Federal Tax Incentives:
Low-Income Housing Credit
The IRC §42 Low Income Housing Credit Program was enacted by Congress as part of the Tax Reform Act of 1986 to encourage new construction and rehabilitation of existing buildings as low-income rental housing for households with income at or below specified income levels. Owners of rental buildings in low-income housing projects may qualify for the low-income housing credit, which is part of the general business tax credit, using Form 8586 to calculate the amount of the credit.
The IRC §42 program provides tax incentives for investors to make equity investments. In exchange for equity, investors receive tax credits and other tax benefits associated with ownership of the project to offset federal income taxes for a ten year period. These tax benefits, plus the possibility of cash proceeds from the eventual sale of the project, represent the investors' return on investment.
The taxpayer can build new housing, or acquire and rehabilitate existing housing. The housing can be apartments, single-family housing, single-occupancy rooms, or even transitional housing for the homeless. The project may include both low- income and market-rate rental units, and a portion of the property may be for commercial use. The housing must qualify as residential rental property; e.g., no hotels, hospitals, or nursing homes, etc.
The taxpayer agrees to provide low-income housing for at least thirty years. The taxpayer receives credit for ten years (credit period), must provide low-income housing under IRS jurisdiction for fifteen years (compliance period), and under the state agency's sole jurisdiction for at least an additional fifteen years (extended use period). All three time periods begin on the same day; i.e., the first day of the tax year in which the building is placed in service, or if the taxpayer elects, the beginning of the following year.
The amount of credit the taxpayer can claim each year is determined as:
Eligible Basis x Applicable Fraction = Qualified Basis
The eligible basis is the total allowable costs associated with the depreciable residential rental project.
The applicable fraction is the portion of rental units that are qualified low-income units.
Qualified Basis x Applicable Percentage = Annual Credit Amount
The applicable percentage is the discount factor needed to limit the annual credit to the present value of either 70% or 30% of the qualified basis, depending on the characteristics of the housing.
The allowable credit may be reduced (in part or in whole) if the taxpayer is not compliant with IRC §42 requirements. The taxpayer may also be subject to the recapture of credit claimed in prior years under IRC §42(j). If a taxpayer disposes of a low-income building (or interest therein), no credit is allowable in the year of the disposition and the taxpayer is subject to recapture unless the taxpayer reasonably expects that the building will continue to be operated as a low-income building for the remaining compliance period.
The program is jointly administered by the IRS and state-authorized tax credit allocating agencies. Each state receives tax credits annually. The agencies are responsible for identifying the state's housing needs, allocating credit to qualifying projects that meet the state's QAP criteria, and monitoring the operating project for on-going compliance with IRC §42. Noncompliance is reported to the IRS.
The IRS' compliance responsibilities include the processing of forms submitted by state agencies and taxpayers, and ensuring compliance through activities such as auditing taxpayers' federal income tax returns.
Below outlines a summary of the eligible wage expenses and criteria for claiming the credit.
Overview of the IRC §42 Program
The taxpayer agrees to provide low-income housing for at least thirty years.
In exchange for the investment in low-income housing, the taxpayer will receive tax credits for each of ten years, which is known as the "credit period."
To keep the credit, the taxpayer must provide low-income housing for fifteen years, which is known as the "compliance period." Failure to maintain the housing in compliance with IRC §42 requirements for the entire compliance period can result in the recapture of a portion of the credit allowable in prior years.
After IRS jurisdiction ends, the state agency has sole jurisdiction and the taxpayer must continue to provide low-income housing for at least another fifteen years. The "extended use period" is at least 30 years, beginning with the first year of the credit period.
All three time periods begin on the same day; i.e., the first day of the tax year in which the building is placed in service, or if the taxpayer elects, the beginning of the following tax year.
Types of Housing
The credit supports a variety of housing opportunities:
The taxpayer can build new housing or rehabilitate existing buildings.
The housing can be apartments, single- family housing, single-occupancy rooms, or even transitional housing for the homeless.
A building may be mixed low-income and market-rate rental units and a portion of the building may be for commercial use.
Generally, the housing must be used on a non-transient basis; i.e., an initial 6-month lease term. Also, the housing must qualify as residential rental property; e.g., no hotels, hospitals, or nursing homes, etc.
