Two Common Errors That Can Cause Trouble For Tax Credit Developers
By Caitlin Jones & A. J. Johnson
9 min read
Tax Credit Advisor February, 2006: As every tax credit developer and manager knows, there is no shortage of complex rules for the program, any one of which can threaten the credits of a property when incorrectly applied. But two issues have been recurring problems in 2005 and deserve special attention as we move into the New Year. They involve the incorrect inclusion of common area in eligible basis and failure to include mandatory charges to residents in gross rent.
Incorrectly Including Common Area in Eligible Basis
Eligible basis is a term unique to the Low-Income Housing Tax Credit Program. In simplest terms, eligible basis is the depreciable cost of a tax credit building. Once eligible basis is determined, it becomes a critical element in the calculation of annual credits. By multiplying eligible basis times a buildings applicable fraction, qualified basis is determined. Qualified basis is the amount of cost on which annual credits may be claimed.
Eligible basis is the adjusted basis as of the close of the first taxable year of the credit period. Some project costs may not be included in eligible basis, such as the disproportionate cost of non-low-income units; commercial, industrial, office or retail space; permanent financing costs; syndication costs; amount of federal grants; and common area not for use by all residents or for which a separate fee is charged. It is the issue of common areas that is often misunderstood and will be addressed by this article.
Before discussing the common area issue, a quick examination of the importance of eligible basis is in order. Developers work hard to maintain eligible basis; the following example illustrates the reason:
- Eligible basis of $10 million;
- Applicable fraction (percentage of building occupied by low-income residents) of 100%;
- Eligible basis times applicable fraction equals qualified basis of $10 million;
- Tax Credit percentage of 9% (this is the credit which is used for properties that have no federal or tax exempt financing);
- Qualified basis times applicable percentage equals $900,000 (annual credit). (Keep in mind that the actual credit percentage varies from month-to-month);
- Credit is taken each year for 10 years for a total credit of $9,000,000.
In today’s environment, investors are willing to invest equity of approximately $.90 for every $1.00 of ten-year credit. Obviously, a reduction in credits will reduce equity and potentially the developers fee, something no developer wants, so maintaining eligible basis is critical. For example, a reduction in eligible basis of $500,000 would result in a reduction in annual credits of $45,000 or $450,000 over ten years. This could reduce equity by approximately $405,000.
Once a project’s eligible basis is initially determined, it must be maintained throughout the compliance period. Changes in eligible basis during this 15-year period will be reported by State Housing Credit Agencies (HCA’s) to the IRS on Form 8823.
As noted above, common facilities (such as community rooms, parking areas, etc.) may be included in eligible basis if these facilities are “available on a comparable basis to all tenants and for which no separate fee is charged for use of the facilities, or facilities reasonably required by the project.” This requirement is outlined in IRS Regulation 1.42-5(b)(ix).
The eligible basis discussion in the General Explanation of the Tax Reform Act of 1986 states that “the allocable cost of tenant facilities, such as swimming pools, other recreational facilities, and parking areas may be included (in basis) provided there is no separate fee for the use of these facilities and they are made available on a comparable basis to all tenants in the project.” This requirement is re-stated in Treasury Regulation 1.103-8(b)(4)(iii).
Most developers and managers of tax credit properties know that residents may not pay extra for the use of common areas, but there is often a lack of understanding of the “comparable use” requirement.
Comparable Use
As stated throughout the tax credit regulations, common areas included in eligible basis must be available on a comparable basis to all residents. Basically, this means that all residents must have approximately equivalent access and use of the facility. When this space is not available to all residents on a comparable basis, it becomes an eligible basis issue. For example, assume a 100-unit property with 50 common area storage units (i.e., the storage units are not part of the individual apartments). Most owners would include the cost of these storage units in basis and make the storage available at no charge to residents, on a first come-first served basis. The mistake here is that since there is not enough storage for all residents, none of the cost of the storage units may be included in basis. If a State HCA discovers that such space was included in basis, the violation would be reported to the IRS as a reduction in eligible basis, resulting in a potentially significant reduction to credits. The good news is that once the space is removed from basis, a fee may be charged for its use.
