Section 42, Low-Income Housing Credit Average Income Test Procedures

<RULE> DEPARTMENT OF THE TREASURY <SUBAGY>Internal Revenue Service</SUBAGY> <CFR>26 CFR Part 1</CFR> <DEPDOC>[TD 10036]</DEPDOC> <RIN>RIN 1545-BQ47</RIN> <SUBJECT>Section 42, Low-Income Housing Credit Average Income Test Procedures</SUBJECT> <HD SOURCE="HED">AGENCY:</HD> Internal Revenue Service (IRS), Treasury. <HD SOURCE="HED">ACTION:</HD> Final regulations and removal of temporary regulations. <SUM> <HD SOURCE="HED">SUMMARY:</HD> This document contains final regulations setting forth recordkeeping and reporting requirements for the average income test for purposes of the low-income housing credit. If a building is part of a residential rental project that satisfies the average income test, the building may be eligible to earn low-income housing credits. These final regulations affect owners of low-income housing projects, State or local housing credit agencies that monitor compliance with the requirements for low-income housing credits, and, indirectly, tenants in low-income housing projects. </SUM> <EFFDATE> <HD SOURCE="HED">DATES:</HD> <E T="03">Effective date:</E> These regulations are effective on September 30, 2025. <E T="03">Applicability date:</E> For dates of applicability, see § 1.42-19(f). </EFFDATE> <FURINF> <HD SOURCE="HED">FOR FURTHER INFORMATION CONTACT:</HD> Waheed Olayan at (202) 317-4137 (not a toll-free number). </FURINF> <SUPLINF> <HD SOURCE="HED">SUPPLEMENTARY INFORMATION:</HD> <HD SOURCE="HD1">Authority</HD> This document contains amendments to the Income Tax Regulations (26 CFR part 1) under section 42 of the Internal Revenue Code (Code) relating to recordkeeping and reporting requirements for the average income test for purposes of the low-income housing credit (final regulations). The final regulations are issued under the authority granted to the Secretary of the Treasury or the Secretary's delegate (Secretary) in sections 42(n) and 7805(a) of the Code. Section 42(n) provides, in part, “The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of [section 42] . . .” Section 7805(a) provides, “[T]he Secretary shall prescribe all needful rules and regulations for the enforcement of [the Code], including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue.” <HD SOURCE="HD1">Background</HD> The Tax Reform Act of 1986, Public Law 99-514, 100 Stat. 2085 (1986 Act) created the low-income housing credit under section 42. Section 42(a) provides that the amount of the low-income housing credit for any taxable year in the credit period is an amount equal to the applicable percentage (effectively, a credit rate) of the qualified basis of each qualified low-income building. Section 42(c)(1)(A) provides that the “qualified basis” of any qualified low-income building for any taxable year is an amount equal to: (i) the applicable fraction, determined as of the close of the taxable year, multiplied by (ii) the eligible basis of the building (determined under section 42(d)). Section 42(c)(1)(B) defines the term “applicable fraction” as the smaller of the unit fraction or floor space fraction. The unit fraction is the number of low-income units in the building divided by the number of residential rental units (whether or not occupied) in the building. The floor space fraction is the total floor space of low-income units in the building divided by the total floor space of residential rental units (whether or not occupied) in the building. Subject to certain exceptions in section 42(i)(3)(B), section 42(i)(3) defines the term “low-income unit” as any unit in a building if the unit is rent-restricted and the individuals occupying the unit meet the income limitation under section 42(g)(1) that applies to the project of which the building is a part. Section 42(d)(1) and (2) describe how to calculate the eligible basis of a new building or an existing building, respectively. Section 42(c)(2) defines the term “qualified low-income building” as any building which is part of a qualified low-income housing project at all times during the compliance period (as defined in section 42(i)(1), the period of 15 taxable years beginning with the first taxable year of the credit period). For a project to qualify as a low-income housing project, it must satisfy one of the section 42(g) minimum set-aside tests, as elected by the taxpayer. Prior to the enactment of the Consolidated Appropriations Act of 2018, Public Law 115-141, 132 Stat. 348 (2018 Act), section 42(g) contained two minimum set-aside tests, known as the 20-50 test and the 40-60 test. Under the 20-50 test, an electing taxpayer cannot earn any low-income housing credits unless at least 20 percent of the residential units in the project both are rent-restricted and are occupied by tenants whose gross income is 50 percent or less of the area median gross income (AMGI). Under the 40-60 test, an electing taxpayer cannot earn any low-income housing credits unless at least 40 percent of the residential units in the