Combining with Other Tax Credits
Besides qualifying for the Low-Income Housing Credit under IRC §42, the taxpayer may also qualify for the Rehabilitation Credit under IRC §47 and the Energy Credit under IRC §48, but not the New Markets Credit under IRC §45D. A building may also qualify for tax-exempt bond financing under IRC §146, in which case the taxpayer is also subject to the rules under IRC §142(d). The taxpayer may also use other federally-sourced loans and grants to finance and operate the building.
Computation of Allowable Annual Credit
The amount of credit the taxpayer can claim each year is determined as:
Eligible Basis x Applicable Fraction = Qualified Basis.
Qualified Basis x Applicable Percentage = Annual Credit Amount
The Eligible Basis is the total allowable cost associated with the depreciable residential rental project. If the building is located in a high cost area, the eligible basis may be increased to 130% of the actual costs.
The Applicable Fraction is the portion of rental units that are qualified low-income units; determined as the lesser of square footage or number of units. To qualify, the unit must be occupied (or last occupied) by an income-qualifying household and, if the household is comprised entirely of full-time students who otherwise qualify as low-income tenants, the unit is qualified only if an exception under IRC §42(i) (3) (D) is met. The housing must be suitable for occupancy and free from health and safety hazards. The rent must also be restricted; i.e., the rent
cannot exceed 30% of the income limit applicable to the building location. The unit must be for use by the general public
Qualified Basis is the product of the Eligible Basis and the Applicable Fraction.
The amount of credit, over the ten-year credit period, is equal to the present value of either 70% or 30% of the qualified basis, depending on the characteristics of the housing. The discount factor is known as the Applicable Percentage and is based on interest rates.
The taxpayer is also subject to the following rules which may impact compliance on a unit-by-unit basis, at the building level, or the entire project.
Minimum Set-Aside – A housing project will not qualify for any credit unless it includes a specified minimum number of qualified low-income rental units.
Available Unit Rule – Generally, if the income of an existing tenant rises above a specific limit, the next available comparable unit in the building must be rented to an income-qualified tenant.
Vacant Unit Rule – If a low-income unit becomes vacant, the taxpayer must make reasonable attempts to rent the unit to income-qualified tenants before renting any market-rate units to tenants who are not income-qualified.
General Public Use – The rental units must be available for use by the general public. A unit is for use by the general public if the unit is rented in a manner consistent with housing policy governing non-discrimination, as evidenced by rules or regulations of the Department of Housing and Urban Development (HUD)(24 CFR subtitle A and Chapters I through XX), and if the unit is not provided only for a member of a social organization, not provided by an employer for its employees, or not part of a hospital, nursing home, sanitarium, life care facility, trailer park, or intermediate care facility for individuals with mental or physical disabilities.
Material Participation of Qualified Nonprofit Organizations – If the taxpayer received an allocation under IRC §42(h)(5), a set-aside of credit designated for projects owned by qualified nonprofit organizations, then the qualified nonprofit organization must materially participate in both the development and operation of the project throughout the 15-year compliance period.
Extended Use Agreement – No credit is allowable for a taxable year unless this agreement between the taxpayer and the state agency allocating the credit is in effect as of the last day of such taxable year. The agreement must be recorded in the land records as a restrictive covenant and is enforceable under state law.
Certifications and Annual Reports – A taxpayer completes a certification with respect to the first year of the credit period, which is a one-time filing of Form 8609, Low-Income Housing Credit Allocation and Certification, with the IRS. Part I is completed by the state agency and Part II is completed by the taxpayer.
The taxpayer also files Form 8609-A, Annual Statement for Low-Income Housing Credit, with its tax return for each year of the 15-year compliance period. The taxpayer is also required to certify at least annually to the state agency that the project met all the requirements.
Inspections by State Agency – Tenant records and the low-income project are subject to physical inspection by the state agency.
Credit Disallowance and Recapture
The building owner must file Form 8609-A annually for 15 years. And, the building must continue to meet certification requirements. If not, the owner may have to recapture a portion of the credit allocation using Form 8611, Recapture of Low-Income Housing Credit. Recapture refers to adding back income that a credit previously reduced.
There is a 15-year compliance period during which the residential rental building must continue to meet certain requirements. If, as of the close of any tax year in this period, there is a reduction in the qualified basis of the building from the previous year, you may have to recapture a part of the credit you have taken. Similarly, you may have to recapture part of the credits taken in previous years upon certain dispositions of the building or interests therein, unless you follow the procedures to prevent recapture. See Recapture and building dispositions in the Instructions for Form 8609-A, Annual Statement for Low-Income Housing Credit, for details. If you must recapture credits, use Form 8611, Recapture of Low-Income Housing Credit. See section 42(j) for details.
