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November 2, 2020

IRS releases proposed regulations on implementing average income test for low-income housing tax credits

The IRS and Treasury Department, in proposed regulations (REG-119890-18), address how low-income housing project owners should implement the average income set-aside test to qualify for the IRC Section 42 credit. In particular, the proposed regulations would update the "next available unit rule" under the average income test and allow mitigation actions to prevent the owners from failing to qualify under this test if one residential unit no longer complies with the IRC Section 42 requirements.


For residential units to qualify as a low-income housing project, a certain percentage must be rent-restricted and occupied by low-income tenants. Previously, the tenants' gross income had to be at or below a certain percentage of the area median gross income (AGI) under one of two minimum set-aside requirements defined in IRC Section 42(g). The Consolidated Appropriations Act of 2018 (Pub. L. No. 115-141)(2018 Act) added a third minimum set-aside test, the average income test. Revenue Ruling 2020-04 clarified how to calculate income limits under this test (see Tax Alert 2020-0280).

Before the 2018 Act, owners had the option of choosing between (1) the 20-50 test (at least 20% of the residential units in the project must be both rent-restricted and occupied by tenants whose gross income is 50% or less of AGI), or (2) the 40-60 test (at least 40% of the residential units in the project must be both rent-restricted and occupied by tenants whose gross income is 60% or less of AGI).

The 2018 Act added the average income test under IRC Section 42(g)(1)(C). That test, if used, requires:

  • At least 40% (25% or more if the project is in a high-cost housing area) of the residential units in the project to be both rent-restricted and occupied by tenants whose income does not exceed the imputed income limitation designated by the owner for the respective unit
  • The designated imputed income limitation of any unit to be 20%, 30%, 40%, 50%, 60%, 70%, or 80% of AGI
  • The average of the designated imputed income limitations not to exceed 60% of AGI

Under the original two tests, a unit ceases to be a low-income unit if (1) the tenant's income increases above 140% of the imputed income limitation applicable to the unit and (2) a new tenant, whose income exceeds the applicable income limitation, occupies any residential unit in the building of a comparable or smaller size (next-available-unit rule). Under the average income test, the first condition is met if the tenant's income increases above 140% of the greater of (1) 60% of AMGI or (2) the imputed income limitation designated by the owner for the unit.

Next-available-unit rule

The proposed regulations would amend Treas. Reg. Section 1.42-15 to update the next-available-unit rule for the average income test. Owners using this test would not need to comply with the next-available-unit rule in a specific order, if multiple units fail the low-income requirements at the same time in a project that has a mix of low-income and market-rate units. "Instead, 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," according to the Preamble.

Designating imputed income limitations

The proposed regulations would specify that owners should designate the imputed income limitations of units in accordance with both IRS and state and local housing agency procedures. In addition, the initial designation of all the units taken into account for the average income test must be completed by the close of the first tax year of the credit period. After that, owners cannot make changes to the designated imputed income limitations.

Mitigating actions

Under the 20-50 or 40-60 set-aside tests, the failure of one unit to meet the low-income requirements does not necessarily jeopardize the qualification of the entire project, even if that failure results in a recapture of tax credits. Under the average income set-aside test, however, a non-qualifying unit with a designated imputed income limitation that is less than 60% of AGI would bring down the project's average, potentially causing the entire project to fail and a large recapture of tax credits.

The proposed regulations would allow owners using the average income set-aside test to avoid disqualifying the project by taking mitigating action within 60 days of the close of the year for which the project might fail. If these mitigation actions are taken within the appropriate time period, the project would be treated as having satisfied the average income test at the close of the immediately preceding year.

The proposed regulations specify two alternative mitigating actions: (1) Convert one or more market-rate units to low-income units (where that unit was vacant or occupied by a tenant who qualifies under the low-income and imputed income limitation requirements); or (2) Identify one or more low-income units as "removed" units under IRC Section 42 (a removed unit can be designated as such in accordance with certain IRS and/or state and local housing agency procedures and is not included in the average income computation).

The IRS requested comments on an alternative mitigating approach that would allow the owner to redesignate the imputed income limitation of a low-income unit to return the average to a maximum of 60% of AGI, if the average income test rose above 60% of AGI as of the close of the tax year. If the redesignation causes a low-income unit to fail to qualify, the owner would be required to apply the next-available-unit rule applicable to the average income test.


The proposed regulations should help with the adoption of so-called income averaging projects. It lays out clear rules for how to manage the next available unit when there are multiple income thresholds. The proposed regulations also provide for two reasonable mitigation actions to be taken up to 60 days after year-end to avoid failing the minimum set-aside requirement during the previous year.

Giving the owner a reasonable time after the end of the year to identify and mitigate the issue lessens the risk of non-compliance. Nonetheless, projects that employ income averaging are subject to significantly more complex compliance hurdles than those projects employing either the 20-50 or 40-60 set-aside rules. It will be incumbent upon asset managers and compliance professionals to proactively monitor this as opposed to waiting until the end of the year and applying the mitigation factors.


Contact Information
For additional information concerning this Alert, please contact:
Tax Credit Investment Advisory Services Group
   • Michael Bernier (
   • Renee Ibarra (