project both are rent-restricted and are occupied by tenants whose gross income is 60 percent or less of AMGI. The 2018 Act added section 42(g)(1)(C), which gives taxpayers a third option for their election of a minimum set-aside test—the average income test. Under the average income test, an electing taxpayer cannot earn any low-income housing credits unless—(i) 40 percent  <SU>1</SU> <FTREF/> or more of the residential units in the project both are rent-restricted and are occupied by tenants whose income does not exceed the imputed income limitation that the taxpayer designated with respect to the specific unit; and (ii) the average of the imputed income designations of these units does not exceed 60 percent of AMGI. <FTNT> <SU>1</SU>  In the case of a project described in section 142(d)(6), this “40 percent” is replaced with “25 percent.” </FTNT> Special rules in section 42(g)(1)(C)(ii)(I) through (III) govern the income limitations of low-income units as well as the role of those limitations in the average income test. Under the 20-50 and 40-60 tests, the income limitations for all low-income units flow automatically from the taxpayer's election of one of those two set-side tests. In contrast, under the average income test, the electing taxpayer must designate each unit's imputed income limitation, which will then be taken into account in applying the test. In addition, section 42(g)(1)(C)(ii)(III) requires the imputed income limitation designated for any unit to be 20, 30, 40, 50, 60, 70, or 80 percent of AMGI. Under section 42(g), once a taxpayer elects to use a particular set-aside test for a project, that election is irrevocable. Thus, once a taxpayer has elected to use any of the three tests, the taxpayer may not subsequently elect to use one of the others. Although a taxpayer may have elected the 20-40 or 40-60 test before the average income test became available, the later availability of the average income test does not affect the irrevocability of the earlier election. Under section 42(m)(1), every State or local housing credit agency (Agency) making allocations of the ability to earn low-income housing credits must have a qualified allocation plan (QAP) to guide it in making those allocations. Under section 42(m)(1)(B)(iii), a QAP must also contain a procedure that the Agency (or its agent) will follow in monitoring noncompliance with low-income housing credit requirements and in notifying the IRS of any such noncompliance. See § 1.42-5 of the Income Tax Regulations for rules implementing this requirement. Section 1.42-5(e)(2) provides that a QAP must require an Agency to provide prompt written notice to the owner of a low-income housing project if the Agency does not receive the certification described in § 1.42-5(c)(1), or does not receive, or is not permitted to inspect, the tenant income certifications, supporting documentation, and rent records described in § 1.42-5(c)(2)(ii), or discovers by inspection, review, or in some other manner, that the project is not in compliance with the provisions of section 42. Section 1.42-5(e)(4) both sets the correction period after an Agency has notified an owner under § 1.42-5(e)(2) and provides that the correction period shall be that period specified in the monitoring procedure during which an owner must supply any missing certifications and bring the project into compliance with the provisions of section 42. The correction period is not to exceed 90 days from the date of the notice to the owner described in § 1.42-5(e)(2). An Agency may extend the correction period for up to 6 months, but only if the Agency determines there is good cause for granting the extension. On October 30, 2020, the Department of Treasury (Treasury Department) and the IRS published a notice of proposed rulemaking (REG-119890-18) in the <E T="04">Federal Register</E> (85 FR 68816) proposing regulations setting forth guidance on the average income test under section 42(g)(1)(C) (2020 proposed regulations). On March 24, 2021, the Treasury Department and the IRS held a public hearing on the 2020 proposed regulations. The possibility of a “cliff” (as described in following two paragraphs) was one of the main concerns that commenters expressed regarding the 2020 proposed regulations. Almost all projects earning low-income housing credits have more than the minimum number of low-income units needed for the project to qualify for the credits. Thus, with the 20-50 or 40-60 tests, a later discovery that some unit failed to be a low-income unit generally would reduce the amount of credit earned but would not totally preclude a project's eligibility. By contrast, in response to the 2020 proposed regulations, commenters were concerned about the following possibility with respect to the average income test: S ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ Preview showing 10k of 47k characters. Full document text is stored and available for version comparison. ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━