In general, the credit may be disallowed (in part or in whole). Not only is the credit disallowed in the year of a noncompliance event, but if the qualified basis is less at the end of that taxable year than the qualified basis at the close of the preceding taxable year, the taxpayer is subject to the credit recapture provisions under IRC §42(j) as mentioned above. The recapture amount is computed as a percentage of the credit claimed in prior years plus interest. The recapture percentage is based on the year within the 15-year compliance period that the noncompliance occurred.
No credit is allowable for the year in which a taxpayer disposes of a building (or interest therein) and the recapture provisions are also applicable unless, under IRC §42(j) (6), it is reasonably expected that the new owner will continue to operate the building as a qualified low-income building for the remainder of the 15-year compliance period.
State Housing Agency Responsibilities
The program is jointly administered by the IRS and state-authorized tax credit allocating agencies. Each state receives tax credits on an annual basis. Under IRC §42(h) (3), the amount of credit available to the state for allocation to taxpayers for any calendar year is the "credit ceiling."
Qualified Allocation Plan (QAP)
The state agencies are responsible for determining which housing projects should receive credits
and the dollar amount allocated. Under IRC §42(m) (1), the state agency must develop a Qualified Allocation Plan (QAP) that is approved by the governmental unit having jurisdiction over the state allocating agency. The QAP must have the following characteristics:
Identifies the selection criteria to be used for determining housing priorities that are appropriate to local conditions. The selection criteria must include project location, housing needs characteristics, project and sponsor characteristics, tenant populations with special needs, public housing waiting lists, tenant populations of individuals with children, projects intended for eventual tenant ownership, the energy efficiency of the project, and the historic nature of the project.
Gives preference to projects serving the lowest income tenants, for the longest periods, located in qualified census tracts, and which will contribute to a concerted community revitalization plan.
The allocating agencies are responsible for allocating tax credits to qualifying projects that meet the QAP's criteria. The allocation process varies among the states, but generally, real estate developers apply for the credit and submit proposals which are then ranked according to the criteria in the QAP. If accepted, the state agency and developer will enter into a contract, documented with a "reservation" of credit, followed by a "binding commitment" to allocate credit in the future, or "carryover allocation," which is documented on Schedule A (Form 8610), Carryover Allocation of Low-Income Housing Credit. Generally, owners must place the projects in service by the close of the second calendar year following the year the carryover allocation of credit is made or return the credit to the state for reallocation to other projects.
An allocating agency is to provide no more credit than deemed necessary to ensure the project's financial feasibility throughout the 15-year compliance period. In general, the agency is to compare the proposed project's total developmental costs with the anticipated private and governmental financing (other than equity raised from tax credits). The difference between the total development costs and financing (other than equity raised through the credit) is commonly referred to as the "equity" gap the IRC §42 credit is intended to fill. The Agency will allocate to the project only the amount of credit necessary to fill this equity gap.
The credit allocation is documented on Forms 8609, Low-Income Housing Credit Allocation and Certification. The agency executes Part I and then mails the Form 8609 to the taxpayer. The taxpayer then completes the certification required under IRC §42(l) (1) for the first year of the credit period by completing Part II of the Form 8609 and submitting it to the IRS.
The QAP must also provide procedures that the state agency will follow to monitor the project for continuous compliance with IRC §42 requirements and notify the IRS if noncompliance occurs. The compliance monitoring requirement was made effective on January 1, 1992, and applies to all buildings for which a low-income housing credit under IRC §42 is, or has been, allowable at any time.
Treas. Reg. §1.42-5 provides the minimum standards for conducting compliance monitoring activities. At least once every three years, the state agency must conduct on-site inspections for all buildings in the project and, for at least 20% of the project's low-income units, inspect the units and review the low-income certifications, the documentation supporting the certifications, and the rent records for the tenants in those units.
The compliance monitoring regulations also require the owner of a project, at a minimum, to certify annually to the state agency that for the preceding 12-month period the project was in compliance with the requirements of IRC §42. The certification covers a variety of requirements, including that the owner has received an annual income certification from each low-income tenant and documentation supporting that certification, and that each building in the project was suitable for occupancy, taking into account local health, safety, and building codes. Treas. Reg.
§1.42-5(c) (1) lists the annual certification requirements.
