Article | Will the AIT "Live Happily Ever After"?

According to IRS data, between 2018 and 2022 approximately 200 taxpayers elected the average income test (AIT) for projects containing just over 2,000 buildings. This is a significant segment of the recent LIHTC portfolio. However, adoption rates of the AIT were diminishing because of uncertainty caused by proposed AIT regulations and the potential cost of establishing the accuracy of owner and state HFA interpretations of the AIT in the courts.

After a two-year build-up of suspense in the housing industry, the IRS released final regulations for the LIHTC AIT minimum set-aside on October 7, 2022. This finalized a new Treas. Reg. 1.42-19. Additional temporary 1.42-19T provisions were also included for further public consideration. It appears clear that the new rule will be welcome and addresses the major concerns created by the original proposed regulation from 2020. This will likely restore investor and developer confidence in the viability of the AIT option.

The Story Thus Far…

Adding to the three existing minimum set-aside options, the AIT minimum set-aside was signed into law as part of the Omnibus Tax Act on March 23, 2018. The AIT expands the number of people that can be assisted in LIHTC housing. Households up to 80% MTSP income limits now qualify at AIT properties. It additionally provided significant benefits to rehabs for the preservation of existing aging federal Section 8 and other affordable housing. It also has substantial potential asset management and debt leveraging benefits needed to make more projects viable.

Motivated by the pressing need for housing, the LIHTC industry sought to apply the new option that Congress had made available upon passage of the law. State LIHTC allocating agencies implemented the much-needed AIT with various, but generally consistent, policies. For almost three years, the AIT was observed to be the most common minimum set-aside election in many areas of the country. 

On October 30, 2020, a proposed Treasury Regulation was released to provide federal guidance for the AIT. The impracticality of the proposed provisions had a chilling effect on the use of the AIT by states, developers, and investors. Particularly, the following areas were problematic in the proposed rule.

1. When the AIT minimum set-aside is violated. The minimum set-aside was proposed to be violated by having even one unit out of compliance if losing the designation of the unit caused the average of designations at the property to exceed 60%. As a violation of the minimum set-aside results in disallowance of all credits and recapture of past claimed credits, this consequence would have been magnitudes more punishing to AIT properties when compared to the other three set-aside options, which can sustain noncompliance down to below 20% (for 20-50 projects), 25% (for 25-60 NYC projects), or 40% (for 40-60 projects) before facing this fate. This proposed provision is often referred to in the industry as “the cliff”, as it makes the risk of noncompliance so much more immediate than where “the cliff” of ultimate noncompliance has always existed for the other minimum set-asides – at 20%, 25%, or 40%. In the comments to the final rule, the IRS acknowledged that this proposed rule “magnified the adverse consequences of a single unit’s failure to maintain low-income status.”
2. Mitigation of AIT noncompliance. Because of problems created by the above approach, there were limited proposed options to fix noncompliance. However, there was great concern that these would not be adequate. For instance, the time was limited to 60 days after the year of the noncompliance incident, a timeframe that often would not work. After consideration, the IRS stated in the comments to the final rule that “even alert and well-advised taxpayers might be unable to timely take mitigating actions to be eligible to receive credits for their projects.”
3. Changing AIT designations. The proposed rule required the owner to designate units from 20% to 80%, in 10% increments. This had to be done by the end of the first year of the compliance period and the designations were fixed throughout the extended use period. This created insurmountable problems for using the AIT with other affordable housing programs, which generally require floating of units. Also at issue were the Fair Housing Act, VAWA, Section 504, and other civil rights legislation. These would suggest that transferring households to address the rights of the household is reasonable and necessary. Finally, it was inconsistent with existing LIHTC guidance, such as when units switch status when a household transfers between units within a project.

The IRS asked for public comment, and the industry provided it! They received over one hundred letters from all segments of the industry and participated in a hearing that lasted several hours. Representatives from the IRS and General Counsel were also available for listening sessions in public forums such as at NCSHA Conferences.

As time progressed, bipartisan members of Congress, from both the Senate and the House, and the Administration increased pressure to address the unresolved issues with the AIT. See the bottom of this post HERE for links to the new rule and AIT-related historical documents.

A Happy Ending? More Workable Policies…Worth the Wait?

A preliminary review indicates that the major issues with the proposed rule have been resolved. We will cover these in the order listed above.

