Compliance Differences Between IRC 42 and 142: Part 1

Published by Stephan Morgan on Monday, October 5, 2020
Journal Cover October Thumb 2020

The 9 percent low-income housing tax credit (LIHTC) and 4 percent LIHTC share similarities–both are indirect federal subsidies to help financing the rehabilitation or construction of affordable housing. However, there are significant differences when it comes to compliance requirements.

The 9 percent LIHTC generally applies to new construction or rehabilitation costs without tax-exempt housing bonds, while the 4 percent LIHTC applies to acquisition of existing buildings or new construction or rehabilitation costs with tax-exempt housing bonds under Internal Revenue Code (IRC) 142. For purposes of this article we will narrow the scope of our discussion of IRC Section 142 to Subsection (d) specifically, as it outlines the compliance guidelines for qualified residential rental developments financed with tax-exempt bonds.  Additionally, we will call LIHTC developments without tax-exempt bonds “9 percent developments” and LIHTC developments with tax-exempt bonds “4 percent developments”.

A property owner or developer who is using tax-exempt bonds to finance a rental housing development and wants to use 4 percent LIHTCs must first consider the many technical requirements of Internal Revenue Code (IRC) Section 42. The focus of this article, and two to follow in the November and December issues, are the requirements specific to the tax-exempt bonds and the key differences in compliance requirements between IRC Section 42 and IRC Section 142.

This month our focus will be on the five specific areas listed below.

  • Unit vacancy
  • Minimum set-aside
  • Over-income units
  • Tenant transfers
  • Rent limits and tenant rent

Minimum Set-Aside

A traditional LIHTC development is made up of
qualified low-income buildings. Each of the qualified buildings is subject to one of three minimum set-asides, which the property owner is required to elect and maintain for the duration of the 15-year compliance period. These three tests are referred to as the 20/50 test, 40/60 test, and the average income test. This restriction is typically on a building-by-building basis.

Tax-exempt bond developments have a similar requirement; however, there are a few key differences. The first is that the minimum set-aside must be maintained on a development as a whole pursuant to IRC Section 142(d)(1). Furthermore, IRC Section 142(d)(7) states that the applicable set-aside must be continually satisfied throughout the development period and the development must certify that they continue to meet this requirement by filing Form 8703 annually with the IRS.

For a LIHTC development, the minimum set-aside requirements generally must be met by the end of the first year of the tax credit period. However for acquisition rehabilitation tax-exempt bond developments also seeking LIHTCs, it is important to note that the development must meet the above requirements of IRC Section 142(d)(1) within 120 days of the acquisition date if they are planning to receive LIHTCs from the date of acquisition.

Unit Vacancy

Generally set forth in the regulatory agreements for
tax-exempt bond developments, a unit will often maintain its low-income status only if the unit was reoccupied for a period of time exceeding 31 consecutive days. Further, the unit will be considered “low-income” if the individual or family now occupying the unit satisfies the definition of a low income unit under IRC Section 142(d)(4)(C)(i). For LIHTC developments, the same unit in this example would maintain its low-income status if the previous occupants’ income met the limitation applicable at the time immediately before the tenant moving out. For this to apply, the unit must also continue to be marketed for rent.

Over-Income Units

As detailed in Treasury Regulation (Treas Reg) Section 1.42-15, any tenant occupying a traditional LIHTC property may have their income increase above the applicable income limit so long as they were initially qualified at move-in. However, if the tenant’s income increased by more than 140 percent of the applicable limit, the next available unit of comparable or smaller size in the building must be rented to a qualified tenant in order for the over-income tenant to continue to be qualified. Generally for a tax-exempt bond development, the next available unit rule is on a development basis rather than a building-by-building basis. However, pursuant to IRC Section 142(d)(3)(C) an exception to this rule is allowed for tax-exempt bond developments that are also awarded 4 percent LIHTCs. In this case, the guidance under IRC 142 replaces the term “project” with “building” in order to conform with IRC Section 42.

Tenant Transfers

Tenants transferring from one unit to another unit in the same building do not need to be recertified for a LIHTC development, and also do not need to be recertified if transferring between buildings if the project elected Yes to question 8b on the IRS Form 8609, according to Treas Reg Section 1.42-15. However, Treas Reg Section 1.42-15 specifically states that this section of the Treas Reg in not intended as an interpretation under IRC Section 142. Therefore, tenants who transfer from one unit to another within a tax-exempt bond development must be recertified.

Rent Limits and Tenant Rent

IRC Section 142 does not detail the requirements to tax-exempt bond compliance, such as rent restrictions. As such, the additional detail not found in IRC Section 142(d), pertaining to rent restrictions in this example, are generally outlined in the bond regulatory agreements or the declaration of restrictive covenants. It is common for applicable tax-exempt bond rent limits to vary from the imputed rent limits for LIHTC developments whose rent limits are imputed at 1.5 persons per bedroom. This may not always apply to a tax-exempt bond development where, for example, rent for a one-bedroom unit may be imputed at two persons (rather than 1.5 persons).

Generally, neither 4 percent nor 9 percent LIHTC developments consider Section 8 housing assistance payments as rent.

For a tax-exempt bond development, rents generally do not need to be reduced by a utility allowance for the utilities paid for by the tenants themselves (unless specified in the regulatory agreements). Conversely, for a LIHTC development, rents must be reduced by a utility allowance for the utilities that a tenant pays themselves.

Topics to be Discussed Next Month

We have only begun to scratch the surface of the key differences in compliance requirements for 4 percent LIHTCs and 9 percent LIHTCs. In November’s issue, we will discuss the following areas through the same lens: certificate of income, verification of income and assets, full-time student status, transient basis of units and recertification.