On Oct. 7, 2022, the Internal Revenue Service (IRS) released final guidance for the Average Income Test (AIT) Oct. 7, 2022, in the form of Treasury Regulation (Treas. Reg.) Section 1.42-19. With the final regulation came temporary regulations that include recordkeeping and reporting requirements to necessitate the administration and compliance for the final regulations.

The final regulations introduced the following new terms and concepts necessary to frame resolutions to concerns identified in the proposed regulations, where the temporary regulations provide a context for the practical application.

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 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 units in the group does not exceed 60% of AMI. This concept is used in both the context of meeting the minimum set-aside as well as applicable fraction determinations. The owner must annually 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.

Unit Designations

Under AIT, a unit can be designated from 20% to 80%, limited to 10% increments. Once a unit is designated, a change to the designation is limited to one of the permitted justifications described in Treas. Reg. Section 1.42-19(d). The final regulation prescribes a process through which an owner initially designates a unit and a process through which a unit’s designation can be changed after initially designated.

A unit’s designation is initially set and, if subsequently changed, by the owner recording the limitation in its books and records. When a unit’s designation changes, 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).

The preamble to the final regulation provides insight into the intent of the temporary regulations:

In general, these substantive final regulations provide significant flexibility with respect to satisfying the average income test, identifying a qualified group of units for use in the average income set-aside test and applicable fraction determinations, and changing the imputed income limitation designations of residential units. This increased flexibility was in response to taxpayer comments on the proposed regulations, including taxpayer complaints about burdens in the proposed regulations. The increased regulatory flexibility, in turn, necessitates these recordkeeping and reporting requirements to enhance administrability and certainty for the taxpayers and Agencies that will be taking advantage of the flexibility.

While the intent of the temporary regulations seems to suggest that their creation is responsive to the need for recordkeeping and reporting requirements to enhance administrability and certainty for the taxpayers and Agencies that will be taking advantage of the flexibility. However, certain interpretations caused concern that the language was limiting in nature, facilitating the need for written comment. Written public comment to the temporary regulation was due Dec. 12, 2022, with all submitted comment expressing the same sentiment.

Before opining on the application of the temporary regulation, as proposed, it is important to remember how the low-income housing tax credit (LIHTC) is calculated. For a project to be eligible to earn a LIHTC, the minimum set-aside must be met by Dec. 31 of the first year of the compliance period and as of Dec. 31 every year of the compliance period. Failure to meet in the first year results in total loss of credit; failing to meet in any other year of the compliance period results in total recapture of any accelerated credits claimed and completed disallowance of credit the year in which it was not met. For AIT, the minimum set-aside is met under AIT if at least 40% of the building’s residential units are low-income units and have designated imputed income limitations that collectively average 60% or less of AMI.

Once the minimum set-aside is met, then the amount of credit that each building in a project will deliver is based on that building’s qualified basis, which is the eligible basis multiplied by the building’s applicable fraction. The calculation of the buildings qualified basis is also completed Dec. 31 every year of the compliance period where a reduction in a buildings qualified basis would affect the amount of credit the building will deliver.

The final regulations introduce the term qualified group of units (see above). 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% more of the residential units in the project.

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

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:

In addition to the qualified group of units intended to satisfy the minimum set-aside, the owner is required to also record a qualified group of units in the applicable fractions of all buildings in the project. In the above example of a two-building project, each building is 100% low-income, yielding a 100% applicable fraction. As a result, the qualified group of units used to determine the building’s applicable fraction would be all 30 units in the project.

The temporary regulation provides that the building owner must communicate the qualified group of units for both determination of the minimum set-aside and applicable fraction(s) to the state agency. The interpretation that the language was limiting in nature is rooted in the idea that if noncompliance is observed after these groups are reported to the state agency, how is the qualified group of units affected?

As a reminder, the final AIT regulations expand the definition what a low-income unit is under the AIT to now include that the unit is part of a qualified group of units. In other words, if a unit is reported to the state agency as being part of a qualified group of units and noncompliance is later identified for that unit, are the other units that were reported as part of that group still considered low-income under the expanded definition?

Looking at the qualified group of units reported to the state agency in the above example for 20X1:

In 20X3, the state agency conducts a review of the LIHTC certification and determined that unit 113 is not in compliance. When unit 113 is removed from this qualified group of units, there would now only be 11 units reported, when 12 are required; and, when removing the unit 113 designation of 40% from the average, the average of the designations for the 11 remaining units is 61.82%.

Further, unit 113 was also reported in the qualified group of units for determination of the building’s application fraction. When removing the unit 113 designation of 40% from this qualified group of units, the average of the designations for the remaining 29 units is 60.69%.