1. When the AIT minimum set-aside is violated. In the commentary for the final rule, the IRS said regarding near-universal objection to the proposed approach that “these commenters correctly asserted that the average income test is a minimum set-aside test, and, therefore, a project should meet the test if the minimum requirements of the test are satisfied, even if low-income units not necessary for the minimum are noncompliant.” After consideration of all factors, the conclusion was that the final rule “revisions provide more flexibility for meeting the average income test than had been available under the proposed regulations. Most importantly, the revised rules limit the impact of one unit’s noncompliance on the ability of a project to satisfy the average income test.” Rather than requiring the average across all units when meeting the minimum set-aside, the final AIT rule set-aside is met when at least 40% of the project’s total units are eligible LIHTC units and have been designated to collectively average no more than 60%. Thus the “final regulations generally avoid the outsized impact that one unit’s loss of low-income status could have under the proposed regulations. The interpretation of the average income set-aside in the final regulations is consistent with the majority of comments on this issue.”
2. Mitigation of AIT noncompliance. The mitigating options in the proposed rule were removed from the final rule. These were only originally suggested to address the risk created by the proposed regulations.
3. Changing AIT Designations. The final rule allows changes to designations in the following circumstances
   • As the IRS permits. If permission for the change is contained in IRS forms, instructions, or guidance published in the Internal Revenue Bulletin.
   • As the state HFA permits. When the Agency with jurisdiction of the project has issued public written guidance that provides conditions for a permitted change that applies to all AIT projects under the jurisdiction of the Agency, such changes are permissible.
   • As appropriate to other laws. A change in designation is permissible when the change is required or appropriate to enhance protections contained in the following laws.
     • The Americans with Disabilities Act (ADA)
     • The Fair Housing Act (FHA)
     • The Violence Against Women Act (VAWA)
     • The Rehabilitation Act of 1973 (Section 504)
     • Any other State, Federal, or local law or program that protects tenants and that is identified by the IRS or the state HFA, as covered above.
   • As households transfer. If a current income-qualified tenant moves to a different unit in the project, the unit to which the tenant moves has its imputed income designation changed to the limitation of the unit from which the tenant is moving; and the vacated unit takes on the prior limitation of the tenant’s new unit.
   • To address issues with the average. When the average is out of compliance with the minimum set-aside or the applicable fraction, redesignation may be allowed. This is limited to newly designated, or redesignated, units that are vacant or are occupied by a tenant that would satisfy new, lower imputed income limitation.

What about the applicable fraction? How does the AIT relate to the applicable fraction(s) for building(s) in an AIT project? The rule adds a clarified definition of a low-income unit. This is used for both the minimum set-aside and the applicable fraction(s) for an AIT project. The IRS explains that “to qualify as a low-income unit in a project electing the average income test, a residential unit, in addition to meeting the other requirements to be a low-income unit under section 42(i)(3) [the provisions traditionally required of LIHTC units in order to be low-income units], must be part of a group of units such that the average of the imputed income limitations of the units in the group does not exceed 60 percent.” See the example below relating to the minimum set-aside and applicable fraction tests for a property. The commentary does clarify that “the potential downside of this approach to an owner is that if one unit loses low-income status, then it is possible that other units’ status as low-income units may be impacted. Specifically, an owner may have to exclude one or more otherwise qualifying units from the qualified group of units for use in applicable fraction determinations for the group to retain an average income limitation that does not exceed 60% of AMGI. This, however, will not always be the case. For example, if a unit designated at 60, 70, or 80 percent of AMGI loses low-income status and no other changes occurred, then the owner could maintain the required average limitation of the qualified group of units without excluding any of the other units from the qualified group of units that had been taken into account in the previous year. Also, as is discussed later, in some cases a unit may be included in the qualified group of units after its income limitation has been designated or redesignated to a lower income limitation.” Please note this comment for the discussion of addressing noncompliance later.

Example | AIT Minimum Set-Aside & Applicable Fraction

Minimum Set-Aside. A project has a total of 100 units. Forty of the units are designated as follows:

Units 1–40

• 10 at 40%
• 10 at 50%
• 10 at 70%
• 10 at 80%.

These average 60% and the project meets the AIT.

The applicable fraction. The project is intended to be 100% LIHTC. All buildings should have 100% applicable fractions.

