The most recent affordable housing set-aside established by the Internal Revenue Service (IRS) is called Average Income. The compliance impact for developers and investors involved in the Low-Income Housing Tax Credit (LIHTC) can be significant. This article focuses on a review of the Average Income Test (AIT) and how it can actually be used as mechanism for employees to make smarter compliance decisions, potentially improving efficiencies (and decreased waste).
Brief History of Average Income
Average Income is relatively new within LIHTC. First introduced in 2018, it offers an alternative approach for developers to demonstrate compliance with the minimum set-aside requirement. The AIT is a quantified method to measure this, and it exists for achieving two purposes: (1) Meet the demand for affordable housing by reserving (or 'setting aside') a percentage of the total units for households that earn at or below a certain level, and (2) Provide a means for measuring owner compliance with program requirements.
Traditionally, projects needed to designate a specific percentage of units (typically 40% or 60%) as low-income at the project (which, the taxpayer is required to elect if a project consists of multiple buildings) and that they must remain this way throughout the compliance period. Average income, as a new set-aside, allows for greater flexibility by permitting developers to maintain an average across all units in a designated group at the project.
Initially, proposed regulations in 2020 presented significant challenges for practical implementation. These challenges led to industry pushback, prompting the IRS to revise the regulations and incorporate critical elements from public feedback into the final version released in October 2022.
Impacts of the Average Income Final Regulations:
- Elimination of the "Cliff Effect". The initially proposed regulations imposed a harsh penalty for projects should even one unit fail to meet the low-income requirements. If such a non-compliant unit existed, and its removal caused the average income of the remaining units to exceed 60%, the entire project would be deemed out of compliance. This scenario, dubbed the cliff effect, generated significant concern because now the risks seemed to outweigh the intended purpose of average income, which was to create flexibility in providing housing while being compliant. The final regulations then addressed this issue by introducing a more forgiving approach. As long as at least 40% of the project's units remain designated, known as the qualified group, and their combined average income meets the 60% threshold, the project will be considered compliant. This removes the risk of a single unit jeopardizing the entire project's status.
- Increased Flexibility in Unit Designations. The initial proposal mandated rigid unit designations during the first year of the compliance period. Once assigned, these designations could not be changed for the duration of the extended use period. This inflexibility posed challenges, namely that a critical component of compliance is the ability to correct non-compliance, thus potentially leading to conflicts with other federal housing program regulations. Fortunately, the final regulations provided greater flexibility. Developers can now adjust unit designations under specific circumstances, including conflicts with other federal laws, tenant transfers, or as authorized by the Housing Finance Agency (HFA). This allows for a more adaptable approach to managing the project's low-income unit composition.
- Clarification on Unit Non-Compliance. The final regulations clarify the consequences of non-compliance at the unit level. While the "cliff effect" is eliminated, it remains crucial that individual units meet the low-income definition. This means a unit's imputed income limitation, along with the designations of all other units in the project, must collectively average at most 60%. Should a unit be deemed non-compliant, developers can only include truly low-income units in their annual credit calculations. This might require removing other qualified units from the calculation to maintain the project's overall average below 60%. In essence, a single non-compliant unit could potentially lead to a loss of credits on multiple units.
Potential Impacts on Profitability
The AIT offers potential benefits, when used for decision-making purposes. If not properly understood by both the owner (when electing the required and irrevocable MSA on the Form 8609) and compliance teams (for maintaining compliance), then there is a chance it will be a drawback. Considerations:
- Flexible Compliance Management: The final regulations' relaxed approach to unit designations allows for more strategic management of the project's income mix. Owners can potentially adjust unit designations to maximize occupancy rates and minimize vacancies, which can directly impact rental income.
- Reduced Risk of Credit Loss: The elimination of the "cliff effect" provides owners with greater peace of mind. Even if a single unit experiences non-compliance, the project can potentially maintain its overall low-income status and avoid a complete loss of tax credits. This translates to a more predictable and stable revenue stream from tax credits.
- Administrative Burden can be Reduced: The increased flexibility in unit designations requires initial training on the MSA options for staff. If compliance is managed internally, a training program should be created to regularly update knowledge. Owners need to establish clear procedures for tracking unit designations, monitoring tenant income eligibility, and documenting any changes made. This can add to the overall management workload, however, by implementing standard operating procedures, a compliance team can template administration tracking, reducing overall expenses.
- Potential for Credit Loss Still Exists: While the "cliff effect" is gone, non-compliance at the unit level can still lead to some loss of credits. Owners need to be vigilant in maintaining income eligibility for all designated low-income units to avoid any negative impact on their bottom line.
Average income represents a significant change from the initial proposals. For the discerning owner that accounts for compliance training, average income is an opportunity to adapt strategy, resulting in increased ROI.
