Maximizing Equity with First-Year Compliance
First-year compliance with low-income housing tax credits (LIHTC) rules can have a significant effect on LIHTC equity, both good and bad.
Partnership agreements are drafted with investor equity based on total tax credits delivered, as well as the timing of those tax credits, especially in the first year. Credits are earned annually over a 15-year period and generally allocated to the investor over a 10-year period. Investor equity is usually contributed during construction, with a final installment shortly after the property is placed in service. The final installment often has upward or downward adjusters depending on the delivery of credits in the first year. We will discuss various ways to maximize first-year credits in order to maximize equity.
Timely Place the Property in Service
The LIHTC is claimed annually for 10 years. The credit calculation begins with the first full month in which the building is placed in service or Jan. 1 of the following year if owner makes an election to defer the credit period. During the first year of the credit period, the low-income occupancy percentage is calculated on a monthly basis and the first-year credit calculation is based on average occupancy during the year. Therefore, the earlier the property is placed in service, the easier it is to increase the average occupancy. Credits are determined on a building-by-building basis, so accelerating the placed-in-service dates on any buildings will help increase first year credits.
Occupancy for each month is determined “as of the close of each full month of such year during which such building was in service” pursuant to Internal Revenue Code (IRC) Section 42(f)(2)(A). For example, if the building is placed in service Jan. 2, then the credit cannot be claimed for the month of January. Instead, the credit will be claimed starting the month of February. The building needs to be placed in service on the first of the month in order to have a full month to start credits. Therefore, it’s best to try and place a building in service on the first of the month with units leased up by the close of that full month to count as a qualified unit to earn credits.
In the case of acquisition/rehabilitation, if you are doing a rolling rehabilitation, try to take the units offline to do rehabilitation during the month instead of at the end of the month to avoid overlapping two months. For example, if rehabilitation takes two weeks, take the units offline for two weeks in the middle of the month so that the units are back in service by the close of the same month in order to claim credits for that month.
Placed-In-Service Date Definition
It is also important to understand how Internal Revenue Service (IRS) defines the term “placed in service.” Pursuant to IRS Notice 88-116, “the placed-in-service date for a new or existing building used as residential rental property is the date on which the building is “ready and available” for its specifically assigned function, i.e., the date on which the first unit in the building is certified as being suitable for occupancy in accordance with state or local law.” The two main factors that the IRS requires is that a building is “ready and available.” As long as one unit is ready and available, the building is considered placed in service, which means a temporary certificate of occupancy issued on one unit meets the definition of placed in service for that building.
Accelerate Initial Lease-Up
It is important to lease up qualified units timely and potentially faster than projected to get upward adjuster on the equity installment.
On new construction developments, property managers generally begin qualifying households within 120 days of the building placed-in-service date. Communication between the owner and management is the key as to when the buildings are expected to be placed in service, so that the management can begin the qualifying process early but not too early in case the placed-in service date gets delayed for any reasons.
On acquisition/rehabilitation developments, property managers generally begin qualifying households within 120 days of acquisition.
Pursuant to IRC Section 42(e)(4)(B), qualified LIHTC units are included in the first-year applicable fraction for both acquisition and rehab “buildings” starting on the later of the acquisition date or Jan. 1 of the year the rehab is completed. This is known as the “tack-back rule” because it allows rehab credits to “tack back” to the later of the acquisition date or Jan. 1 of the year the rehab is completed.
Revenue Procedure 2003-82 Safe harbor
Pursuant to IRS Revenue Procedure 2003-82, the IRS provides a safe harbor under which, if certain conditions are met, a residential rental unit will be treated as a low-income unit even though the occupants’ incomes exceed the income limit at the beginning of the building’s 10-year credit period. In order to qualify, the household must have been income-qualified at the time the owner acquired the building or the date the household started occupying the unit, whichever is later. The owner must maintain documentation of the income qualification and the unit must be rent restricted. Therefore, even if owners are deferring the credit period, it might be a good idea to certify tenants early. See the next paragraph for more details.