However, not all examples of comparable use are as clear-cut. How would an owner handle the situation where there are not enough parking spaces to serve all units in a project? If spaces were “assigned” to particular residents, the cost of parking clearly could not be included in basis. But, what if the spaces were available on a “first come-first served” basis? Theoretically, every resident would have a comparable chance to find a parking space each day and the comparable use test appears to be met. But, what about residents that work? By arriving home late, do they really have “comparable use?” This situation is not quite as clear. Owners must look at each situation based on its own facts and circumstances, but in all cases, space that is not clearly available to all residents on a comparable basis should not be included in eligible basis.
Mandatory Fees
There are two basic categories of fees that are generally charged at tax credit properties, one-time fees and recurring fees.
Recurring fees are those that are generally charged and understood by tax credit developers and managers. These are fees that are paid on a regular (often monthly) basis. Examples of recurring fees that are optional and normally considered as acceptable include pet fees, washer/dryer rentals, and cable TV fees. Mandatory fees (those that are not optional to residents) must be included in gross rent for tax credit purposes. So, essentially, these fees, when added to rent being charged to residents, must not cause the gross rent to exceed the maximum allowable tax credit rent. If they do, the property is in an excess rent situation. Examples of recurring fees that are normally considered mandatory and not acceptable are month-to-month lease fees, charges for the use of in-unit washer/dryer hookups, and requiring that residents obtain renters insurance.
One-Time Fees
One-time fees are usually fees that are paid “up-front,” such as application fees. If required as a condition of occupancy, these up-front fees must be included in gross rent for Section 42 purposes (to the extent that such fees exceed actual “out-of-pocket” costs). For example, a property charges applicants an application fee of $35, of which $30 is actual processing costs paid to third parties. In this case, $5.00 must be included in gross rent. Whether this rent must be prorated across the lease period or included in the first months rent differs on a state-by-state basis. Other examples of one-time fees that must be included in rent include redecoration fees, occupancy fees, and administrative fees. Regardless of what they are called, the IRS just considers these to be “rent.”
Owners and managers must keep in mind that fees are only an issue if payment of the fee, plus rent, exceeds the allowable Section 42 rent level. Also, any fee is generally allowable if it is for a service that is clearly optional to the resident.
While most owners understand that recurring fees must clearly be optional, confusion revolves around the “one-time fees.” The General Explanation of the Tax Reform Act of 1986 states that “a service is optional if payment for the service is not required as a condition of occupancy.” It also states “any charges for services that are not optional to low-income tenants must be included in gross rent for purposes of Section 42(g)(2)(a).”
Treasury Regulation 1.42-11(b)(1) and Revenue Ruling 91-38 provide additional guidance in this area. Both indicate that in addition to not being mandatory, there must also be a “reasonable alternative” to a particular service.
Additional Guidance
Private Letter Ruling 9330013 provides additional guidance on the IRS position relative to Application Fees (keeping in mind that Private Letter Rulings apply only to the taxpayer to whom they are given). This PLR indicated that any application fee in excess of third party costs should be included in gross rent for Section 42 purposes. It further stated that as an alternative to requiring an application fee, management may require that the fee be paid directly to the third party. The ruling went on to indicate that, “rent in the context of Section 42 of the Code is a periodic charge for the right to occupy or use someone else’s property. Thus, Taxpayers one-time application fee that reimburses their out-of-pocket expenses for checking credit and landlord references is not rent under Section 42 (g)(2).
The issue of Application Fees is one of the most misunderstood fees related to the tax credit program. Owners and managers must realize that to the extent these fees exceed actual costs, they must be included in gross rent, and any mandatory fees in excess of gross rent should be rebated to residents and the fees eliminated or rents lowered to appropriate levels.
General Recommendation
As a general recommendation, the State HCA should approve any fee in addition to rent. For example, while most states will permit monthly pet fees as an optional fee, some will not. In these cases, any additional fee paid to keep a pet will have to be included in gross rent for Section 42 purposes. From the standpoint of the IRS, rent by any other name is still considered rent and owners must be careful regarding any charges in addition to rent.
There are many complex requirements of the Section 42 program, but the two outlined in this article, common areas in eligible basis and the charging of one-time fees, are among the issues causing considerable problems for properties at the present time. Each of these issues is becoming more of a focus for State Housing Credit Agencies and owners need to be aware of the potential threat to credits for violating these areas of tax credit law.
By A.J. Johnson
