On October 30, the IRS published a Notice of Proposed Rulemaking in the Federal Register. This Notice concerns the LIHTC Average Income Test and outlines the current intention of the IRS with regard to certain rules governing the Average Income (AI) test.
Written comments regarding the proposed rules must be received at the IRS no later than December 29, 2020.
Section 42(g)(1)(C)(i) enunciates the requirement of the AI set-aside, stating that a project meets the minimum requirements of the average income test if 40 percent or more (25 percent in New York City) of the residential units in the project are both rent-restricted and occupied by tenants whose income does not exceed the imputed income limitation designated by the owner with respect to the respective unit. The owner must designate the imputed income limitation for each unit and the designated imputed income limitation of any unit must be 20, 30, 40, 50, 60, 70, or 80 percent of AMGI. The Code provides that the average of the imputed income limitations designated by the taxpayer (i.e., owner) for each unit must not exceed 60 percent of AMGI.
Section 42(g)(2)(D)(iii) was added to the Code to provide a new next available unit (NAU) rule for situations in which the owner has elected the AI test. Under this new NAU rule, a unit ceases to be a low-income unit if two conditions are met: (1) the income of an occupant of a low-income unit increases above 140% of the greater of (i) 60% of AMGI, or (ii) the imputed income limitation designated by the owner with respect to the unit; and (2) any other residential rental unit in the building that is of a size comparable to, or smaller than, that unit is occupied by a new tenant whose income exceeds the applicable imputed income limitation. If the new tenant occupies a unit that was taken into account as a low-income unit prior to becoming vacant, the applicable imputed income limitation is the limitation designated with respect to the unit. If the new tenant occupies a market-rate unit, the applicable imputed income limitation is the limitation that would have to be designated with respect to the unit in order for the project to continue to maintain an average of the designations of 60% of AMGI or lower.
Under §42(g), once a taxpayer elects to use a particular set-aside test with respect to a low-income housing project, that election is irrevocable. Thus, if a taxpayer had previously elected to use the 20/50 or 40/60 test, the taxpayer may not subsequently elect to use the AI test.
Explanation of Provisions
- Proposed §1.42-15, Next Available Unit Rule for the Average Income Test
- The proposed regulations update the NAU provisions in §1.42.15. In situations where multiple units are over-income at the same time in an AI project that has a mix of low-income and market-rate units, these regulations provide that the owner need not comply with the NAU rule in a specific order. Renting any available comparable or smaller vacant unit to a qualified tenant maintains the status of all over-income units as low-income units until the next comparable or smaller unit becomes available. E.g., in a 20-unit building with nine low-income units (three units at 80% of AMGI, two units at 70% of AMGI, one unit at 40% of AMGI, and three units at 80% of AMGI), if there are two over-income units, one a 30% income three-bedroom unit and another a 70% two-bedroom unit, and the NAU is a vacant two-bedroom market-rate unit, renting the vacant two-bedroom unit to occupants at either the 30 or 70 percent income limitation would satisfy both the minimum set-aside of 40% and the average test of 60% or lower. This will be the case even if the 30% unit was the first unit to exceed the 140% income level.
- Proposed §1.42-19, Average Income Test
- Designation of Imputed Income Limitations: The proposed regulations provide that a taxpayer must designate the imputed income limitation of each unit taken into account under the AI test in accordance with (1) any procedures established by the IRS; and (2) any procedures established by the Agency that has jurisdiction over the LIHTC project that contains the units to be designated, to the extent that those Agency procedures are consistent with any IRS guidance and the proposed regulations. The IRS does agree that Agencies should generally be able to establish designation procedures that accommodate their needs. Agencies will be permitted to require income recertifications, set compliance testing periods, and adjust compliance monitoring fees to reflect the additional costs associated with monitoring the AI test.
- Method and Timing of Unit Designation
- Designation of the AI limitation with respect to a unit is, first, for Agencies to evaluate the proper mix of units in a project in making housing credit dollar amount allocations consistent with the state policies and procedures set forth in the QAP, and second, to carry out their compliance-monitoring responsibilities.
- The proposed regulation requires that taxpayers designate the units in accordance with the Agency procedures relating to such designations, provide that the Agency procedures are consistent with any requirements and procedures relating to unit designation that the IRS may require.
- The proposed regulations provide that the taxpayer must complete the initial designation of all the units included in the AI test as of the close of the first taxable year of the credit period.
- The proposed regulations provide that no change to the designated income limitations may be made. Based on this, it does not appear that the “floating” of units would be permitted. This will be problematic from a project operational standpoint and should be objected to in comments submitted to the IRS.
- Requirement to Maintain 60 Percent AMGI Average Test and Opportunity to Take Mitigating Actions
- For a project electing the AI test, in addition to the project containing at least 40% low-income units, the designated imputed income limitations of the project must meet the requirement of an average test. That is, the average of the designated imputed income limitations of all low-income units (including units in excess of the minimum 40% set-aside) must be 60 percent of AMGI or lower. Residential units that are not included in the computation of the average (i.e., market units) do not count as low-income units. Accordingly, in each taxable year, the average of all the designations must be 60% of AMGI or lower.
