Advice for Compliance in LIHTC Acquisition/Rehab Projects
By A. J. Johnson & Caitlin Jones
11 min read
THE AFFORDABLE HOUSING portfolio is aging, as every affordable housing professional is aware. HUD Section 8 properties have expiring rent subsidy contracts, and Rural Development Section 515 rural rental properties are often in dire need of rehabilitation and a new influx of equity. Even a share of low-income housing tax credit (LIHTC) projects now need repairs. In addition, other federal housing programs (e.g., HUD’s Section 202/811, 236, 221(d)(3), and 221(d)(4)) have deteriorating properties within their portfolios.
State housing credit agencies (HCAs) recognize this need and problem, and the vast majority emphasize preservation in their LIHTC programs. Some set aside a portion of their annual credit authority for preservation projects; some have made preservation a priority in their Qualified Allocation Plans; and many award extra points to tax credit applications for proposed preservation projects.
This article will highlight some of the primary concerns and issues for developers and property managers in housing credit acquisition/ rehab projects. While it will focus on projects seeking both acquisition and rehabilitation credits, it will also, where appropriate, address issues relating to rehab only credit projects.
Special Issues
The four questions most vexing to developers and managers when contemplating an acquisition/rehabilitation project are:
1. When is my building/project considered to be “placed in service”?
2. When can I qualify my residents (to determine if they qualify as low-income)?
3. Can residents be qualified and then temporarily relocated during rehabilitation?
4. When can the tax credits be claimed (both acquisition and rehabilitation)?
Definition of Placed in Service
IRS Notice 88-116 says that “for purposes of Section 42 [of the Internal Revenue Code], the term “˜placed in service’ has two definitions — one for buildings and one for rehabilitation expenditures that are treated as separate new buildings (Section 42(e)(4)(A).”
New or Acquired Buildings: A new building is considered placed in service on the date the first unit in the building is certified as suitable for occupancy according to state or local law. This is normally the date a certificate of occupancy is issued by a local or state agency. For an existing building, the placed-in-service date is the date the building is acquired by the new owner (assuming it is occupied or could be occupied).
Rehabilitation Expenditures: Rehabilitation expenditures are treated as a separate building under the housing credit program. They are considered to be placed in service at the close of any 24-month period — selected by the taxpayer — over which the rehab expenditures are aggregated. This applies even if the building is occupied during the rehab period; a building can be placed in service before the rehabilitation is completed. IRS guidance clarifies rehab expenditures may be placed in service before the end of a 24-month period.
The placed-in-service date for a rehabilitation is the date on which the rehab expenditures are placed into the eligible basis of the project. Once an owner is ready to establish eligible basis (including rehab costs), the rehab expenditures are deemed placed in service.
Applicable Fraction
Under the LIHTC program, the qualified basis of a building, which determines the credit amount, is equal to the product of the building’s eligible basis times its “applicable fraction.” The latter is the portion of the building occupied by qualified low-income tenants: either the percentage of total building units occupied by lowincome tenants (unit fraction), or the aggregate rentable space for the low-income units as a percentage of the total rentable space in the building (floor space fraction).
The applicable fraction may be determined at the placed-in-service date for an existing building. This is the date the building is acquired by the new owner (assuming it is occupied or ready for occupancy under local law). The placed-in-service date of the rehabilitation expenditures is generally irrelevant for purposes of the applicable fraction.
According to the “8823 Guide” published by the IRS in January 2007, if residents living in a building at the time of acquisition are qualified and certified as lowincome residents within 120 days of the acquisition date, their units will be considered qualified as of the acquisition date.
Example: A building was acquired by a new owner on June 1, 2007. If it was habitable, June 1 is the placed-in-service date for establishing tenant eligibility. If all residents are qualified and certified by September 29, 2007 (within 120 days of the acquisition date), full acquisition and rehabilitation tax credits may be claimed for the building beginning in June 2007. If the owner doesn’t complete and place the rehab in service until 2008, the acquisition and rehab credits can’t be taken until starting in January 2008 (i.e. acquisition credits can’t be claimed in a year prior to claiming rehab credits). If the owner elects to take the tax credits in 2007, any rehab costs incurred in 2008 can’t be included in basis. [Note: This example assumes the minimum rehab expenditure test (discussed below) and rehab eligible basis target were met in 2007.]
A unit vacant at the time of acquisition becomes qualified when the first eligible resident moves in and is properly certified.
The applicable fraction and eligible basis are always calculated on a building-by-building basis. However, the placed-in-service date may be met on either a building or a project basis, as determined by the owner’s election on IRS Form 8609.
Source of Requirements
So where in the federal tax code is this confusing rehabilitation/ applicable fraction issue found?
Section 42(e)(4)(B) states, “The applicable fraction under subsection (c)(1) shall be the applicable fraction for the building (without regard to paragraph (1)) with respect to which the expenditures were incurred.”