Units 41–60

• 20 at 50%
• 20 at 60%
• 20 at 70%

These, when added to the sampling used to prove the AIT, average 60% overall. Since all units average no more than 60%, each unit can be used for the applicable fraction for the building the unit is in.

When designations are first set. For AIT projects existing as of Dec. 31, 2022, occupied LIHTC units are designated on Jan. 1, 2023. For vacant units and for future AIT projects, a unit is designated before the move-in of a low-income household.

Redesignation may still be needed for noncompliance. As with traditional LIHTC practice for the original three minimum set-asides, a unit that is noncompliant with its AIT designation will not be usable for the minimum set-aside or the applicable fraction(s) for a project. As 40% of the units probably still average 60% or less, only significant losses of units to noncompliance will violate the minimum set-aside. However, the unit loss may also have the effect of raising the average for the project, requiring that an additional unit, or units, be removed from the applicable fraction(s) to restore the 60% average. As noted above, the final rule contemplates that avoiding this is one reason to redesignate units.

Example | AIT Minimum Set-Aside & Noncompliance

Minimum Set-Aside. The same project from the above Example has noncompliance with a unit as follows:

• 10 at 40%
• 10 at 50%
• 10 at 70%
• 10 at 80%.
• 19 at 50%
• 20 at 60%
• 20 at 70%
• 1 at 50% is noncompliant

Minimum set-aside. As there is still a set of 40% of the units that average 60%, the minimum set-aside has not been violated (see the top four sets of designations on the list).

Applicable fraction(s). The average of the project, not including the noncompliant 50% units, is now 60.10%. Beyond not claiming the 50% unit, an additional 70% unit may need to be excluded from the applicable fraction for the building that it is in to restore the 60% project average until the noncompliant unit can be restored or other mitigating action taken.

Redesignation for noncompliance. As noted above, the mitigation for violations of the minimum set-aside that was proposed in the rule did not make it into the final rule, as this was generally no longer needed. However, mitigation of noncompliance relating to the average concerning the applicable fraction(s) would appear to be one of the reasons that a state HFA written guidance would allow changing the designation on units (See “As the state HFA permits,” above). Remember the above-quoted comment from the IRS that ”in some cases a unit may be included in the qualified group of units [used for the applicable fraction(s) for the project] after its income limitation has been designated or redesignated to a lower income limitation.” [bolded emphasis ours]

How designations are made and changed. The temporary part of the regulation provides that a taxpayer designates a unit’s imputed income limitation by recording the limitation in its books and records, where it must be retained for the same period as other records retained under the compliance monitoring regulations in Treas. Reg. 1.42-5.

The initial designation of a unit is to be made no later than when a unit is first occupied as a low-income unit. The designation must also be communicated annually to the applicable Agency, and the applicable Agency may establish the time and manner in which information is provided to it.

When an owner changes a designation, they implement the change by recording the new designation in their books and records and communicate the new designation to the Agency per Agency policy.

The final rule gives flexibility to Agencies to determine the best time and manner for taxpayers to communicate the information so each Agency can ensure the system best serves that particular Agency with minimal burden. The temporary regulation also provides Agencies with the discretion to waive in writing failure to comply with the temporary regulations’ recordkeeping and reporting requirements on a case-by-case basis. The waiver may be done up to 180 days after discovery of the failure, whether by taxpayer or Agency. At the discretion of the applicable Agency, this waiver may treat the relevant requirements, and related tax consequences, as having been satisfied.

What rules applied to existing AIT properties in the Past?

It is probably no surprise that the regulation does not allow owners to change the AIT election for existing projects that have made the election. This is because the minimum set-aside election is irrevocable by statute. However, it is anticipated that the new, far more flexible, rule comports with what owners who elected the AIT were expecting. For taxable years prior to the first taxable year to which these regulations apply, taxpayers are allowed to rely on a reasonable interpretation of the statute in implementing the average income test for taxable years to which these regulations did not apply. This means that reasonable state HFA interpretations from the past may be relied upon.

It appears that some details of various states' descriptions of the AIT may change to be more correct with the final rule, especially relating to the applicable fraction. However, a review of a compilation of state AIT policies that Costello uses would seem to indicate that most states will not need to substantially change their existing AIT policies unless they want to.

