IRS Issues Guidance on Common Area Noncompliance

Published by Joyce Hsia on Wednesday, November 6, 2019
Journal cover thumb November 2019

This article will discuss common area requirements, some typical common area noncompliance, how noncompliance should be presented on IRS Form 8823, and will elaborate on the different issues presented in the IRS PMTA-2019-04.

Common Area Requirements

As set forth by the IRS 8823 Guide, “The common area must be structurally sound, secure, and functionally adequate for the purposes intended. The basement, garage/carport, restrooms, closets, utility rooms, mechanical rooms, community rooms, day care rooms, halls/corridors, stairs, kitchens, laundry rooms, office, porch, patio, balcony and trash collection areas, if applicable, must be free of health and safety hazards, operable, and in good repair. All common area ceilings, doors, floors, HVAC, lighting, outlets/switches, smoke detectors, stairs, walls and windows, to the extent applicable, must be free of health and safety hazards, operable and in good repair.” Parking lots and driveways, lobby areas, pools, play areas and equipment, roads and walkways must be free of health and safety hazards and in good repair. Housing credit agencies must use either (a) the local health, safety and building codes (or other habitability standards) or (b) the Uniform Physical Condition Standards (UPCS) (24 C.F.R. section 5.703) to inspect the project, but not in combination.

Four main criteria generally need to be met in order for common area costs to be included in eligible basis:

Common areas are functionally related to the low-income units;

Common areas are reasonably required for the project;

There is no additional charge to the tenants for the use of the common areas; and

Common areas are available to all tenants on absolute priority basis over nontenants.

Typical Common Area Noncompliance

Typical common area noncompliance may involve converting common areas to commercial property, charging fees for facilities (such as a swimming pool) or habitability and health/safety violations. Note that charging for services is not the same as charging for the use of a facility, therefore, charging for services isn’t necessarily common area noncompliance. For example, charging for day care services is OK, as long as it doesn’t include an indirect charge to the tenant for the use of the day care space and is limited to just charges for services.

The date of noncompliance is the specific date the residential space is converted to commercial space or when a fee is charged or when common space is not habitable.

Noncompliance and Eligible Basis

Common areas are considered residential rental property if functionally related to the LIHTC building or LIHTC development. Under IRC Section 42(d)(4)(A) and Section 42(d)(4)(B), the eligible basis for a qualified LIHTC building or a qualified LIHTC project includes the adjusted basis of the property used in common areas or provided as comparable amenities to all residential rental units in the building. Therefore, if a common area of a qualified LIHTC building or a qualified LIHTC project is noncompliant during the compliance period–and if the noncompliance is uncorrected as of the close of the taxable year in which the noncompliance occurs–the noncompliance should be treated as a reduction in the eligible basis of the building. IRS PMTA-2019-04 requires that the noncompliance of a common area should be treated as a change in the eligible basis of the qualified LIHTC building or the qualified LIHTC project in the taxable year in which the noncompliance occurs.

Noncompliance and Recapture

If the noncompliance of a common area in a qualified LIHTC building or a qualified LIHTC project is treated as a reduction in the eligible basis, recapture under IRC Section 42(j) may be triggered. As emphasized by the IRS PMTA-2019-04, the eligible basis of the building is reduced by the amount of the total costs of the specific common area that caused the noncompliance. IRS PMTA-2019-04 indicates that the reduction in the eligible basis is likely the costs attributable to the entire common area, not just the costs attributable to the portion of the noncompliant common area. IRS PMTA-2019-04 provides the following example to illustrate how this will work:

A qualified low-income building contains multiple common areas. One of the common areas is a laundry room for use by all tenants of the building without additional charge. The laundry room contains 20 laundry machines. For purposes of the low-income housing credit under Section 42, the costs of the laundry room ($40,000), and those of the 20 laundry machines ($10,000), were included in the eligible basis of the building (a total of $50,000) as of the close of Year 1 in the credit period. In June of Year 3, during the compliance period, the state housing credit agency (Agency) inspected the building and discovered that 10 of the laundry machines were not properly functional and, therefore, the common area (the laundry room) was deemed noncompliant. The Agency allowed the owner three months to correct the noncompliance, but the owner failed to correct the noncompliance by the end of Year 3. Therefore, in Year 3, there is a reduction of the eligible basis of the building in the amount of the total costs of the laundry room that was previously included in the eligible basis ($50,000), because the laundry room is noncompliant. The reduction is not limited to the amount of the costs attributable to the nonfunctional laundry machines ($5,000).

This example in PMTA-2019-04 is concerning because the entire laundry room common area is considered out of compliance when just a portion of the laundry machines are out of compliance.

Let’s change the IRS example to assume the same facts, except the tenants need to pay to use laundry machines and therefore, the $10,000 cost of the laundry machines was never in eligible basis. Therefore, in Year 3, there is a reduction of the eligible basis of the building in the amount of the laundry room costs of $40,000 that was previously included in the eligible basis, because the laundry room is noncompliant. However, there is no reduction of the eligible basis of the building in the amount of the 20 laundry machines of $10,000, since the $10,000 was never included in the eligible basis.

Noncompliance and Applicable Fraction

The noncompliance of a common area in a qualified LIHTC building or a qualified LIHTC development should not be treated as a change in the applicable fraction of the building in the taxable year in which the noncompliance occurs. The noncompliance of a common area is treated as a reduction in eligible basis but not a reduction in the applicable fraction.

The IRS PMTA-2019-04 says that if the adjusted basis of the common area is allocated to the eligible basis of one or more buildings in a low-income housing property for purposes of calculating the credit, such as a carport that is use by all of the tenants of a qualified multibuilding low-income housing project, the reduction in the eligible basis of the buildings based on the noncompliance of the common area should be allocated accordingly to the applicable buildings.

Noncompliance and Form 8823

If common area noncompliance is discovered by the state housing credit agency, the state agency will check both Box 11c for inspection standard violation and Box 11e for reduction in eligible basis on the IRS Form 8823.

Converting common areas to commercial property or charging fees for facilities are typical noncompliance for common areas and these types of noncompliance also need to be reported in box 11e of the IRS Form 8823. Whether the cost of these converted spaces can be restored to eligible basis by changing the properties back into common areas has not been determined. The IRS PMTA-2019-04 says that in these instances, the state housing credit agency should not report the building back in compliance. Instead, the state agency should contact the IRS National Office LIHTC program analyst for instructions.

The guidance and clarification in the IRS PMTA-2019-04 is definitely unfavorable because it suggests basis reduction for an entire common area even if only part of the common area is noncompliant. While it is general knowledge that violations of the rules relating to common area could result in credit loss and recapture, it is now even more crucial to ensure the qualified LIHTC building or the qualified LIHTC project is in compliance with all the applicable rules relating to common area.