For both qualified groups of units, the effect of noncompliance for unit 113 is that the average of both groups exceeds 60%, seemingly causing the same disastrous cliff effect intended to have been thwarted in the final regulations. The temporary regulation offers a solution. The state agency could, at its discretion and on a case-by-case basis, waive any failure to compliance with identification of low-income units for use in the average income set-aside test or the applicable fraction determination. The proposed language seems to suggest that, if the state agency was not willing to waive any failure to comply, then one unit being out of compliance would cause total loss of credit.

In the above example, in 20X3 when the noncompliance for unit 113 is discovered, the state agency would need to allow the owner to do the following:

1. Minimum set-aside: Identify another unit within the project to comprise the 12 units needed to support that the minimum requirement is met and that unit’s designation needs to restore the 60% average. Unit 201 is designated as 20%. With unit 201, there are 12 units identified and the average of the unit’s designations is 58.33%, restoring the average for the purpose of the qualified group of units for use in the average income set-aside test. This action would require the state agency to allow the owner to amend the qualified group of units for reporting year 20X1 remove unit 113 and replace with unit 201.
2. Applicable fraction determination: Since all 30 units were reported as part of the qualified group of units for the applicable fraction determination, the owner would need to restore the project average through the process described in Treas. Reg. Section 1.42-19(d)(v) or exclude one or more otherwise qualifying units from the qualified group of units for use in applicable fraction determinations for the group to retain an average income limitation that does not exceed 60% of AMI.

To restore the project average under Treas. Reg. Section 1.42-19(d)(v), the owner would need to identify a unit that is designated higher than the tenant’s actual AMI and reduce that unit’s designation. For example, unit 210 is designated as 80% but a tenant receiving Section 8 rental assistance live in the unit and has an actual income at 60% AMI and the gross rent for the unit never exceed the 60% rent limit at any point in their occupancy. The designation for unit 210 is reduced from 80% to 60% so that when the designation of all units (other than unit 113) is averaged, the project average is restored. This action would require the state agency to allow the owner to amend the qualified group of units for reporting year 20X1 exclude unit 113 and to change the designation for unit 210 from 80% to 60%. This approach would mean loss of credit for one unit, limiting the reduction in the qualified basis to unit 113.

To exclude a unit, the owner would need to identify an otherwise qualifying unit from the qualified group of units for use in applicable fraction determinations in 20X1 so that the remaining units’ average does not exceed 60%. For example, unit 110 is designated as 80% and unit 110 is excluded from the qualified groups of units so that when the designations of the remaining 28 units are averages, the qualified group of units is restored to 60%. This action would require the state agency to allow the owner to amend the qualified group of units for reporting year 20X1 to exclude both units 110 and 113. This approach would his approach would mean loss of credit for two units, extending the reduction in the qualified basis to also include unit 110.

Under the temporary regulations, the owner’s ability to take this action is contingent of the state agency’s approval. If the state agency does not allow the building owner to amend the qualified group of units because of the noncompliance with unit 113, then a staunch reading of the provision suggests that the minimum set-aside would be considered failed in 20X1 and, since the minimum set-aside is not met, no credit would be allowed in 20X1. This is conflict with the clear message of flexibility in the preamble, offering an opportunity for clarity before the temporary regulations become final.

The first recommended language change is to streamline the reporting process so that owners can just report one group of qualified units to the state agency, where the 40% minimum set-aside is contained within the qualified group of units. Often, as in the example above, there are several ways to identify a minimum of 40% of the units for use in the average income set-aside test. So long as reporting represents at least 40% of the residential units in the project, the exact unit numbers that comprise that 40% should not be relevant.

The second recommend language change is to allow an owner to submit a new qualified group of units if a unit goes out of compliance, without needing state approval. It is important to note that this does not change the ways that an owner can change designations, that part of the regulation is final and not covered in this proposed language. This change just allows an owner to submit a new qualified group of upon discovery of compliance, without needing the state to grant case by case approval.

Conclusion

These temporary regulations contemplate how unit designations are reported to the state agency and do not alter the substance of the basic rule provisions.  In fact, the preamble is clear that nothing in the temporary regulations is intended to create any barrier in the use of the Average Income Test.  As state agencies develop their own policies in response, property owners and managers should continue to record initial unit designations, changes in unit designations, the qualified group of units for use in the average income set-aside test and applicable fraction determinations in their books and records. Maintaining these records in a clear and concise manner will allow a seamless transition for when these temporary regulations are made final.