The Available Unit Rule

An area for significant flexibility in both the proposed and final rule relates to the Available Unit Rule (AUR), also known as the Next Available Unit Rule (NAUR). The new rule adds provisions to the AUR Treas. Reg. 1.42-15. The AUR rule is triggered once units are “over-income” at income recertification for units at projects that have market (non-LIHTC) units. The definition of “over-income” differs for AIT buildings, to be over 140% of the 60% limit for units designated 20% - 60%, or over 140% of the 70% or 80% limit for units designated at 70% or 80%, respectively. Once a household is over-income, the next available unit(s) must be rented to LIHTC households, until the applicable fraction is restored for the building. The AIT statute adds that units already designated for the AIT will be rented to households meeting the designation already assigned. Market units, however, must be redesignated to replace the over-income designation(s). If only one unit is over-income, this is a fairly straightforward process. However, when there is more than one over-income unit at the same time, this can create some additional complexity for AIT properties. The new rule explains that the average must be maintained when designating the new LIHTC units for purpose of the AUR, but not when ultimately renting them.

The new AUR regulation provides an example that is instructive. It demonstrates that an owner will redesignate units to satisfy the AUR as a market unit becomes available, even if the units are actually rented in a different order. The average would need to be taken into consideration when setting the designation of a vacant market unit, but the units can be finally rented in any order.

Example | AIT & The AUR Adapted from the new Treas. Reg. 1.42-15

A one-building project where all units are the same size has the following designations assigned by unit number.

1. 80%
2. 80%
3. 80%
4. 80%
5. Market
6. 40%
7. 40%
8. 40%
9. 40%
10. Market

1. Units 1 and 6 are over-income at recertification in a year because they exceed 140% of the 80% and 60% limits, respectively. The AUR is in effect and will determine what should be done with future units. The already designated LIHTC units will continue to be rented to households at their previously designated limits.

2. The market unit 5 becomes vacant. Prior to renting unit 5, the owner assigns a 40% designation to that unit. This maintains the 60% average of designations, as follows.

1. 80% - Over-income
2. 80%
3. 80%
4. 80%
5. 40% - Vacant (former market unit)
6. 40% - Over-income
7. 40%
8. 40%
9. 40%
10. Market

The owner did not replace the over-80% designation first, as it would have raised the average imputed designations to over 60%.

 3. The market unit 10 becomes vacant. Prior to renting units 5 or 10, the owner assigns an 80% designation to unit 10. This maintains the 60% average of designations, as follows.

1. 80% - Over-income
2. 80%
3. 80%
4. 80%
5. 40% - Vacant (former market unit)
6. 40% - Over-income
7. 40%
8. 40%
9. 40%
10. 80% - Vacant (former market unit)

 4. The vacant units can be rented in any order now that the units have been designated so as to maintain the average. In this example, the new 80% unit 10 is rented, and later the new 40% unit 5.

Note on state HFA unit parity policies. Some states implemented parity rules that required the AIT designations be equally assigned to each unit size across a project. Parity is not required by the AIT statute or rules but may be helpful in supporting efforts toward equal treatment under the Fair Housing Act and avoiding disparate impact based on familial status or other protected classes. The AUR requires renting the next available unit of the same size or smaller and restoration of the applicable fraction may involve square footage as well as the number of units in the calculation to determine if the rule is satisfied. Because of this, state policies regarding parity of unit designations (that all designations be equally represented among unit sizes equally) may not be achievable. For instance, a 40% designation may have to float from a 2-bedroom unit to a 1-bedroom if the 1-bedroom is the next unit available. The average does not take into consideration unit sizes on a federal level. However, a state will have to consider the possibility in any parity policies that absolute parity is not possible in some scenarios if the owner follows the AIT AUR. Flexibility or allowance for this eventuality should be considered.

What is left to do?

The IRS has determined that more comments are needed on the recordkeeping provisions. However, according to the comments on the new rule, “it would frustrate the public interest to delay the applicability date of the regulations until the recordkeeping and reporting requirements have received additional notice and comment.” Therefore, they proposed part of the rule to be temporary pending comments from the public. This section should be reviewed by all interested persons and any needed comments should be submitted.

Conclusion

As mentioned at the outset, approximately 2,000 buildings are already subject to the AIT. With the benefit of this guidance, the IRS projects that an additional 100 taxpayers will elect the AIT annually, including around 1,000 buildings, because of the certainty allowed by the new rule. It would appear that the new provisions may go a long way to addressing industry concerns. Time will tell, but there could be a happy ending to the tale of the AIT.