Final Average Income Test regulations clarify key terms, eliminate ‘cliff test’
The Consolidated Appropriations Act of 2018 amended Internal Revenue Code (IRC) Section 42(g) and established the Average Income Test as the third minimum set-aside option for low-income housing tax credit (LIHTC) projects. To qualify, 40% or more of a project’s units (25% or more in the case of a Section 142(d)(6) project) must be rent restricted and occupied by tenants who satisfy the income limitations designated to each unit. Proposed regulations released in October 2020 provided guidance on how to apply the average income test to projects selecting the set-aside. However, the proposed regulations raised several critical questions and were the subject of industry-wide critique.
The proposed regulations led to confusion surrounding the “Next Available Unit Rule” stipulated in Section 42(g)(2)(D) and introduced what became known as the “cliff test” related to non-compliance of even one unit. The project was required to calculate the 60% AMI average minimum set-aside on all low-income units and not a smaller sample of units, potentially leading to failure to satisfy the 40% requirement in Section 42(g)(1)(C)(i). Another area of concern was the methodology of designating the income limits associated with low-income units.
After nearly two years, on October 7, the IRS and Treasury released final regulations that provide much-needed clarity to all LIHTC stakeholders. Below we have detailed the key provisions of the final regulations and the practical changes for LIHTC projects.
The proposed regulations relied on the definition of low-income unit in Section 42(i)(3)(A), as it is applied throughout the section. Because a low-income unit in an Income Averaging project is not subject to one project-wide income ceiling, but instead to an individual unit designation that interacts with a project-wide average, the definition required clarification.
The final regulations explain that in the case of Average Income projects, a low-income unit refers to a residential unit that meets the four criteria stipulated: specifically that 1) the unit is rent-restricted, 2) it is occupied by a household that satisfies the imputed income limitation, 3) no other provision of Section 42 would otherwise deny low-income status to the unit, and 4) the unit is part of a qualified group of units (a group of units whose average income is 60% of AMI or less).
In the case of Average Income projects, an over-income unit refers to a residential unit whose occupant’s income grows to more than 140% of the greater of 60% AMI or the income designation of the unit and that meets the first three criteria of a low-income unit listed above.
Finally, the final regulations introduced the concept of a qualified group of units: a group of residential units composed of individual units that satisfy the new definition of low-income unit noted above and, when taken as a group, have an average imputed income limitation of 60% AMI or less. The term is used in two contexts in the final regulations: first, for the minimum set-aside test, and second, for the applicable fraction determination, both of which are discussed in more detail below.
Minimum set-aside and applicable fraction
The most consequential change in the final regulations is related to the minimum set-aside. The proposed regulations stipulated that to meet the requirements of the Average Income set-aside, 1) 40% or more of a project’s units must be rent-restricted and occupied by qualified households, 2) unit income designations must be designated per the regulations, and 3) the average AMI of all low-income units must not exceed 60% of AMI. The final criterion established what was known as the “cliff test,” which could see one over-income unit cause an otherwise compliant project to lose all credits.
The final regulations eliminate the cliff test and note that as long as a project contains a qualified group of units that constitutes at least 40% or more of residential units, it will meet the minimum set-aside test. In plain language, an income averaging project will maintain compliance with the minimum set-aside as long as at least 40% of its units are low-income units with an average AMI of 60% or less. For the past few years, many syndicators and developers have been underwriting a cushion to the 60% AMI ceiling, even on 100% LIHTC projects; with this new guidance, this may no longer be necessary. As such, 100% LIHTC projects and those with high concentrations of low-income units can maximize the cash flow benefits offered by the average income set-aside.
The final regulations note that the project may designate another qualified group of units to determine the applicable fraction. The applicable fraction qualified group of units must contain the minimum set-aside qualified group of units. It may also include additional units as long as the entire group maintains an average AMI of 60% or less. The final regulations also clarify the calculation of the applicable fraction for any building in a multiple-building project: A building’s applicable fraction is determined by the units in the building that are also included in the qualified group of units for the overall project. The building itself (unless it elects to be treated as a separate project) does not require a qualified group of units of its own.
As was the case before the final regulations, when a residential unit loses its designation as a low-income unit due to over-income tenants or some other disqualifying scenario, an otherwise qualified low-income unit(s) may lose its designation as a low-income unit and need to be excluded from the applicable fraction and calculation of qualified basis, as illustrated below.
