IRS Releases Final, Temporary Regulations on the Average Income Test

Published by Stephanie Naquin on Thursday, November 3, 2022
Journal Cover Thumb November 2022

The Internal Revenue Service (IRS) released final regulations on the average income test (AIT) for the low-income housing tax credit (LIHTC) Oct. 7 in the form of Treasury Regulation (Treas. Reg.) Section 1.42-19  (published in the Federal Register Oct. 12). In conjunction with the final regulations, the IRS released temporary regulations in the form of Treas. Reg. Section 1.42-19T that contemplate procedural, administrative and reporting requirements created as context to the implementation of the final regulations.

New Terms

The final regulations introduced new terms and concepts that are necessary to frame the resolutions to concerns identified in the proposed regulations. Before exploring what changed, it is important to understand these new terms and concepts.

Low-Income

In general, for a unit to be considered low-income under Internal Revenue Code (IRC) Section 42, it must be occupied suitable for occupancy and occupied by a household who is income- and rent-restricted at the applicable area median income (AMI) for the unit. The final regulations expanded the definition of what a low-income unit is under the AIT to now include that the unit is part of a qualified group of units.

Qualified Group of Units

The final regulations introduce a new concept to the implementation of AIT in that the owner must identify a qualified group of units that is a group of residential rental units where the average of the imputed income limitations of all the units in the group does not exceed 60% of area median gross income (AMGI). This concept is used in both the context of meeting the minimum set-aside as well as applicable fraction determinations. Annually, the owner must report to the state housing credit agency the qualified group of units intended to satisfy the minimum set-aside and, separately, qualified group of units used to determine the applicable fraction of each building in the project.

What Changed?

The regulations, as proposed, created significant challenges in the practical implementation of AIT. Through both written public comment and a public hearing, the industry outcry was clear that, if adopted as proposed, the AIT would become stagnate in nature. With the final guidance, the industry’s collective voice was heard with the changes to key components of AIT.

Minimum Set-Aside

The proposed regulations came with a steep “cliff effect” in that a single unit going out of compliance could cause a LIHTC project to fail the minimum set-aside. While mitigating action was also proposed that would allow the owner to avoid such catastrophic consequences, that action was unworkable in practical application. With the final regulations, the minimum set-aside is met under AIT if at least 40% of the building’s residential units are eligible to be low-income units and have designated imputed income limitations that collectively average 60% or less of AMGI.

To support that a project’s minimum set-aside is met on an annual basis, the owner identifies a qualified group of units that constitute 40% or more of the residential units in the project.

Example: a 30-unit project where the owner has designated units in the following manner where the imputed income limitations of all the units do not exceed 60%:

Journal Graphic: November 2022, AIT Regulations 1
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To meet the minimum set-aside, a qualified group of 12 units, constituting 40% of the total number of units, must be identified. The owner could carve out this 40% in several different ways, with one example of an acceptable qualified grouping these 12 units:

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This would also represent a qualified grouping of 12 units to support the minimum set-aside as met:

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Unit Designations

The concept of designating units is new to AIT as under the 20-50 or 40-60 tests, a low-income unit is either 50% or 60%. There are no other options. Under AIT, a unit can be designated from 20% to 80%, limited to 10% increments, necessitating a better understanding of the functionality of designations. With the proposed regulations, unit designations were to be made by the end of the first year of the compliance period and those designations were fixed throughout the term of the extended use period. That meant that once a unit was designated, there was no avenue through which a unit’s definition could be changed. This rigidity meant the having to choose between following the average income guidance or possibly violating other federal housing program laws; not to mention the inconsistency with existing LIHTC guidance.

Changes in Unit Designations

The final regulation allows changes in unit designations of a previously designated low-income unit in any of the following circumstances:

  1. Federally permitted changes: As contained in IRS forms, instructions or guidance published in the Internal Revenue Bulletin.
  2. Agency-permitted changes: As described in written public guidance.
  3. Certain laws: As required or appropriate to enhance protections under The Americans with Disabilities Act, The Fair Housing Act, The Violence Against Women Act, The Rehabilitation Act of 1973 or any other state, federal or local law or program that protects tenants.
  4. Tenant movement: When a current income-qualified tenant transfers to a different unit in the same project, the units “swap” status.
  5. Restoring compliance with the average income requirements: As needed for purposes of identifying a qualified group of units, either for purposes of satisfying the AIT set-aside or for purposes of identifying the units to be used in computing applicable fraction(s).

Timing of Unit Designations

For current AIT project with occupied units, the taxpayer must designate an imputed income limitation for the unit no later than Jan. 1, 2023. That designation may not be less than the income that the current occupant of the unit had when that occupancy began.