Acquisition Date vs. Jan. 1
Since credits will not begin until the later of the acquisition date or Jan. 1 of the year the rehab places in service per the tack-back rule, many owners think that they have until January of the year the rehab is placed in service to complete these certifications. That is partially true–except for households whose income increase after acquisition. If you have a household that qualified for the program at the time of acquisition, but then ended up having more income in January of the year that the rehab places in service such that the household no longer qualifies and the certification was not completed until that time, you now have a disqualified household. If the owner had certified the tenant at the time of acquisition, they would qualify under the safe harbor rule in Revenue Procedure 2003-82 and the owner would simply need to apply the available-unit rule. Please also note that if owner chooses to complete certifications in January of the year the rehab places in service or any date other than the acquisition date, owners do not get the 120-day grace period(as explained in the next paragraph) and the certifications must be completed within 120 days before the certification date.
Various 120-Day Rules and 120-Day Grace Period
Pursuant to the IRS Guide for Completing Form 8823 Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition (8823 Guide), revised January 2011, an owner can certify existing households within 120 days of the acquisition date (120-day grace period) and consider those residents qualified as of the date of acquisition. If the owner does not certify the existing household until after that 120-day time period, the resident is qualified as of the date that the certification is completed.
Please also note that the certifications can also be completed up to 120 days before acquisition if the owner has access to the property before the acquisition date. However, we recommend starting the process closer to 90 days before acquisition so the documentation obtained does not become outdated in the case of acquisition delay. Also note that verifications in tenant files are generally valid for up to 120 days before the tenant income certification date.
The 8823 Guide states that “households determined to be income qualified for purposes of IRC Section 42 credit during the 15-year compliance period are concurrently income qualified for the purposes of the +30-year extended use agreement. As a result, any households determined to be income qualified at the time of move-in for purpose of the extended use agreement is a qualified low-income household for any subsequent allocation of IRC Section 42 credit.”
Per the IRS, initial certifications of existing over-income households that will remain in place when a property is resyndicated do not need to be performed by the owner. Each unit will remain qualified and be grandfathered in as long as the owner provides the complete initial certification paperwork to show the household was income eligible when they initially moved into the tax credit property. If the owner does not have the initial certification, then they will be allowed to use a subsequent recertification that clearly shows the unit was once income eligible under the old allocation of tax credits. The owner should perform the annual recertification of each household under their normal recertification anniversary date.
On the other hand, some states require the owner to perform a full income and asset certification for all existing households who remain when property is resyndicated and require the owner or their management agent to create a completely new tax credit file for all existing tenants. For households where the new certification is over the income limits under the new allocation, owners must prove eligibility to be grandfathered in by providing the documentation of the original qualifying certification for the household that clearly shows income eligibility under the old allocation of credits. When the new certifications need to be completed by vary by states. Owners and management agents should check with their state agencies on first-year documentation requirements to avoid any noncompliance. Even if your state does not require new certifications, we strongly recommend owners to perform new certifications on existing tenants in order to confirm the eligibility of tenants rather than simply relying on previous management’s paperwork and therefore avoid any potential first-year noncompliance issues.
Avoid Two-Thirds Credits Over 15 Years
Placed-in-service rules and credit calculations are on a building-by-building basis. Owners should make sure all buildings are 100% qualified at close of the first year to avoid 15-year credits. If the target applicable fraction of 100% was not met at the close of the first year, the owner is subject to the credits being delivered over the 15-year compliance period instead of the 10-year credit period. Physical occupancy is not necessarily required to count a unit as qualified. However, tenants need to have signed the lease and have the right to occupy the unit in order to count the unit as qualified, as well as having signed the tenant income certification along with required verification of income and assets.
If 100% lease-up is challenging, owners may consider monetary incentives such as rent discounts for the first few months. If lease-up is slow and project will be less than 100% at close of first year, owners should consider leasing up some buildings 100% before leasing up other buildings to avoid 15-year credits and consider delaying credit period on buildings less than 100%.
It is important to have another set of eyes on the tenant files. Owners should have third-party review first year tenant files and rent/income limits along with other property compliance issues to mitigate first year noncompliance. Third-party review should be done before the close of the first year, and ideally have the third-party review the first few lease-up tenant files to make sure compliance issues are on track (especially rent and income limits) and errors do not get repeated. Novogradac is available to review tenant files as well as rent/income limits.
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