In the final regulations’ Example 2, a 100% low-income project with a 60% average AMI had a 40% AMI unit become uninhabitable. Because the loss of the 40% unit caused the overall AMI to exceed 60%, the owner was required to remove an otherwise qualified 80% AMI unit (removed unit) from the applicable fraction qualified group of units to maintain compliance with Section 42. The loss of the uninhabitable 40% AMI unit and the removal of the 80% AMI unit from the applicable fraction qualified group of units reduces the qualified basis and results in tax credit recapture. This is a departure from the protection afforded by the proposed regulations, where there was a mitigant in place that would ignore the removed unit for the purposes of calculating tax credit recapture. The final regulations eliminated the cliff test and, with it, the mitigating actions included in the proposed regulations.
The temporary regulations require that each year the project identify a qualified group of units for the minimum set-aside test and a qualified group of units for the applicable fraction. The selected groups must be recorded and maintained in the taxpayer’s records and communicated to the appropriate Agency, following its requirements.
Designation of units
Timing: The proposed regulations required that a unit’s income designation be selected before the close of the first taxable year of the credit period, which presented an issue for projects where units were being placed in service over multiple taxable years. The final regulations allow significantly more flexibility and require only that a unit’s designation be in place before the unit is first occupied as a low-income unit, or, in the case of a changed designation, before the unit is first occupied under the changed income limitation. In practical terms, this change will allow property owners to lease up properties more naturally and to more fluidly assign income designations as demand allows.
Change of income designation: The proposed regulations disallowed the changing of a low-income unit’s designation after it was initially set. Market-rate units were allowed to be converted to low-income units, and the income designation was required within 60 days of the unit’s first treatment as a low-income unit.
While the final regulations state that a unit’s designation generally does not change, they provide much greater flexibility than the proposed regulations by identifying five scenarios in which changes to a unit’s designation may be made. Three are related to governmental action or changes of law, but two are project-specific and will have the most significant impact. The final regulations allow for a change in a unit’s income designation 1) when a tenant moves to a different unit in the project (the income designations swap), and 2) in cases where implementing or reducing the income designation would allow the project to restore compliance with the average income requirements.
In the final regulations’ Example 3, a 100% low-income project with a 60% average AMI had a 40% AMI unit become uninhabitable. The loss of the 40% AMI unit caused the overall AMI to exceed 60%, so the owner was required to take action to maintain compliance with Section 42. Because an 80% AMI unit was occupied by a household whose income did not exceed 60% AMI, the project could change its income designation to 60% AMI and preserve its status as a low-income unit. In contrast to Example 2, in Example 3, the project was able to minimize the impact to the applicable fraction (and qualified basis) to only the one uninhabitable 40% AMI unit.
Under the proposed regulations, an over-income unit would have ceased to be considered a low-income unit if 1) a comparable sized (or smaller) unit was or became available in the same building, and 2) that unit was occupied by a new household with an income that exceeded the income limits of the unit. The income limitation of the unit was defined as the previously designated income limitation for units that were already low-income units at the time of becoming vacant, and for all other units, the highest income limitation, which would maintain a 60% average AMI.
The final regulations amended the next available unit rule to be consistent with the new definition of an over-income unit. They also added a requirement that in instances where more than one unit is over-income at any given time, the taxpayer must take into account the income limitations defined above. This means that in the case of multiple over-income units, while the order in which the next available units are occupied makes no difference, the order in which income designations are assigned to units does make a difference.
The income averaging concept and set-aside were initially pursued to meet the overwhelming demand for affordable housing at the previously unserved or underserved AMI thresholds. The set-aside allows for a greater diversity among the tenant base, can provide for greater access to housing, and may lessen the reliance on federal subsidy for certain AMI threshold units. Overall, the final regulations are in line with what the industry asked for, and the clarity provided by the final regulations takes away the biggest roadblocks to industry-wide acceptance and implementation of the set-aside. The final regulations will almost certainly lead to a direct increase in the number of projects selecting the set-aside and may finally see some of its overarching goals realized.
If you have questions about the new regulations, please contact your CohnReznick service team or Beth Mullen to better understand how this guidance may impact you.
Michael Francescani, Senior Manager, Project Finance & Consulting
Beth Mullen, CPA, Partner, Affordable Housing practice leader
Affordable Housing News & Views