On October 30, 2020, the U.S. Internal Revenue Service (IRS) and the Treasury Department released proposed regulations relating to the “average income test” for purposes of the low-income housing tax credit under Section 42 of the Internal Revenue Code. The proposed regulations provide helpful guidance with respect to the implementation of the average income test and create narrow forms of administrative relief that will help in mitigating some of the risks associated with the average income test.
- For a residential rental project to be eligible for low-income housing tax credits, the project must, among other things, satisfy a minimum “set-aside” requirement at all relevant times. Under the minimum set-aside requirement, a portion of the residential units in the project must remain rent-restricted and occupied by tenants whose income is equal to or less than a specified percentage of area median gross income. Prior to 2018, there were two alternative ways to satisfy the minimum set-aside requirement (the so-called “20-50” and “40-60” tests).
- In 2018, Congress added the average income test as a third way to satisfy the minimum set-aside requirement. The average income test requires that 40% (25% in New York City) of the residential units in the project be rent-restricted and occupied by tenants meeting an “imputed income limitation.” To satisfy the average income test, the taxpayer must designate an income limitation for each low-income unit—between 20% and 80% of area median income, in 10% increments—and the average of such limitations must not exceed 60% of area median income.
Guidance Under the Proposed Regulations
The proposed regulations provide guidance on a project’s initial satisfaction of the average income test as well as certain aspects of the project’s ongoing compliance with the test.
- Designation of Units: Under the proposed regulations, the task of delineating a process for the designation of income limitations is largely delegated to the state credit agencies that administer the low-income housing tax credit program in their respective states. The proposed regulations do, however, require the taxpayer to make the designations by the end of the first taxable year of the credit period for the project.
- Mitigation in the Event of Noncompliance: Projects using the average income test have a heightened risk of failing the minimum set-aside requirement in a given year. This is because even if all of the units in the project are initially set aside for qualifying tenants, a single unit falling out of compliance could, under certain circumstances, cause the average income limitation of the remaining compliant units to exceed 60% of area median income, thereby causing the project as a whole to fail the average income test and, as a result, the minimum set-aside requirement. Absent some form of relief, such a failure would cause the project as a whole to be ineligible for low-income housing tax credits.
- Recognizing this risk, the proposed regulations allow for two kinds of “mitigating actions” to address noncompliant units. In all cases, mitigating actions must be taken within 60 days of the end of the year of noncompliance. Noncompliance discovered after this deadline could not be cured through the proposed mitigating actions.
- The first mitigating action would involve converting certain market-rate units into low-income units. The use of this mitigating action could avoid a loss of low-income housing tax credits, but its applicability requires that eligible market-rate units be available for conversion.
- The second mitigating action would involve “removing” other compliant low-income units from the project’s “applicable fraction,” which could reduce the amount of low-income housing tax credits that the project is entitled to claim.
- The proposed regulations also request comments on a potential third type of mitigation that would involve “redesignating” the income limitation of low-income units.
- Application of the Next Available Unit Rule: An increase in the income of an initially-compliant tenant generally will not disqualify a unit for purposes of the average income test, so long as the next available unit in the project is leased to a tenant meeting either (i) the applicable income limitation for such available unit or, (ii) in the case of a market-rate unit, the limitation that would permit the project to maintain an average income limitation of no more than 60% of area median income.
- The proposed regulations provide that a taxpayer need not comply with this next available unit rule in any specific order. For example, if a 30% unit and a 70% unit are both occupied by tenants whose income has begun to exceed the relevant income limitation, the next available unit may be leased to either a 30% or 70% tenant and still comply with the next available unit rule.
Effective Date and Reliance
The designation and mitigation provisions of the proposed regulations would apply for taxable years beginning after the date final regulations are published, and the next available unit rule provisions would apply to occupancy beginning at least 60 days after such date, but taxpayers generally may rely on the proposed regulations until then.
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