Paragraph (1) says rehabilitation expenditures are treated as a separate new building; therefore, applicable fraction is established without regard to this paragraph. In this case, the applicable fraction is defined by subsection (c)(1) as the smaller of (1) the unit fraction, or (2) the floor space fraction for each building, and is used to establish qualified basis at the close of the first taxable year of the tax credit period.
This section of the Code is referenced in IRS Private Letter Ruling (PLR) No. 200044020, in which the Agency made clear that there is no requirement that “projects engage in a second round of tenant income certifications after performing this task at the time of acquisition of the project and throughout the rehabilitation process as new tenants are admitted.” In other words, once a building is acquired, the qualification of the residents in that building may begin, and these qualifications may be relied upon regardless of when the rehabilitation of the building is completed. The 8823 Guide reaffirms this position.
Rehab Credits Only
Developers seeking credits just for rehabilitation and not also for acquisition should be aware that since the building’s placed-in-service date will be the rehabilitation placed-in-service date, this may also be the date on which residents must be initially qualified. The IRS hasn’t issued any formal guidance on this issue. Since there is some conflict with regard to the establishment of eligible basis for rehab expenditures (i.e. the end of a 24- month period vs. the end of the first year of the credit period), developers and owners should seek sound legal and accounting advice before determining the potential for tax credits in these cases.
Other Requirements
Readers should also understand the following additional LIHTC program requirements:
Safe Harbor Rule. IRS Revenue Procedure 2003-82 sets out “safe harbors” for qualifying low-income residents prior to the beginning of the first taxable year of a building’s tax credit period. This provides a way of ameliorating the risk, primarily in mixed-income projects, in which the “available unit rule” could be violated by renting a vacant unit to a new market-rate tenant while there are already “over-income” residents living in the building (i.e., residents of low-income units whose incomes have risen above 140% of the income limit for a qualified low-income household).
Rev. Proc. 2003-82 is designed to determine if any low-income units are occupied by over-income residents at the beginning of the first year of the credit period, and, if so, to ensure that the available unit rule is followed. Adhering to the revenue procedure can be achieved by following the steps below:
1. A low-income resident may be certified as eligible up to 120 days after the date the existing building was acquired by the new owner, if the resident was in place at the time of acquisition, or the move-in date of the individual;
2. If a low-income resident exceeds the applicable income limit at the beginning of the first credit year, the unit will continue to be treated as low income if:
a. The family’s income is first tested for purposes of the available unit rule at the beginning of the first credit year; and,
b. The unit has been rentrestricted since the resident’s initial qualification date.
Rev. Proc. 2003-82 says that if an owner uses a method consistent with these “safe harbors” to determine whether a unit is low-income at the beginning of the first credit year, the issue won’t be raised during an IRS audit. If this safe harbor guidance isn’t followed, and a vacant unit is rented to a marketrate tenant, the burden will be on the owner to prove there were no over-income residents in a lowincome unit at the beginning of the first year of the credit period.
This means low-income residents qualified before the first credit year should be tested in January of the first credit year. This is especially important for properties with mixed-income buildings.
Example: A building is acquired and a household is qualified in June 2007. Annual recertification is due in June 2008. To satisfy the safe harbor rule, though, the household should be tested for purposes of the available unit rule in January 2008. If this is done and the available unit rule isn’t violated, the IRS will consider this a lowincome unit, even if the tested household is over-income. Conversely, if the safe harbor procedure isn’t followed, and a unit in the building of comparable or smaller size is occupied by a market- rate tenant, the burden will be on the owner to show that the lowincome unit was not over-income at the time the unit was rented to the market-rate tenant.
This rule need only be followed if a household was qualified more than 120 days prior to the start of the first credit year. The “test” consists of confirming with the household that the income certification is still accurate. If the household has additional income, the certification should be updated based on household documentation. Third party verifications aren’t required.
Minimum ExpenditureTest. Also important is the “minimum expenditure test.”
Tax credits can’t be claimed for the acquisition costs of a property unless a minimum amount of renovation is done to the building. These rehabilitation expenditures must, at a minimum, equal the greater of (1) $3,000 per lowincome unit, or (2) 10% of the building’s depreciable basis. Housing credit agencies may set higher minimums.
This article has covered many of the issues involved in developing and managing an acquisition/rehab project. Because they can be complex, developers before undertaking these kinds of deals should seek guidance from a compliance professional or tax credit attorney or accountant.
This article is written by A. J. Johnson. A. J. Johnson is president of A. J. Johnson Consulting Services, Inc., a Williamsburg, VA-based full service real estate consulting firm specializing in due diligence and asset management issues, with an emphasis on low-income housing tax credit properties. He may be reached at 757-259-9920, [email protected].