- In some situations, the AI requirement may magnify the adverse consequences of a single unit’s failure to maintain its status as a low-income unit (this is a reference to the “cliff test” fear). Assume, for example, a 100% low-income project in which a single unit is taken out of service. Under the 20/50 or 40/60 set-asides, the project remains a qualified low-income housing project even though the reduction in qualified basis may trigger a corresponding amount of recapture. However, under the AI set-aside, if the failing unit has a designated imputed income limitation that is 60% or less of AMGI, the average of the limitations without that unit may now be more than 60%. In the absence of some relief provision under the AI test, the entire project would fail, and the taxpayer would experience a large recapture.
- Because there is no indication that Congress intended such a stark disparity between the AI set-aside and the existing 20/50 and 40/60 set-asides, the proposed regulations provide for certain mitigating actions. If the taxpayer takes a mitigating action within 60 days of the close of a year for which the AI test might be violated, to taxpayer avoids total disqualification of the project and significantly reduces the amount of recapture.
- Results Following an Opportunity to Take Mitigating Actions
- The proposed regulations provide that, after any mitigating actions, if, prior to the end of the 60th day following the year in which the project would otherwise fail the 60% test, the project satisfies all other requirements to be a qualified low-income housing project, then as a result of the mitigating action, the project is treated as having satisfied the 60% or lower average test at the close of the immediately preceding year. However, if no mitigating actions are taken, the project fails to be a qualified low-income housing project as of the close of the year in which the project fails the AI test.
- Descriptions of Mitigating Actions
- The proposed regulations provide for two possible mitigating actions: (1) the taxpayer may convert one or more market-rate units to low-income units. Immediately prior to becoming a low-income unit, that unit must be vacant or occupied by a tenant who qualifies for residence in a low-income unit (or units) and whose income is not greater than the new imputed income limitation of that unit (or units); or (2) the taxpayer may identify one or more low-income units as “removed” units. A unit may be a removed unit only if it complies with all the requirements of Section 42 to be a low-income unit. If the taxpayer elects to identify a low-income unit as a removed unit, the designated imputed income limitation of the unit is not changed.
- Tax Treatment of Removed Units
- A removed unit is not included in computing the average of the imputed income limitations of the low-income units under the 60% or lower AI test. If the absence of one or more removed units from the computation causes fewer than 40% (or 25% in New York City) of the residential units to be taken into account in computing the average, the project fails to be a qualified low-income housing project. I.e., the project fails the minimum set-aside test. Also, a removed unit is not treated as a low-income unit for purposes of credit calculation. However, a removed unit will not be subject to recapture (unless the removal of the unit results in a failure to meet the minimum set-aside).
- Request for Comments on an Alternative Mitigating Action Approach
- This is the one area of the proposed regulation for which the IRS is especially interested in receiving comments. The alternative being proposed by the IRS is that, in the event that the average test rises above 60% of AMGI as of the close of a taxable year, due to a low-income unit or units ceasing to be treated as a low-income unit or units, the owner may take the mitigating action of redesignating the imputed income limit of a low-income unit to return the average test to 60% of AMGI or lower. If under this approach, a redesignation causes a low-income unit to exceed 140% of the applicable income limit, the NAU would apply.
Proposed Applicability Date
The amendments to the NAU regulation (1.42-15) are proposed to apply to occupancy beginning 60 or more days after the date the regulations are published as final regulations. The AI test regulations (1.42-19) are proposed to apply to taxable years beginning after the date the regulations are published as final regulations. However, taxpayers may rely on these proposed regulations relating to the NAU rule for occupancy beginning after October 30, 2020, and on or before 60 days after the date, the regulations are published as a final regulation. Taxpayers may also rely on the AI test proposed regulations for taxable years beginning after October 30, 2020, and on or before the date those regulations are published as final regulations.
These proposed regulations do provide some clarity relating to the Available Unit Rule and assist in our understanding that the IRS does not believe a project should lose all credit due to the failure of one unit as a low-income unit (unless the minimum set-aside is not met). However, a significant problem with the proposed regulation is that designations, once set, cannot be changed. The industry will certainly be objecting to this provision during the 60-day comment period. There is one other area on which clarity should be sought. All the mitigation examples in the proposed regulation include a case where a unit is lost due to no longer being suitable for occupancy. Left unanswered is what happens if a low-income unit is occupied by an ineligible household. Does the fact that the owner designation for the unit still results in the 60% AI test being met keep the property in compliance with the 60% test result in the loss of only that one unit with no requirement for mitigation measures? Or, would this unit also no longer be considered a low-income unit for purposes of the 60% average? Also, what if the issue that would remove a unit from the low-income count occurs in one year, is not discovered by the owner, and is discovered by the State Agency during a review that occurs more than 60 days after the end of the tax year in which the event occurred? While this could not happen in the case of a habitability issue, it could certainly occur relative to resident eligibility. Comments seeking clarity on the circumstances under which a unit may no longer be counted toward the 60% average are a certainty. Until this issue is clarified, the safest course of action for owners will be to follow the mitigation alternatives outlined in the proposed regulation in any case where a low-income unit is either not in service or rented to an ineligible household.
It is recommended that all LIHTC industry participants review the proposed regulations and make comments to the IRS by the deadline date of December 29, 2020.