Units that are vacant because they have not yet been initially occupied by a low-income tenant must be designated before the unit is occupied. Meaning, the unit drives who can live there, rather than the resident driving the designation.

Once a unit is designated, that designation can change based on one of the permitted justifications, where a change in a unit’s designation is effectuated by the owner recording the limitation in its books and records. The new designation must also be communicated to the state agency in a manner required by the respective agency and subject to record retention requirements in
Treas. Reg. Section 1.42-5(b)(2).

Effect of Unit Noncompliance

While the final regulations remove the “cliff effect” as it related to minimum set-aside, it makes it clear that for any unit to be considered low-income, it must be part of a project whose total unit designations do not average more than 60% (i.e., the project average). The expanded definition of a low-income having to be part of a qualified group of units introduces a step between discovery of unit noncompliance and its impact on the building’s applicable fraction.

A building’s applicable fraction is evaluated Dec. 31 every year of the compliance period. A decrease in the applicable fraction results in a decrease in the building’s qualified basis with the decrease in qualified basis being the trigger for disallowance of current year LIHTC and recapture of claimed accelerated LIHTC. The concept that this analysis is being conducted Dec. 31 every year of the compliance period does not change with AIT, but the impact that unit noncompliance has on the applicable fraction does.

In general, unit noncompliance could have the following consequences:

  1. The unit determined to have noncompliance cannot be included in the building’s applicable fraction, but the rest of the project average does not exceed 60%, resulting in a reduction in qualified basis proportionate to that unit.
  2. To have a qualified group of units whose average does not exceed 60%, another unit(s), in addition to the unit with the noncompliance, would have to be removed in the building’s applicable fraction, resulting in a greater reduction in qualified basis.
  3. No impact to the building’s applicable fraction because the project average can be restored by changes in unit designations.

Example: A 12-unit, single-building project, with units of the same size. Units have been designated in the following manner where the imputed income limitations of all the units do not exceed 60%:

Journal Graphic: November 2022, AIT Regulations 4
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To meet the minimum set-aside, a qualified group of five units, constituting 40% of the total number of units, must be identified. The owner could carve out this 40% in several different ways, with one example of an acceptable qualified grouping these five units:

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As the project can support that the minimum set-aside, how many LIHTCs the building will deliver is the next consideration. Since the units, in this example, are all the same size, the floor space and unit fraction are equal. As such, the unit fraction will be used in the following scenarios.

Scenario #1:

Unit 109, designated as 80%, is determined to have unit-level noncompliance and remains noncompliant Dec. 31, when the building’s qualified basis is calculated. When the designation for unit 109 (80%) is removed, the remaining 11 units have an imputed income limitation of 58.18%, and all 11 units remain part of a qualified group of units. Unit 109 cannot be included in the building’s applicable fraction, resulting in a reduction in qualified basis proportionate to unit 109 only.

Scenario #2

Unit 112, designated as 40%, is determined to have unit-level noncompliance and remains noncompliant Dec. 31, when the building’s qualified basis is calculated. When the designation for unit 112 (40%) is removed, the remaining 11 units have an imputed income limitation of 61.82%. Because the remaining 11 units are part of a group of units whose imputed income limitation now exceeds 60%, the units no longer satisfy the definition of low income. To resolve this issue, unit 107, which was designated as 80%, is removed from the qualified group of units and the remaining 10 units have an imputed income limitation that does not exceed 60%. Unit 112 cannot be included in the building’s applicable fraction, but neither can unit 107, resulting in a reduction in qualified basis proportionate to both units.

Scenario #3

Same fact pattern as scenario #2. The household in unit 112, designated as 40%, is determined to, due to an error in the calculation of gross income, be income-eligible under the 50% AMI. Unit 107, designated as 80%, had a household whose actual income is 67%. The household moved into unit 107 as the only vacant unit at the time (remember, the unit drives the unit’s designation and not the tenant who occupies the unit, so an applicant at 67% income qualifies for an 80% unit). Because existing imputed income limitations of one or more other units in the project can be changed to restore compliance with the average-income requirement, unit 112 could be redesignated to 50% and unit 107 to a 70%:

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Because all units in the project now fall within the definition of low-income, all the units can be included in the building’s applicable fraction, resulting in no reduction of qualified basis.

Conclusion

The new regulations answer many questions and make the average-income set aside more usable. The IRS was able to bifurcate meeting the minimum set-aside from the applicable fraction and therefore removed the cliff effect that was present in the proposed regulations.

In addition, with these final regulations come temporary regulations specific to procedural, administrative and reporting requirements for which the public comment period ends Dec. 12. The Novogradac LIHTC Working Group is planning to submit comments. To submit input to the LIHTC Working Group, contact Karen Destorel at [email protected]