Reporting Noncompliance to the IRS
When noncompliance is identified or there has been a building disposition, the state agencies are required to notify the IRS using Form 8823, Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition. If the state agency reports that the owner is "out of compliance," the IRS sends a notification letter to the owner identifying the type of noncompliance reported on Form 8823 with instructions to contact the state agency to resolve the issue. Once the issue is resolved, a "back in compliance" Form 8823 is filed with the IRS.
Annual Report to the IRS
IRC §42(l)(3) requires state agencies to submit annual reports to the IRS identifying the annual credit amount allocated to each building for such year, sufficient information to identify each such building and the taxpayer with respect thereto, and other information needed for the administration of the program.
The annual report is made by submitting Form 8610, Annual Low-Income Housing Credit Agencies Report, with copies of the Forms 8609 issued that year and Schedule A (Form 8610), documenting credit carryover allocations, to the IRS by February 28th of the following year. Part I is a reconciliation of the forms submitted with Form 8610, Part II is a reconciliation of the state's credit ceiling and credit allocations, and Part III is a report of the state agency's compliance monitoring activities and compliance with the requirements of Treas. Reg. §1.42-5. State agencies are subject to penalties under IRC §§ 42(l) (3) and 6652(j) for any failure to submit the report timely.
Purpose of Form
Use Form 8586 to claim the low-income housing credit. This general business credit is allowed for each new qualified low-income building placed in service after 1986. Generally, it is taken over a 10-year credit period. The portion of the low-income housing credit attributable to buildings placed in service after 2007 is not limited by tentative minimum tax.
Taxpayers, other than partnerships, S corporations, estates, or trusts, whose only source of this credit is from those pass-through entities, are not required to complete or file this form. Instead, they can report this credit directly on Form 3800.
Qualified Low-Income Housing Project
The credit cannot exceed the amount allocated to the building. See section 42(h)(1) for details. The low-income housing credit can only be claimed for residential rental buildings in low-income housing projects that meet one of the minimum set-aside tests. For details, see the Instructions for Form 8609, Part II, line 10c.
Except for buildings financed with certain tax-exempt bonds, you may not take a low-income housing credit on a building if it has not received an allocation from the housing credit agency. No allocation is needed when 50% or more of the aggregate basis of the building and the land on which the building is located is financed with certain tax-exempt bonds. The owner still must get a Form 8609 from the appropriate housing credit agency (with the applicable items completed, including an assigned BIN). “Land on which the building is located” includes only land that is functionally related and subordinate to the qualified low-income building (see Regulations sections 1.103-8(a)(3) and 1.103-8(b)(4)(iii)).
Applying for the low-income housing credit
Form 8609 is used to certify a building qualifying for the low-income tax credit, as well as allocate the amount of the credit, which usually is spread over a 10-year period, either using Form 8586 or Form 3800. If you have a multi-building project, each building requires its own Form 8609. Credit allocations are made by housing credit agencies at the state or municipal level.
Form 8610, Annual Low-Income Housing Credit Agencies Report, with Forms 8609, LowIncome Housing Credit Allocation and Certification, and Schedule A (Form 8610), Carryover Allocation of Low-Income Housing Credit, submitted by the state agencies are reconciled and processed. Forms 8609 submitted by taxpayers are matched to the state agencies' submissions and processed.
Form 8823, Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition, are processed and a notification letter is sent to the taxpayer identifying the potential noncompliance issues. The Forms 8823 are also evaluated for audit potential. Form 8821 On May 19, 1999, a Memorandum of Understanding (MOU) was finalized as part of a FedState initiative to improve the administration of the LIHC program. The state agencies can require project developers to complete
Form 8821, Tax Information Authorization, as part of their application for an allocation of IRC §42 credit. The taxpayer designates the state agency as the appointee to receive tax information regarding the applicant's prior compliance with IRC §42 requirements; i.e., audit results and Form 8823 filings from other state agencies. The information is used to help the state agency make better informed decisions about credit allocations. The LIHC Compliance Unit provides the information to the state agencies upon request.
Reporting the low-income housing credit on Form 3800
Form 3800, the General Business Credit, reports the Employer Identification Number of a pass-through entity and the amount of your credit allocation, if you have completed Form 8586 to establish your claim.
If you are an individual taxpayer and not an owner of a pass-through entity, you can report the low-income credit directly on Form 3800 without an EIN or completing form 8586.