Eclipsed by the long-awaited final guidance for the average income test (AIT) in the form of Treasury Regulation Section 1.42-19 in October 2022 was the final adoption of the proposed amendments to Treasury Regulation Section 1.42-15 regarding the available unit rule. Before analyzing how this rule is to be applied for AIT, it is important to frame the rule itself.

The Available Unit Rule

The amount of low-income housing tax credits (LIHTCs) that a building will generate is driven by the building’s eligible basis and applicable fraction, with the applicable fraction representing the building’s low-income occupancy. This calculation is completed on an annual basis. If the applicable fraction is affected by an event of noncompliance, the amount of credit that the building generates is impacted.

The applicable fraction is the lesser of the unit fraction or the square footage fraction. Take, for example, a 10-unit single building project where units 101-105 are 1,000 square feet each and units 201-205 are 750 square feet each:

Unit fraction: 6 low-income units / 10 total units = 60%.

Square footage fraction: 5,250 low-income square feet / 8,750 total square feet = 60%.

In this example, the unit fraction and square footage fractions are the same, resulting in the building’s applicable fraction of 60%. If the building’s eligible basis was $750,000 and received a 9% LIHTC, the amount of credit the building would generate is:

When a household is income-eligible at the initial certification and in a subsequent year of occupancy, the household’s income exceeds 140% of the applicable income limit, they are then considered over-income. To continue to include the over-income unit as a low-income unit in the building’s applicable fraction, the available unit rule requires that all next available unit(s) in the building of smaller or comparable size must be leased to a low-income household until such time that the applicable fraction can be met without the over-income unit.

Failure to comply with this rule results in the over-income unit losing its low-income status and reducing the building’s applicable fraction because the over-income unit would have to be removed from the numerator of the applicable fraction.

The Available Unit Rule and AIT

The available unit rule, in concept, functions the same as in other minimum set-asides as it is about maintaining the building’s applicable fraction; however, AIT requires that low-income units be designated in 10% increments from 20% to 80% so that the average of the unit’s designations does not exceed 60%, resulting in a more complex road to compliance.

For the 20-50 minimum set-aside, the applicable income limit is 50% of the area median income (AMI) and a tenant would not be considered over-income until their income exceeds 140% of the 50% income limit. Conversely, for the 40-60 minimum set-aside, the applicable income limit is 60% and a tenant would not be considered over-income until their income exceeds 140% of the 60% income limit. For AIT, the over-income limit is driven by the unit’s designation:

The final AIT guidance expanded the definition of low-income under the AIT to include that the unit is part of 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. As such, we now need to consider both the building’s applicable fraction and the qualified group of units of which the over-income units are a part.

Expanding on the example, the low-income units are designated in the following manner:

The qualified group of units are units 103, 104, 105, 203, 204 and 205 where the average of the units’ designation is 60%.

Using the example from above, suppose in Year 5 of the compliance period that unit 103 is over-income and the next unit that become available in the building is unit 202. Because unit 202 is smaller than unit 103, the compliant approach is to lease unit 202 to a low-income household. The difference in the application of the available unit rule with AIT is that unit 202 needs to be designated with a designation that will preserve the 60% average for the qualified group of units. Since unit 103, the over-income unit, is designated as 40%, the simplest approach would be to designated unit 202 as 40%:

In this example, the unit 202 could be designated at any designated at/below 60% AMI. If the unit was designated as a 70% or and 80% AMI, then the average of the qualified group of units would exceed 60%.

As a reminder, the building’s applicable fraction on which the original qualified basis was calculated is 60%. Unit 103 cannot yet be converted to a market rate because, without unit 103, the building’s applicable fraction would be less than the one used to support full credit delivery. As a result, all units must continue to be leased to low-income tenants.

Unit 102, a 1,000-square-foot, market-rate unit is vacated. Because the unit is smaller or comparable to the over-income unit, the unit must be occupied by a low-income household, but at what designation?

Current average of qualified group of units is 57.14%. The owner must designate unit 102 with a designation that, when included with qualified group of units, preserves the 60% average.

Due to market conditions, the owner chose to designate the unit as 50%, in doing so, the average of the qualified group of units is now 56.25%:

The key is that as units become vacant, they are designated appropriately; however, once designated correctly, the units can be occupied in any order. In this example, unit 202 (40%) and unit 102 (50%) are both vacant. A household that has a gross household income of 45% applies. It is acceptable to lease unit 102 to the applicant, even though unit 202 was the first available unit. A household that has a gross household income of 35% applies and occupies unit 202.

At this point, can unit 103 be converted to a market-rate unit?

Looking at the entire building for the purpose of the building’s applicable fraction, the following configuration in in place:

Unit fraction: 8 low-income units / 10 total units = 80 %.

Square footage fraction: 7,000 low-income square feet / 8,750 total square feet = 80%.

The impact to the applicable fraction if unit 103 is converted to a market-rate unit is:

Unit fraction: 7 low-income units / 10 total units = 70 %.

Square footage fraction: 6,000 low-income square feet / 8,750 total square feet = 68.57 %.

Removing 103 (the over-income unit) at this time would be allowed because, without it, the applicable fraction on which the qualified basis was calculated is preserved.

Now that the available unit rule has been followed, the owner would seek to balance back out the applicable fraction. This could be accomplished by converting one of the low-income units to market rate, but is it is imperative to keep an eye on the average of the designations for the remaining low-income unit to ensure that average never exceeds 60%.

For example, unit 203 (a 750-square-foot, low-income unit, designated as 80%) vacates the unit and a market-rate tenant moves into the unit.

The impact to the average of the qualified group of units is now 55%:

And the impact to the applicable fraction is:

Unit fraction: 6 low-income units / 10 total units = 60 %.

Square footage fraction: 6,000 low-income square feet / 8,750 total square feet = 60 %.

The available unit rule has been met in a manner that preserved the qualified group of units. This process can be more complex when the unit/designation mix is more dynamic, especially when there are more than one unit that is over-income at the same time. Keep in mind that the concepts are the same as units of smaller or comparable size in the building become available.

Conclusion

Understanding compliance with the available unit rule can be challenging, especially when there is more than one over-income unit in a building. Layering in the concept of unit designations as it related to a qualified group of units creates a more complex path to compliance; but understanding that path is paramount as noncompliance with the available unit rule has the unique ability to result in noncompliance with other Internal Revenue Code Section 42 requirements.