Federal Tax Incentives:
Low-Income Housing Credit
Background
The IRC §42 Low-Income Housing Tax Credit (LIHTC), enacted under the Tax Reform Act of 1986, incentivizes the development and rehabilitation of residential rental housing for households meeting income restrictions. Owners of qualifying rental buildings may claim the LIHTC, which is part of the general business credit under IRC §38, by filing Form 8586 and reporting on Form 3800.
Investor Incentives
The LIHTC program provides tax incentives for investors who contribute equity to qualifying projects. In return, investors receive tax credits over a 10-year credit period, plus depreciation and other tax benefits.
Eligible Housing Types
Eligible projects include new construction or acquisition and substantial rehabilitation of residential rental property. Housing may consist of apartments, single-family homes, single-room occupancy units, or transitional housing for the homeless. Mixed-use projects (i.e., low-income and market-rate rentals, including partial commercial use) are permitted, provided the residential portion meets IRC §42 requirements. Commercial use is limited under Treasury guidance. However, the housing must qualify as residential rental property (e.g., no hotels, hospitals, or nursing homes).
Compliance Periods
The taxpayer must commit to an extended use period of at least 30 years:
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10-year credit period (claiming credits).
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15-year compliance period (IRS jurisdiction; failure triggers recapture under IRC §42(j)).
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Additional 15 years under state agency oversight (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.
Credit Computation
The amount of credit the taxpayer can claim each year is determined as:
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"Eligible Basis" x "Applicable Fraction" = "Qualified Basis"
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The "Eligible Basis" is the total depreciable residential rental costs (may include certain soft costs). Increased by up to 130% for projects in Qualified Census Tracts or Difficult Development Areas (IRC §42(d)(5)(B))
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The "Applicable Fraction" is lesser of unit fraction or floor space fraction of qualified low-income units; determined as the lesser of square footage or number of units.
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"Qualified Basis" x "Applicable Percentage" = Annual Credit Amount
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The "Applicable Percentage" is the IRS-published discount factor used to calculate the annual LIHTC amount over the 10-year credit period. It converts the present value of the credit into annual installments, based on the building’s Qualified Basis. The IRS publishes monthly applicable percentage rates based on federal interest rates and present value calculations under IRC §42(b)(1). These rates fluctuate with market interest rates and are commonly referred to as:
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“9% credit” (represents a 10-year stream of credits equaling the present value of 70% of Qualified Basis) for new construction or substantial rehabilitation (not federally subsidized) placed in service after July 30, 2008. The 9% minimum applies to new non-federally subsidized buildings even if the taxpayer made an irrevocable election under former IRC §42(b)(1)(A)(ii). The term “9% credit” is historical; the actual rate fluctuates monthly based on federal interest rates. The IRS calculates this percentage monthly based on (1) the federal mid-term interest rate (published under IRC §1274(d)) and (2) a discount factor that converts the 10-year credit stream into its present value. IRC §42(b)(1) defines applicable percentage and present value concept.
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“4% credit” for acquisition of existing buildings or federally subsidized projects (including tax-exempt bonds), placed into service after December 31, 2020. For the minimum 4% rate to apply, a building must also receive an allocation of housing credit dollar amount after December 31, 2020, or have a portion of the building financed with an obligation described in section 42(h)(4)(A) that is issued after December 31, 2020. Under the Taxpayer Certainty and Disaster Tax Relief Act of 2020, the 4% credit has a statutory floor of 4.00%, so even if interest rates would otherwise push the rate lower, it cannot drop below 4%.
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Election Timing Matters. Developers can elect to lock the applicable percentage at:
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The allocation date (when the state agency issues Form 8609).
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The placed-in-service date (when the building is ready for occupancy).
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Compliance & Recapture
Noncompliance may reduce or eliminate credits and trigger recapture under IRC §42(j). Disposition of a building generally ends credit eligibility and may cause recapture unless the building continues as qualified low-income housing for the remaining compliance period. IRS and state agencies emphasize physical inspections and income certifications; failure to maintain habitability or rent restrictions triggers Form 8823 reporting.
