In 2017, the Tax Cuts and Jobs Act (the “Act”) added a third minimum set-aside option to qualify a project as a qualified low-income project pursuant to Code Section 42(g)(1)(C)—the Average Income Set-Aside. The Average Income Set-Aside permits the owner to designate rest-restricted units to be occupied by qualified tenants so long as the average imputed income limitation for all the low-income units is 60% or less of the area median gross income (“AMGI”). To calculate the average, the owner must designate the imputed income limitation for each low-income unit at 20%, 30%, 40%, 50%, 60%, 70% or 80% of AMGI.
The Average Income Set-Aside gave owners of tax credit projects a method for including mixed-income units and still qualifying for tax credits on those units. However, it also created some questions about the method for designating units, the consequences of failure to satisfy the required average imputed income limitation, and the next available unit rule. Proposed Treasury Regulations addressing the Average Income Set-Aside were published in the Federal Register on October 30, 2020, answering these questions. The Proposed Regulations can be found here.
Under the Proposed Regulations, State Tax Credit Agencies continue to have flexibility in determining the method of designation of the imputed income limitations consistent with the procedures set forth in the State Qualified Action Plans. The imputed income limitation designations must be made before the end of the first year of the credit period.
Failure to Meet the 60% Average
The statutory language contained in the Act raised questions regarding the effect of over-income tenants on the satisfaction of the Average Income Set-Aside. Minimum set-aside tests under Code Section 42(g) are cliff tests. If a project fails to meet the minimum set-aside, then it is not a qualified low-income project and does not qualify for tax credits. However, if a 10-unit 40-60 set-aside project is 100% low-income and one unit falls out of compliance, but the remaining nine units remain low-income units, then the project will continue to qualify as a low-income project and qualify for tax credits on the nine qualified low-income units. If a 10-unit Average Income Set-Aside project with imputed income limitation designations of three units at 40%, four units at 60% and three units at 80%, it has an average imputed income limitation of 60% and qualifies as a low-income project. If one of the 40% AMGI units falls out of compliance, then the average imputed income limitation of the remaining nine units is 62.22%, and it seemed that based on Code Section 42, the project would no longer qualify as a low-income project resulting in a large recapture event, despite 90% of the units in the project remaining rent-restricted and occupied by qualified tenants.
The proposed regulations provide for two mitigating actions that an owner may take within 60 days after the close of the year for which the project would fail the Average Income Set-Aside test in order to permit the project to continue to qualify as a low-income project and qualify for tax credits.
First, the owner may convert a market-rate unit, if any, into a low-income unit. Immediately prior to the conversion, the unit must either be vacant or occupied by a qualified tenant whose income does not exceed the imputed income limitation for that newly designated low-income unit. Second, the owner may remove one or more low-income units in order for the average of the remaining low-income units to pass the test. Removed units will not trigger recapture so long as the remaining low-income units equal at least 40% of the total units in the project. Under the Proposed Regulations, changing the imputed income limitation designations for a previously designated unit is not permitted. If the required mitigation measures are not taken by the 60th day after the end of the year in which the project would fail to satisfy the Average Income Set-Aside, then the project will not qualify for tax credits for such year, and there is recapture of the tax credits with respect to the project. The Treasury Department and IRS have specifically invited comment regarding additional mitigating measures that could be taken.
Next Available Unit Rule
As a general rule, under Code Section 42, low-income units continue to qualify as low-income units even if the tenants occupying such units have incomes that exceed the income limitations, so long as their incomes did not exceed the limitation when they first occupied the unit and so long as their incomes do not exceed 140% of AMGI. In qualified low-income projects with market-rate units, the next available unit rule requires that if there is an over-income tenant in a low-income unit, the next available unit in the project must be rented to a qualified tenant. Thus, if a market-rate unit in the project becomes vacant, it must be treated as a low-income unit and rented to a qualified tenant if any of the low-income units are occupied by tenants whose income exceed 140% of the greater of (i) 60% of AMGI or (ii) the imputed income limitation for that unit.
In a project subject to the 40-60 or 20-50 set-aside, the next available unit rule is straightforward. If a unit is over income because the tenant of such unit has an income that exceeds 140% of 60% of AMGI, then the next available unit that is of a comparable or larger size must be leased to a person whole income is at or below 60% of AMGI. In a project subject to the Average Income Set-Aside that includes market-rate and low-income units designated at different imputed income limitations, the next available unit rule is less clear. The proposed Treasury Regulations require that if the vacant unit was a low-income unit before it became vacant, then the imputed income limitation for that unit will continue to be whatever the imputed income limitation was before the unit became vacant. If the vacant unit was a market-rate unit before it became vacant, the imputed income limitation for that unit is whatever limitation is necessary in order to maintain an average of the imputed income designations of 60% of AMGI or lower. If there are multiple designated units with over-income tenants at the same time, the owner does not have to fill the vacant units in any particular order. Accordingly, if the tenants of a 30% AMGI unit and a 70% AMGI unit are both over income, the next market-rate unit that becomes available may, under the Proposed Regulations, be rented at either the 30% or 70% income limitation, provided that the project’s average imputed income limitation continues to be 60% or less of AMGI.
Reliance and Request for Comment
The Proposed Regulations give State Tax Credit Agencies and taxpayers considerable flexibility while minimizing the potential complexities of the next available unit rule. Further, the Proposed Regulations provide for an equitable method of avoiding a catastrophic recapture event by taking mitigating actions that approximate the consequences of an over-income tenant in a traditional 40-60 or 20-50 minimum set-aside project. The Proposed Regulations may be relied upon by taxpayers beginning after October 30, 2020, and on or before the date the regulations are published as final regulations in the Federal Register, provided that the taxpayer follows the rules in their entirety and in a consistent manner. Treasury and the IRS have requested comment on the Proposed Regulations by December 29, 2020, and has strongly encouraged electronic submissions through the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-104591-18).
Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. The author has provided the links referenced above for information purposes only and by doing so, does not adopt or incorporate the contents. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.