IRS Updates Section 42 Audit Technique Guide

Published by Dirk Wallace on Saturday, November 1, 2014
Journal thumb November 2014

On Sept. 18, the Internal Revenue Service (IRS) released a final draft of the revised audit technique guide (ATG) for the Low-Income Housing Tax Credit (LIHTC) program. A draft ATG was released for public comment Dec. 19, 2013. The ATG was originally created to provide guidance for IRS examiners to audit owners of LIHTC properties, and the revised draft represents the first substantial update to the ATG since 1999.

The final ATG was updated to reflect the feedback the IRS received. Several of the changes that were recommended by the LIHTC Working Group were incorporated into the finalized ATG. In total, more than 100 changes were made. The more substantial revisions are summarized below. It is important to note that although the finalized ATG represents a collection of technical citations, it cannot be relied upon as authoritative literature for sustaining a technical position.

Chapter 7, No Longer Participating in the IRC Section 42 Program
Chapter 7 of the ATG now includes an expanded discussion on state agencies’ authority to determine that a building is no longer participating in the LIHTC program. Specifically, the ATG clarifies that a state agency has the authority to cease compliance monitoring when the state agency notifies the IRS that a building is no longer in compliance or participating in the LIHTC program. The guide also notes that Form 8823, line 11p does not include a box for reporting “noncompliance corrected” when a state agency reports that a building is no longer participating in the LIHTC program.

Chapter 8, Eligible Basis–Includable Costs
The definition of “residential rental property” on Page 8-1 has been expanded to reference IRS Notice 88-91, which explains that a townhouse can be a “qualified low-income building” along with apartment buildings, single-family dwellings, row-houses, duplexes and condominiums. This additional discussion now adds clarity as to what types of structures can be considered to be residential rental property.

The discussion of deferred developer fees, beginning on Page 8-19, clarifies that a deferred developer fee may be documented by either a note or by another document. The draft ATG only referred to a deferred developer fee note with regard to documenting a taxpayer’s intent to pay a deferred developer fee. The inclusion of “other documents” in the final revision broadens the scope of documentation considered by the IRS as evidence of a taxpayer’s intent to pay a deferred developer fee.

Chapter 12, Applicable Fraction
“Applicable Fraction Defined” was expanded to include a definition of “floor space” on Page 12-2. This clarifies the components of “floor space” and removes ambiguity regarding the calculation of a building’s applicable fraction.

A new section titled “Units Occupied by On-Site Managers, Maintenance Personnel, and Security Guards” was added on Page 12-9. This additional section clarifies that facilities functionally related and subordinate to residential units (such as units for resident managers or maintenance personnel) are considered residential rental property and can therefore be included in eligible basis for the purposes of the LIHTC. It further clarifies that these units are excluded from both the numerator and denominator for the purposes of determining a building’s applicable fraction. Audit techniques for this issue are outlined on Page 12-14 to assist examiners in determining if such a unit should be treated as a facility reasonably required for the project and not treated as a residential unit.

Another new section titled “Emergency Housing Relief” was added to this chapter on Page 12-9, which references IRS Revenue Procedures 2007-54 and 2014-49. This additional section discusses a LIHTC project’s ability to provide emergency housing for displaced persons, as well as relief that can be provided to a LIHTC property located in an area declared a major disaster area by the president under the Stafford Act. The “Casualty Losses in Federally Declared Disaster Areas” section of the ATG was expanded to include a reference to the newly released IRS Rev. Proc. 2014-49. Rev. Proc. 2014-49 applies to LIHTC properties in an area declared a major disaster area on or after Aug. 21, 2014. The key distinctions between this Rev. Proc. 2014-49 and Rev. Proc. 2007-54 are a shortening of the reasonable restoration period for recapture relief for damaged buildings, an extension of the period during which an agency may allow an owner within its jurisdiction to provide emergency housing to displaced individuals from other jurisdictions, the elimination of the need for income self-certification for eligibility, and more extensive guidance regarding the consequences of renting to temporarily displaced individuals.

A note has been added to the “Casualty Losses in Federally Declared Disaster Areas” section on Page 12-24 to clarify that Rev. Proc. 2007-54 applies to IRC Section 42 tax credits, including projects financed by tax-exempt bonds through the volume cap under IRC Section 142(d). This clarifies the ambiguity of the language in Rev. Proc. 2007-54 regarding its applicability to projects financed by tax-exempt bonds through the volume cap under IRC Section 142(d).

Examples #4 and #5 on Pages 12-44 and 12-45, respectively, were expanded to demonstrate the computation of the applicable fraction for the first year of the credit period under IRC Section 42(f)(2)(A) using the lesser of the unit fraction or the floor space fraction methods as required by IRC Section 42(c)(1)(B). This addition to the ATG makes it clear that the first-year applicable fraction is based on qualified occupancy at the close of each month, and that the calculation for the year should be the the lesser of the sum of the monthly unit fractions or the sum of the monthly floor space fractions for the entire first year.

Appendix C, Treatment of Assets/Costs for IRC Section 42 Purposes
“Accounting Costs” are now separately addressed on Page C-1. This addition now includes a discussion on the treatment of accounting costs during the construction period of a building, which was omitted from the draft ATG. The final ATG explains that accounting costs incurred during the construction period to account for the costs of construction are indirect costs that directly benefit, or are incurred by reason of, the taxpayer’s improvement and, therefore, are capitalized to the basis of the property improved under IRC Sections 263(a) and 263A. The ATG further explains that such accounting costs should be allocated among the improved property, and to the extent the cost of the improved property is included in eligible basis, the improved property’s allocated share of these accounting costs are also included in eligible basis. Examples the ATG provides include accounting for costs according to a construction contract, securing advances from a construction loan, or submitting documentation to HUD for reimbursement.

A new section titled “Acquiring Occupied Building: Tenant Relocation Costs” has been added on Page C-10. This addition now includes a discussion on the treatment of costs incurred to permanently relocate nonqualifying tenants and costs incurred to temporarily relocate qualifying tenants during rehabilitation. The ATG states that the relocation costs are deducted under IRC Section 162. The LIHTC Working Group will request clarification from the IRS regarding the treatment of temporary relocation costs, as the treatment described in the ATG is controversial among LIHTC industry participants.

The section of the ATG titled “Real Estate Taxes” on Page C-10 has been expanded to include taxes incurred during the pre-production period. This addition clarifies that real estate taxes incurred when real property is acquired with the intent to develop are capitalized under IRC Section 263A, even if no positive steps to begin developing the property have occurred.

IRC Section 266 is addressed in a new section titled “Carrying Charges Other Than Interest” on Page C-11 of the ATG. This new section explains the capitalization of otherwise deductible carrying charges paid or incurred with respect to improved but unproductive real property allowed under IRC Section 266. Most significantly, the ATG states that carrying charges (other than interest) that are attributable to vacant units that have been rehabilitated for which the production period of IRC Section 263A(f) has ended, that are available for rent but not yet been rented out, and are located in a low-income building that has been placed in service can be capitalized to the building under IRC Section 263A as post-production costs.

The above changes represent only the more significant updates that the IRS made to the ATG. The revised ATG, as well as the IRS’ summary that was published in IRS LIHC Newsletter #56, can be found online at www.taxcredithousing.com.

If you are an investor, developer, syndicator or LIHTC industry professional and would like to be part of our group and get the inside track on issues affecting the LIHTC program, or you have technical program issues that need resolved, join the LIHTC Working Group and add your issues to the agenda. For more information about becoming a member, email [email protected].