Using the Average Income Set-Aside in a 4 Percent, Tax-Exempt Bond-Financed Property
When Congress included the average income test as a new set-aside for low-income housing tax credit (LIHTC) properties in the Consolidated Appropriations Act of 2018 (Act), most industry participants didn’t foresee the various road blocks with its implementation.
Instead, the industry focus was on the fact that developers would now be able to provide housing for lower-income households with no additional subsidy, while also increasing the available rental population by including higher income households. The excitement grew as many thought the average income set-aside would also allow more 4 percent tax-exempt bond developments to be financially feasible. In theory, a 4 percent LIHTC development would be able to support more permanent debt by charging higher rents. However, tax-exempt bond finance properties come with their own set of unique rules in addition to the Internal Revenue Code (IRC) Section 42 guidelines.
Set-Asides for Tax-Exempt Bond Properties
Prior to the Act, there were two set-asides available for LIHTC properties:
- at least 20 percent of the units had to be both rent restricted and occupied by households with incomes at or below 50 percent of area median income (AMI), or
- at least 40 percent of the units had to be both rent restricted and occupied by households with income at or below 60 percent AMI.
The Act allowed for a new third minimum set-aside called the average income test, which allows the taxpayer to designate units at AMI limits between 20 percent and 80 percent (using 10 percent increments). However, the Act only revised the language in IRC Section 42 related to the minimum set-asides. IRC Section 142, which governs tax-exempt private activity bonds (PABs), was not revised. As a result, a property that receives LIHTCs and is financed by tax-exempt bonds will have to meet the requirements of both IRC Section 42 and Section 142.
At first glance, an owner would not have difficulty with initially meeting one of the two minimum set-asides under IRC Section 142 and the average income set-aside under IRC Section 42. For example, if an owner had a 100-unit LIHTC property and rented 50 units to households at 40 percent AMI and 50 units to households at 80 percent AMI, both set-asides would be met. However, subsequent compliance monitoring may prove more problematic.
The main concern with 4 percent tax-exempt bond properties is not initially meeting the minimum set-aside, but rather complying with the next-available-unit rule when a 70 percent or 80 percent AMI unit becomes vacant.
The Act adds updated language for the next-available-unit rule for average-income properties in IRC Section 42(g)(2)(D)(v). If a household’s income increases above 140 percent of the greater of:
- 60 percent of AMI, or
- The applicable designated income limit of the unit (i.e. 20, 30, 40….etc. percent of AMI)
the unit will only remain LIHTC eligible if the owner rents another smaller or comparable unit to a household whose income is within its imputed income limit.
The average income rule also requires LIHTC property owners to take into account whether the vacant unit was a LIHTC unit or a market-rate unit. If the comparable or smaller vacant unit is a LIHTC unit, the owner would be required to rent the unit based on the income designation of the vacant unit. If the comparable or smaller vacant unit is not rent restricted, the owner would be required to rent the unit based on the income designation of the over-income unit.
As previously mentioned, IRC Section 142 was not updated for the average income test. Therefore, when applying the next-available-unit rule to a 4 percent tax-exempt bond property utilizing the average income set-aside, the 70 percent and 80 percent AMI units would not be considered “rent restricted,” under IRC Section 142. For example, if a 40 percent AMI unit is over income and a 70 percent AMI unit becomes vacant, IRC Section 142 would require the owner to rent the next available unit to a household with an AMI of 60 percent or less. The rules for PABs will view the 70 percent AMI unit as a market rate unit and the next available unit would have to be rent restricted (i.e., rented to a household at 60 percent AMI or less), since the over-income unit is rent restricted, under IRC section 142. Over time, it is possible that many of the 70 percent and 80 percent AMI units in a 4 percent tax-exempt bond property could become 60 percent AMI units, if rent restricted units continue to go over income.