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Average Income: Back to Basics Six Years after Set-Aside Test’s Implementation

Published by Thomas Stagg on Monday, February 5, 2024

Journal Cover February 2024   Download PDF

The average-income minimum set-aside test (AIT) will celebrate its six-year anniversary in March. The AIT has had a somewhat tumultuous existence, but the final and temporary regulations released in October 2022 help clarify a lot of the confusion surrounding the AIT. To further clarify some of the confusion around the AIT, we will examine some of the important aspects.

Meeting the Minimum Set Aside

To meet the minimum, a project must have a grouping of qualified units that includes 40% of the units and the income designations of the group average 60% of area median income (AMI) or less. A couple of important notes here: first, like other set asides, a 100% low-income housing tax credit (LIHTC) project should not have issues satisfying the minimum set-aside test. On a 100% LIHTC project, one or two units going out of compliance will not result in a failure of the minimum set-aside. The minimum set-aside would only be at risk if there is substantial noncompliance at the project. For example, if you have a 50-unit project, you will satisfy the minimum set aside as long as 20 units in your project have designations that average 60% 
of AMI or less.

Calculating the Applicable Fraction

In a LIHTC project using one of the other minimum set asides, you can earn credits on any unit that is qualified. AIT adds a little complication, because you can only claim credits to the extent the qualified unit is part of a group of qualified units that average 60% of AMI or less. The IRS refers to this as a group of qualified units.

If all units in your project are rented at their designations (assuming you didn’t err when designating units) you would be able to claim credits on all qualified units. However, if a unit with a designation of 50% or less goes out of compliance, it can impact other units. It is important to note that noncompliance with a unit that has a designation of 60% or greater will be treated the same as noncompliance under other minimum set-asides and only result in loss of credits and recapture on the noncompliant unit. 

If you have noncompliance on a unit with a designation of 50% or less, you will need to determine what units you can include in your grouping of qualified units and still average 60% or less of AMI. If your initial designations averaged 60% of AMI, then noncompliance with a unit with a designation of 50% or less will result in two or more units needing to be removed from the group of qualified units. For example, if your qualified units averaged 60% before the noncompliance and the noncompliance was on a 40% unit, you would need to exclude the noncompliant unit from the grouping of qualified units and an 80% unit from the grouping of qualified units. However, if the project did not have any 80% units and only had 70% units, you would need to exclude two 70% units to restore your average.

The fact that one unit going out of compliance can cause a project to lose credits on one or more units is one of the drawbacks of AIT. However, there may be ways to mitigate the impact that we will discuss later.

Designating Units

A large part of AIT is designating units, so understanding the basics of unit designation is important. First, it is the owner who designates a unit’s AMI. An owner can designate a unit as a 20%, 30% 40%, 50%, 60%, 70% or 80% unit. The tenant’s income and the rent charged must be less than the designation of the unit to be considered qualified. The tenant’s actual income does not change the designation. For example, if a household with income of less than 50% of AMI moves into a unit designated as a 60% unit, the unit remains a 60% unit and the owner can continue to charge 60% rent unless the owner chooses to redesignate the unit. 

A unit must be initially designated before initial occupancy. The IRS does not prescribe the manner to make a designation, but it does state that that designation must be recorded in the taxpayers’ books and records. From a practical standpoint the designation of each unit will be recorded on the tenant’s tenant income certification. 

A unit’s designation can only change in specific circumstances allowed in the regulations. The regulation allows for changing designations if allowed by the IRS or state agency, required by certain laws (e.g., fair housing), tenants transferring between units or to restore noncompliance. State agencies vary on when and how and when they permit an owner to 
change designations. 

Mitigating Noncompliance

There are a few ways to mitigate noncompliance in AIT projects.

If a tenant is determined to be over the income limit but is under 80% of AMI, the first mitigating step is to see if the unit can be redesignated to the appropriate designation for the tenant. Redesignating this unit may require you to change the designation of another unit in your project to maintain an average designation of 60% of AMI or less. In this case, you would need to find a unit that can have its designation reduced. For example, if a tenant with income less than 50% AMI is living in a unit designated as a 60% AMI unit, the unit’s designation could be reduced to 50% AMI. The regulation seems to indicate that if this is done before the close of the year, the redesignated unit’s rent would need to be decreased as of the redesignation date and the fact that it was charged higher rent based on its previous designation during the year would not impact the ability to redesignate the unit.

If you are unable to change the designations of your units so that the designations of your units average 60%, you would lose credits on any units that could not be included in a grouping of qualified units that average 60% of AMI or less. An owner will want to be strategic with what otherwise-qualified units are removed from the grouping of qualified units to restore the average of 60% AMI or less. Generally, when removing units from a grouping of qualified units, you will want to remove the smallest units with the highest designation until the 60% AMI average can be restored. 

Conclusion: AIT Can Be Worth the Challenges

Although AIT has some compliance quirks that need to be mastered, its implementation can result in a more robust tenant population and allow for households earning up to 80% of AMI to benefit from affordable housing, while their higher rents can help subsidize lower income units in the same project. 

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