The LIHTC program requires that in order for credits to be claimed, low-income projects and units must be suitable for occupancy under regulations prescribed by the Secretary of the Treasury. Units that are not suitable for occupancy on the last day of the taxable year may not be included as low-income units in a building’s applicable fraction. The IRS recently provided an example of how a reduction in the applicable fraction as a result of a habitability issue can impact a buildings credits; I believe it is instructive for all those involved in the operation of tax credit projects to relay that IRS example.
Assume a 100% low-income building with ten residential units. At the end of the year, three of the ten units are not suitable for occupancy. Using the Unit Fraction calculation, the Applicable Fraction is 70% (7÷10). Since the Applicable Fraction of a building is the lesser of the Unit Fraction or the Floor Space Fraction, the affected square footage must also be examined. Assume the building contains five units of 1,000 square feet each and five units with 1,200 square feet each, for a total of 11,000 square feet. All three out of compliance units were units with 1,200 square feet. The building has now lost 3,600 square feet of low-income space leaving 7,400 low-income square feet. 7,400÷11,000=.6727, so the Floor Space Fraction is 67%; this is the buildings new Applicable Fraction – at least for that year.
Suppose the eligible basis of the building is $833,333 with 9% credits. This means the annual credit for the building is $75,000 (833,333 X1.00 X .90). When the Applicable Fraction is reduced to 67%, the calculation is now as follows:
Eligible Basis: $833,333 time Applicable Fraction of 67% = qualified basis of $558,333. This qualified basis times the 9% tax credit = annual credits of $50,250, resulting in a credit reduction for that tax year of $24,750.
Now, here is where it gets ugly. Because the qualified basis is less than it was at the end of the prior tax year, the recapture provisions of §42(j) are applied. Suppose this was the sixth year of the compliance period. The recapture rate is .333; $24,750 X .333 = $8,241; this is the amount that must be paid back for each of the first five years of the compliance period, or $41,205. This amount, plus interest, must be paid back. When the interest is added, the total due the IRS would be $50,461; all this just because management failed to make three units suitable for occupancy by the end of the year.
The IRS continues to make it clear that units that are vacant and not turned to be made market ready are not eligible for credits. Hopefully, this example will serve notice that the penalty for failing to turn units can be severe – so, no matter how long a unit may be vacant, turn it and get it market ready. Failing to do so can have severe consequences.