October 12, 2022
Final rules modify average income test for low-income housing credits
In temporary and final regulations (TD 9967) under IRC Section 42, the IRS and Treasury Department modified the average income test for purposes of the low-income housing credit (LIHC) so the test applies to rent-restricted units collectively instead of individually. Accompanying proposed regulations (REG-113068-22) address recordkeeping and reporting requirements for the average income test for purposes of the LIHC, reflecting the temporary regulations in the final rule. Separately, the IRS extended by one year the compliance (often called placed-in-service) deadlines (Notice 2022-52) for most qualified low-income housing projects to comply with IRC Section42 requirements.
The final regulations generally apply to tax years beginning after December 31, 2022. According to the Preamble, for "[tax] years prior to the first [tax] year to which these regulations apply, taxpayers may rely on a reasonable interpretation of the statute in implementing the average income test for [tax] years to which these regulations do not apply."
For a residential building to qualify as a low-income housing project, a certain percentage of its units 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 based on average income, the so-called income averaging 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:
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.
In October 2020, the IRS and Treasury proposed regulations addressing how low-income housing project owners should implement the average income set-aside test to qualify for the IRC Section 42 credit (see Tax Alert 2020-2608). They received numerous comments and held a public hearing. The final regulations adopt the proposed regulations with some modifications.
Modify average income test
The most significant change in the final regulations is the modification of the average income test. Under the proposed regulations, a non-qualifying unit with a designated imputed income limitation that was 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. To avoid this outcome, the final regulations consider the average income test to be satisfied if at least 40% of the building's residential units are eligible to be low-income units and have designated imputed income limitations that collectively average 60% or less of AMGI.
As a result of the revisions, the mitigating actions that a taxpayer could take if the project failed the average income test in the proposed regulations are no longer necessary and have been deleted.
Allow change in unit designations
The proposed regulations did not allow unit designations to be changed for different average incomes. The final regulations allow unit designations to be changed if certain conditions are met.
Proposed regulations on recordkeeping
The IRS and Treasury also released proposed regulations (REG-113068-22) on recordkeeping and reporting requirements for the average income test for purposes of the LIHC. The proposed regulations are the same as the temporary regulations in the final regulations.
The temporary regulations require a taxpayer to separately identify (1) units in the qualified group of units used for satisfying the average income set-aside and (2) units in the qualified group for purposes of the applicable fractions. This information must be recorded in the taxpayer's books and records and sent to the applicable agency.
Compliance deadlines extended
The IRS granted additional temporary relief (Notice 2022-52) from certain requirements under IRC Section42 for qualified low-income housing projects to respond to labor and supply-chain disruptions. The Notice amplifies and modifies Notice 2022-5 (see Tax Alert 2022-0060) by extending the deadlines for the IRC Section 42(h)(1)(E)(i) placed-in-service requirement. The deadlines are extended to:
The Notice also added the following deadline:
The Notice also changed from 18 to 24 months the time for reasonable restoration of a qualifying project due to casualty loss.
Taxpayers should find the changes in the final regulations to be favorable. Previously, taxpayers had to be concerned that a single over-income unit could result in the building average being above 60%, which would cause all tax credits to be lost (due to failure to meet the 40-60 requirements). The final regulations avoid this "cliff" risk by applying a reasonable interpretation of the 40-60 test so any combination of units that results in at least 40% of the units being at or below the 60% threshold would allow the project to continue to qualify for tax credits. The rules do not, however, eliminate the potential for the loss of tax credits on any unit that does not comply with the requirements even if the project itself does not fail compliance.
We expect that this new guidance will result in taxpayers building additional units utilizing the income averaging set aside. This set aside allows taxpayers to use the rental revenue from higher income individuals (70% and 80% of AMI) to offer units to lower income individuals (20%, 30%, 40% or 50% of AMI).
The one-year extension of the placed-in-service deadline (typically one year from receipt of the carryover allocation) will help many projects that were struggling with construction delays due to labor shortages and supply chain issues. The supply chain issue is particularly detrimental in rental housing projects because the delay in certain items can result in an inability to get a certificate of occupancy, which is widely seen as a proxy for the placed-in-service requirement.