Administration
The program is jointly administered by the IRS and state housing credit agencies under state Qualified Allocation Plans (QAPs). States receive annual credit allocations under IRC §42(h). Agencies allocate credits, monitor compliance, and report noncompliance to the IRS on Form 8823.
Combining with Other Tax Credits
Projects may also qualify for credits under IRC §§47 (Rehabilitation) and 48 (Energy Credit), and for tax-exempt bond financing under IRC §146 (subject to §142(d) rules). Coordination rules apply to prevent double benefits.
Compliance Requirements
Taxpayers must comply with multiple rules under IRC §42 and Treas. Reg. §1.42-5, which apply at the unit, building, and project level. Noncompliance can result in credit disallowance or recapture under IRC §42(j).
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Minimum Set-Aside – A project must meet one of the minimum set-aside tests under IRC §42(g):
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20-50 Test: At least 20% of units occupied by households at or below 50% of area median income (AMI).
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40-60 Test: At least 40% of units occupied by households at or below 60% of AMI.
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Average Income Test: Average income of designated units does not exceed 60% of AMI.
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Available Unit Rule – If a tenant’s income exceeds 140% of the applicable limit, the next available unit of comparable or smaller size must be rented to a qualified household (IRC §42(g)(2)(D)).
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Vacant Unit Rule – Owners must make reasonable attempts to rent vacant low-income units to qualified tenants before renting any market-rate units (Treas. Reg. §1.42-5(c)(1)(ix)).
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General Public Use – Units must be available to the general public under HUD non-discrimination rules (24 CFR Subtitle A). Units cannot be restricted to members of social organizations, employees of the owner, or used as part of hospitals, nursing homes, or similar facilities (IRC §42(i)(3)(B)).
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Material Participation of Qualified Nonprofit Organizations – Projects allocated credits under the nonprofit set-aside (§42(h)(5)) require material participation by the nonprofit in development and operation throughout the compliance period.
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Extended Use Agreement – An Extended Use Agreement under IRC §42(h)(6) must be recorded as a restrictive covenant and remain in effect through the extended use period (minimum 30 years).
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Certifications and Annual Reports – Owners must file Form 8609 (Part II) for the first credit year and Form 8609-A annually for 15 years. Annual certifications to the state agency are required under Treas. Reg. §1.42-5(c)(1).
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Inspections by State Agency – State agencies must inspect projects at least once every three years and review tenant income certifications for at least 20% of low-income units (Treas. Reg. §1.42-5(d)).
Credit Disallowance and Recapture
Failure to comply can result in credit disallowance for the current year and recapture of prior credits under IRC §42(j). Recapture is calculated as a percentage of prior credits plus interest. Use Form Form 8611, for recapture reporting.
State Housing Agency Responsibilities
State agencies allocate credits under IRC §42(h) and monitor compliance per Treas. Reg. §1.42-5. They report noncompliance or building dispositions to the IRS using Form 8823.
Qualified Allocation Plan (QAP)
Each state must adopt a QAP under IRC §42(m)(1), approved by the relevant governmental unit. QAPs must include selection criteria (location, housing needs, sponsor characteristics, special needs populations, energy efficiency, historic nature) and give preference to projects serving the lowest-income tenants for the longest periods.
Allocating Credits
Credits are allocated via reservation, binding commitment, or carryover allocation (Schedule A of Form 8610). Projects must generally be placed in service by the end of the second year following carryover allocation.
Compliance Monitoring
Treas. Reg. §1.42-5 requires state agencies to monitor compliance and report noncompliance to the IRS. Owners must certify annually that all requirements were met.
Reporting Noncompliance to the IRS
State agencies report noncompliance or dispositions on Form 8823. IRS sends notices to owners and requires resolution before filing a “back in compliance” Form 8823, Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition.
Annual Report to the IRS
State agencies file Form Form 8610, Annual Low-Income Housing Credit Agencies Report annually with copies of Forms 8609 and Schedules A (Form 8609). Penalties apply for late filing under IRC §§42(l)(3) and 6652(j).
Recordkeeping
Owners must retain Form 8586, Forms 8609, Schedules A (Form 8609), Form 8611, and related documentation for at least three years after the compliance period ends.