IRS Publishes Proposed Regulations for the Average Income Minimum Set Aside Election
On Friday, October 30th, the IRS published proposed regulations related to the Average Income Minimum Set Aside Test under the LIHTC Program.
The IRS is proposing changes (click here to read full proposed regulation) to Treasury Regulation 1.42-15, which speaks to the Next Available Unit Rule, and is proposing anew Treasury Regulation, 1.42-19, which speaks to Unit Designations and addressing non-compliance for projects with the Average Income Minimum Set Aside Election.
Treas. Reg. 1.42-15 Next Available Unit Rule
When the Average Income Minimum Set Aside option was added to Section 42(g)(1)(C)(iii) of the Internal Revenue Code in 2018, text was also added to 42(g)(2)(D) to provide the requirements related to meeting the next available unit rule for projects that have elected the Average Income Set Aside Election.
42(g)(2)(D)(iii) essentially states that for Average Income Set Aside projects, a household is considered over-income if the household exceeds the greater of:
- 140% of the 60% Income limit or
- 140% of the income limit designated to the unit (70% or 80%)
42(g)(2)(D)(v) provides that low-income units will not be affected by the Next Available Unit Rule, as such units will continue to be rented to households who meet the income limit designated to the unit.
What was not made expressly clear in the text of 42(g)(2)(D) is what action should be taken to meet the Next Available Unit Rule in the event a building has more than one low-income unit that is over-income—the proposed update to Treas. Reg. 1.42-15 clarifies that the Next Available Unit Rule does not need to be complied with in any specific order.
In a nutshell, if a building has two low-income units that are over-income, a 30% unit, and a 70% unit, the next available unit could be rented to a household that qualifies at 30% or 70%. Assuming that the next available unit was rented to a household qualifying at 70%, the next available unit would then need to be rented to a household qualifying at 30%.
Treas. Reg. 1.42-19 Average Income
These new proposed regulations clarify the requirements regarding Unit Designations and also addresses “Mitigating Actions” that, if taken timely, can eliminate the negative impact of an out-of-compliance unit on the projects minimum set aside.
Some key takeaways regarding 1.42-19
- Unit Designations must be made in accordance with the Housing Finance Agency’s procedures and prior to the last day of the first year of the credit period.
- Unit Designations cannot be changed after initially designated.
- A single out-of-compliance unit could cause a 100% project to fail the minimum set-aside unless mitigating action is taken within 60 days after the end of the owner’s taxable year.
- Defines “Mitigating Actions” as the conversion of a market-rate unit or the removal of units from minimum set aside computation.
- The income limit designation for out-of-compliance units and “removed units” are excluded when determining whether the Minimum Aside is initially met and continues to be met and are excluded when determining the building’s applicable fraction.
There have been two interpretations regarding non-compliance with the Average Income Test floating around in the industry since the Average Income election was made an option in 2018. The proposed regulations fall in line with interpretation 2 discussed below.
Out-of-Compliance Units- Designations INCLUDED in the 60% Average Income Test
One interpretation is that a project continues to meet the minimum set-aside if 40% or more of the units are rent-restricted and occupied by households whose income does not exceed the income limitation originally designated to the units.
Meaning, after the initial test is met, if a unit is determined to be out of compliance, the designation of the out-of-compliance unit is still included when determining whether the project meets the 60% average income test.
However, the out-of-compliance units would be excluded as qualified low-income units when determining whether the 40% occupancy test has been met and would also be excluded from the applicable fraction.
In the example below, the project one out-of-compliance unit.
Under this interpretation, there is no impact on the minimum set-aside, as the designation of the out-of-compliance unit is still include when determining if the 60% income limit test has been met; however, the out of compliance unit is not included when determining the 40% occupancy test is met and is not included as a low-income unit when determining the applicable fraction. This results in a credit loss of $4.500.
Out-of-Compliance Units – Designations EXCLUDED in the 60% Average Income test
Another interpretation, now supported by the proposed regulation, is that the Minimum Set Aside Test is considered to be met if it can be demonstrated that at least 40% of the units in the project are qualified low-income units and that the average of the income-level designations for the units included in the 40% calculation averages 60% or less.
Meaning that after the initial test is met, if a unit is determined to be out of compliance, the designation of the out-of-compliance unit is excluded when determining whether the project meets the average income test.
Additionally, the out-of-compliance units would be excluded as qualified low-income units when determining the applicable fraction.
In the example below, the project has one non-compliant unit (unit 104).
Under this interpretation, the designation of the out-of-compliance unit is excluded when determining if the 60% average income limit test has been met and is excluded when determining if the 40% occupancy test is met. Furthermore, the out-of-compliance unit is not included as a low-income unit when determining the applicable fraction. This results in a Minimum Set Aside Violation, which results in complete credit loss for the taxable year.
Based on the proposed regulations, when a project fails to meet the Average Income minimum set-aside due to an out-of-compliance unit, if an owner takes mitigating actions to restore compliance within 60 days of the close of the “failed” year, the owner avoids the complete loss of credits for that tax year.
Mitigating Actions include:
Conversion of a Market Rate Unit
This action involves converting a market-rate unit to a low-income unit. This conversion could include occupied market-rate units occupied by a household that is LIHTC eligible or a vacant market-rate unit that is rented to a LIHTC eligible household.
Removing Low-Income Units from the Average Income Computation
This action involves the income level designation removal of one or more compliant low-income units from the computation of the average income set aside to the average income limit designation to 60% or less. The unit’s status as a removed unit can be removed at any time by the project owner.
A building has 4 units; 2 units designated at 40% and 2 units designated at 80%
(40% = 40% =80% =80% =240%; 240% ÷ 4 units = 60%).
One of the 50% unit is determined to be out of compliance as of the last day of the owner’s tax year, which pushes the average income level above 60% to 66.67% (40% + 80% + 40% = 200%; 200% ÷ 3 units = 66.67%.
The owner can remove one of the 80% units from the computation, which would reduce the average income level back to 60%. (40% + 80% = 120%; 120% ÷ 2 units = 60%)
The proposed regulations state that while a removed unit would not be included as a low-income unit when determining the applicable fraction to calculate the owner’s annual credit, removed units do not trigger the recapture of previously claimed credits.
Deadline for Comments
Written (including electronic)comments must be received by December 29, 2020. You can click here to make comments on “www.regulations.gov”