, in increments of 10 percent, from 20 percent to 80 percent. A Code Literalist relies heavily on the word “designate” in the IRC language. Their interpretation is that, so long as 40 percent of the units are occupied by individuals whose income and rent does not exceed that unit’s designation, the project meets the average income minimum set-aside test. The Code Literalist believes the mix of percentages of the in compliance units does not matter, as long as the designations of the units (including units that subsequently go out of compliance) results in an average affordability of 60 percent and that 40 percent of the units are compliant with the designations.
By way of illustration, this simplified hypothetical property would comply:
In the scenario above, the designations of the units average 60 percent AMI, meeting the “average test” described in §42(g)(1)(C)(ii)(II). Units 5-10 are out of compliance and the consequence is no credit can be claimed for those units; however, the minimum set-aside is met because, because at least, 40 percent of the unit are rented at the unit’s designation.
This Code Literalist answer is the most favorable from a credit standpoint. Even though the average affordability of the compliant units exceeds 60 percent, only credits on the units out of compliance would be lost.
There is currently no guidance on how and when a unit is designated (please watch for a future blog post on this topic), which is problematic as the Code Literalist approach is contingent on a unit’s designation. The perspective hangs on the idea that, it is the average affordability of the unit designations that matters when satisfying the minimum set-aside, and not the average affordability of the income compliant units. However, people who are skeptical of this treatment have concerns that, in order for a unit to maintain its designation, it must continuously satisfy that designation by either being occupied by someone who initially met the income limitation and continuously meets the rent limitation or by being considered a qualified vacant unit. It is unknown if a unit maintains it designation if an unqualified household is moved into the unit.
2. Minimum Set-Aside Loyalist
A Minimum Set-Aside Loyalist believes that projects must continuously maintain an average of rents and initial incomes no greater than 60 percent to avoid failing the minimum set-aside. Even one unit out of compliance may result in the entire project losing all credits. In the hypothetical below, a loyalist believes noncompliance in a single unit would result in failing the minimum set-aside.
Using the same project composition as above, the Loyalist believes simply because unit 10, a unit designated at 40 percent, is out of compliance, the minimum set-aside has not been met because the resulting average affordability of the remaining qualified units in the project is now 62.2 percent. The Loyalist focuses solely on the project average income test described in §42(g)(1)(C)(ii)(II) and does not consider the minimum unit requirements portion of the minimum set-aside test.
Since the Loyalist sees this as a failure to meet the minimum set-aside, no credit can be claimed for the project. However, the Minimum Set-Aside Loyalist ignores the fact that the project can still satisfy both parts of the minimum set-aside. In the example above, the project can clearly substantiate that at least 40 percent of its units have an average income that is less than 60 percent. In fact, 40 percent of the units above (units 6, 7, 8 and 9), have an average affordability that is 40 percent of AMI, which clearly shows the project still meets the minimum set-aside. In addition, 80 percent of projects units (units 1-4 plus 6-9) have an average affordability of 60 percent. Therefore, the argument that the project has failed the minimum set-aside does not appear to make logical sense.
The third interpretation is one that seeks to find a middle ground between the Code Literalist and the Minimum Set-Side Loyalist. A Compromiser agrees with a Minimum Set-Aside Loyalist that all units being included in the applicable fraction for purposes of claiming credits must have an average affordability of 60 percent, but sees that disallowing all credits for one unit being out of compliance does not make sense. A Compromiser believes that a project can take credits on any mix of units; as long as, those units are at least 40 percent of the project and have an average affordability of 60 percent. A Compromiser says a project owner forgoes LIHTCs on however many units are necessary to keep the 60 percent AMI average. In the following example, two 40 percent units are noncompliant, so the owner would forgo LIHTCs on two 80 percent units to maintain an average affordability of 60 percent.
It would appear in the scenario above the property clearly meets the minimum set-aside test because six units (60 percent > 40 percent) have an average affordability of 60 percent. However, the downside of this approach is that non-compliance on a single unit may result in losing credits on one or more units when those noncompliant units are at the lower AMI levels such as 20 and 30 percent. Although the owner is not able to claim credits on the two 80 percent units in this example, the owner would likely still have to maintain the units as affordable units due to regulatory agreements with the state, the lease agreement and the fact that the 80 percent tenants did not do anything that impacted their status as a LIHTC tenant.
Impact of Buffer Units
All of the scenarios above assume that the project property is right at 60 percent average affordability. However, many projects, either due to state requirements, market demand, or investor requirements will have an average affordability that is less than 60 percent. In this case, issues relating to the minimum set-aside need not be considered until the average affordability increases above 60 percent or the percentage of affordable units decreases below 40 percent. Let’s look at an example to illustrate this point. For example, consider a project that has 60 units at 50 percent of AMI and 40 units at 70 percent of AMI. The average affordability of this project would be 58 percent. If an unqualified tenant moved into a 50 percent unit and that unit was no longer considered an affordable unit, then the average affordability would increase to 58.08 percent. The project would lose credits on the un-qualified unit, but would not have any issues with the minimum set-aside test because the average affordability is still less than 60 percent and more than 40 percent of the project property is affordable. In fact, in this scenario, 20 of the 50 percent units could go out of compliance and the project would still satisfy the minimum set-aside with an average affordability of 60 percent and 80 percent of the project affordable.
There are still many questions about income averaging; however, as an industry we should continue to find ways to use this tool to produce more affordable housing.