December 01, 2020
Community Development Finance Law Alert
Author(s): Forrest David Milder
In 2018, “income averaging” was added to the LIHTC Code provisions, and the IRS has now issued proposed regulations. This alert discusses the proposed rules, with illustrations, and then explains some of the concerns that have been voiced in the housing industry.
The minimum set-aside requirement. For most of the history of the section 42 low-income housing tax credit (“LIHTC”), there have been two tests with respect to the “minimum set aside.” These are the “20-50 test,” pursuant to which at least 20% of the residential units in a project must be both rent restricted and occupied by tenants whose gross income is 50% or less of area medium gross income (“AMGI”), and the "40-60 test," under which at least 40% of the residential units must be both rent restricted and occupied by tenants whose gross income is 60% or less of AMGI. These are often referred to as “cliff tests,” because if a project fails the minimum set aside, then it doesn’t qualify for any credits. In other word, the project has “fallen off a cliff.” Of course, once the minimum set aside is met, the actual tax credit computation is based on the building’s “qualified basis,” that is, its eligible basis multiplied by the ratio of low-income units to total units in the building.
Income averaging becomes law in 2018. The Consolidated Appropriations Act of 2018 (“2018 Act”) added a third minimum set aside test, often referred to as “income averaging.” It should be noted that the Internal Revenue Service (“IRS”) refers to this as the “average income test.”
How does income averaging work? Pursuant to income averaging, an LIHTC project can designate units that are a mix of unit percentages, ranging from 20% to 80% of AMGI, and count all of them toward meeting the 40-60 minimum set aside requirements, provided (A) the average of these imputed income limitations does not exceed 60%, and (B) 40% or more of the units in the project are both rent restricted and occupied by tenants whose income does not exceed the imputed income limitation provided.
Example: Assume a project has ten 40% units, ten 60% units, five 80% units, and 10 market-rate units, all of equal size. The average percentage for the low-income units is 10 times 40% plus 10 times 60% plus 5 times 80%, divided by 25, or 56%, which is below 60%, and therefore meets the set aside, while the fraction for computing the building’s applicable basis is 25 low-income units divided by 35 total units, or 71.4%.
Following adoption of the 2018 Act, the LIHTC community has sought guidance from the IRS on how some of these rules should be applied. In the absence of IRS guidance, some intrepid project sponsors, and their corresponding state agencies, have endeavored to fashion rules that they believe comply with the statutory requirements. Of course, they didn’t know if the IRS would agree.
The proposed regulations. The IRS has now published proposed regulations, which interpret the income averaging provisions. Presented with a complex statutory regime, the IRS has made a thoughtful and practical response. As proposed regulations, they are not yet considered law, but they do represent the IRS’s view of how the law should be applied, and they merit close review. Still, some of the rules have drawn fire and the IRS is accepting comments, on a pretty quick timetable; comments are due by December 29, 2020.
Here are the basic rules:
Examples. A couple of examples will help illustrate the new rules. To illustrate the proposed rules, we’ll assume a small 7-unit building. We discuss larger projects below. Assume that we have a project that consists of two 40% units, two 60% units, two 80% units, and one fair market value unit.
Suppose that one of the 40% units becomes uninhabitable. On these facts, the average income test would be failed, because the remaining designated units would average out to 64%, i.e., (40+60+60+80+80/5).
To bring the project back into compliance, the fair market value unit could be designated as a 40% unit in order to replace the one that was no longer habitable. However, remember that this option is only available if the fair market value unit is either vacant or occupied by someone who already meets the 40% requirement. It would not be possible to simply remove the 40% unit from the mix, because this would leave us at 64%, as I described above. So, the only other alternative would be to remove a matching 80% unit. As a result, the project would now be back at the 60% level, i.e., (40+60+60+80/4).
Criticism of the removed unit concept. The removed unit concept has been subject to criticism. Some conclude that once the project has designated units, which together pass the 60% test, the Internal Revenue Code does not require that the project (as a project) continue to meet the averaging test in subsequent years; they see the test as only requiring that each individual unit be designated at a particular percentage, and then that unit must meet the percentage that has been so designated. If a unit fails to meet its percentage, be it 20% or 80% or anything in between, then only that unit would be backed out of tax credit basis. Thus, when a 40% unit is removed from the mix for failing to comply with the LIHTC requirements, critics of the proposed regulations contend that this should be the extent of the impact, and removal of a corresponding 80% unit is beyond the statutory requirement.
A particular source of concern arises when income averaging is compared with a “traditional” 40-60 project. A traditional 40-60 project that is (for example) 100% low income), can lose many units to disqualification before it “falls off the cliff” by dipping below the 40-60 requirements. In comparison, an income averaging project that is 100% affordable will have to take affirmative steps right away, depending on how close its average percentage is to 60 of AMGI.
Example. Project 1 has five equally sized units, and a total eligible basis of $1 million. All five are at 60% of AMGI, and it uses the “traditional” 40-60 set aside. If unit 1 goes out of service, the applicable fraction falls to 80%, and its applicable basis falls to $800,000.
Project 2 also has five equally sized units, and total eligible basis of $1 million. Project 2 uses income averaging, with two units designated 40%, one designated 60%, and two designated 80%. If a 40% unit goes out of service, then the remaining units are at 65% (40+60+80+80/4), and therefore, the minimum set aside test is not met. Accordingly, further steps must be taken.
The mitigation strategy in the proposed regulations would likely call for an 80% unit to be removed as well as the nonqualified unit, bringing the project back into compliance at 60% (40+60+80/3), but reducing the applicable basis by two units to $600,000.
Now, suppose a second 40% unit goes out of service in each project. Then, Project 1 would still have 3 of 5 units in service, and an applicable basis of $600,000. However, Project 2 would lose not just the two nonqualifying 40% units, but also the two removed 80% units. As a result, Project 2 would “fall off the cliff,” since now the project would only have 1 out of 5, or 20% qualifying units, failing the minimum set aside requirement.
As the example illustrates, the removed unit solution is most problematic when there are a relatively small number of units in the project. If, instead of 5 units, a project had 50 units, then it could have 15 nonqualifying 40% units, plus another 15 removed 80% units and still pass the minimum set aside (because 50 less 30 is 20, and 20/50 is 40%). Furthermore, with a larger project, it is possible to have a “buffer”—have enough below 60% units so that it is not necessary to remove any of the above 60% units, even if one or more below 60% units should become unqualified.
Example. Project 3 has 100 units. 40 are at 40%, 30 are at 60%, and 30 are at 80%. Using income averaging, this passes the minimum set aside at 58% ((40x40)+(30x60)+(30x80)/100). If eight of the 40% units became unqualified, the project would still qualify at 59.6% ((32x40)+(30x60)+(30x80)/92), and all of the 80% units could still be included in computing qualified basis.
The bottom line is that we expect the IRS to receive comments on the proposed regulations asking for it to eliminate the removed unit concept, and it remains to be seen how it will respond.
Other Issues. There are other issues in the proposed regulations that are likely to generate comments as well:
Giving comments to the IRS. The IRS has set December 29 as the due date for submitting comments. These can be submitted here, indicating IRS and REG-104591-18 in the comments. We are participating in submissions; let us know if you would like our assistance in submitting a comment.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.