Documents Critical to the IRS Section 42 Audit Process

DDespite a recent increase in IRS audit activity relating to Low-Income Housing Tax Credit (LIHTC) projects, audits of such projects remain relatively rare. However, such audits do occur, and owners should ensure that record retention protocols include the documents that are likely to be part of any IRS audit.

If the IRS selects a LIHTC property or owner for audit, the initial step will usually be a notice by mail to the property owner. This notice will request documents to be made available for the audit. This request is known as an Information Document Request (IDR) and is issued on IRS Form 4564.

The IRS has broad authority when requesting documents. IRC §7601 empowers IRS employees to “inquire after and concerning all persons who may be liable for any internal revenue tax.” IRC §7602 authorizes the IRS to examine any books, materials, data, or papers that may be relevant.

Owners should be aware of and familiar with the forms that the IRS will review as part of a Section 42 audit.

Owner-Submitted IRS Forms

In addition to the forms submitted annually when claiming the credits, owners are required to submit a one-time “First-Year Certification” on IRS Form 8609. This form identifies specific information needed for program administration and documents specific elections that will govern how the site is operated.

Form 8609

Part I of the 8609 is completed by the allocating agency. It documents approval of the building (every building receives a separate 8609) and shows the maximum annual credit that may be claimed on the building.

Part II of the form is completed by the owner and specifies a number of elements critical to operating the building. Owners are not entitled to credits until Part II has been completed and sent to the IRS. Housing Finance Agencies (HFAs) are often slow in issuing 8609s and owners may be tempted to claim credit prior to receipt of the 8609. The IRS takes his very seriously and may believe that an owner is fraudulently claiming the credit. If an owner cannot provide a reasonable explanation for an early claiming of credits, the IRS may disallow and/or recapture credits.

The Form 8609 is only submitted for the first year of the credit period.

Form 8609-A

This form is sent to the IRS for each year of the 15-year compliance period. The form is submitted for each building and is a complement to the 8609. It is this form that shows the amount of credit for a building each year.

Form 8586

This form summarizes key information from the Forms 8609-A and is filed with the IRS for each year that credits are claimed. This form shows the amount of credit claimed for the entire project during that year (the 8609-A forms show credit for each building).

Form 8823

This form is submitted by the HFA to the IRS whenever an HFA discovers noncompliance or an owner disposes of a property through sale, foreclosure, or destruction. An uncorrected 8823 is a major trigger to potential IRS audit activity.

General Recordkeeping & Retention Requirements

26 CFR Part I – 1.42-5(b) specifies owner recordkeeping and retention requirements for the Section 42 program. In addition to the retention of site records, owners must also provide annual reports to the HFA. At a minimum, the following records are required:

  • Records for each qualified low-income resident by building and unit for the entire 15-year compliance period;
  • Copies of tenant files;
  • Records regarding the use of facilities included in the project’s eligible basis;
  • Records for the first year of the credit period must be retained for at least six years after the due date of the tax return for the last year of the compliance period. These are known as “21-year files.”
  • All other records should be retained for at least six years after the due date for filing of the tax return for that year.

Initial Information Document Request (IDR)

The first document request is likely to ask for the following:

  • General Information
    • Partnership Agreement;
    • Prospectus/Offering Memorandum related to the organization or syndication of the partnership;
    • Documentation of the partners’ capital contributions and current balance;
    • Credit Allocation Application;
    • Market Study;
    • Credit Allocation Award or Carryover Allocation;
    • Extended Use Agreement;
    • All Forms 8609 issued to the owner; and
    • Internal Audit reports.
  • Tax Returns
    • Copies of tax returns for the tax year prior to the earliest year under audit, and all tax returns for years after the tax years under audit;
    • Trial balance and any work papers used to prepare the tax return under audit; and
    • Depreciation schedules.
  • Eligible Basis
    • Final cost certification submitted to the HFA with supporting documentation;
    • Documentation of all financing sources;
    • Development contracts or agreements; and
    • Documentation of cost allocations between land, nonqualifying land improvements, and depreciable residential rental property included in eligible basis.
  • Low-Income Households
    • For the years under audit, rent rolls identifying the households and family size for each low-income unit; and
    • Documentation of internal controls in place to ensure that income-qualified households occupy the low-income units.
  • First and 11th Year of the Compliance Period
    • If the first year of the compliance period is audited, the specific rule for computing the applicable fraction under §42(f)(2) is used. The owner will be requested to provide:
      • Certificates of occupancy;
      • A schedule showing when each low-income unit was first occupied by an income-qualified household; and
      • Computation of the first-year applicable fraction, including the computation of the applicable fraction on a monthly basis.
    • If the 11th year of the compliance period is audited and the owner has claimed credit in that year, the owner will be asked for the information noted above as well as a copy of tax documents for the first year of the credit period.
  • Additions to Qualified Basis
    • A list of units first occupied by qualifying tenants after the end of the first year of the compliance period, identifying when a qualifying household first occupied the unit; or
    • Confirmation that all units were occupied by qualified households by the end of the first year of the credit period.
  • Rents & Other Sources of Income or Funds
    • Description of residential rental units including total number of units, total number of low-income units, size (bedrooms), and rents charged for low-income and market units;
    • Documentation that rents are properly restricted;
    • Sources of rent subsidies;
    • Documentation for the computation of any utility allowances;
    • Fees for services provided to tenants in addition to housing;
    • Other income from related activities such as vending machines, laundry facilities, etc.;
    • Other income from sources such as commercial use of a portion of the property; and
    • Documentation of funds received from other sources such as federal grants or subsidies received during the year, additional capital contributions, or loan proceeds.
  • Noncompliance
    • If the audit was triggered by receipt of 8823s, the owner will be asked to document corrective actions taken.
  • Dispositions
    • If the site was sold, the IRS will request documentation regarding the sale. These documents will include:
      • Sales contract;
      • Settlement documents;
      • Computation of capital gain/loss;
      • How the gain/loss was distributed among the partners; and
      • Whether the sale required the new owner to operate the site as a qualified low-income project for the remainder of the 15-year compliance period.

Every owner of a LIHTC project should have a system in place for retaining records required by the Internal Revenue Code. The items noted above will form the core of the documents to be retained and protected.