Why Income Averaging Matters
By Edward Seiler
7 min read
New LIHTC option has industry abuzz
If you’ve attended an affordable housing conference in the past few months, much of the conversation has likely centered around income averaging. The Consolidated Appropriations Act of 2018, an omnibus spending bill covering many agencies passed by both houses of Congress in March, included this brand new Low Income Housing Tax Credit (LIHTC) qualification option. Income averaging is not a completely new idea—it was included, for example, in Senators Cantwell and Hatch’s Affordable Housing Credit Improvement Act both in 2016 and 2017. But now that it has passed, it needs to be understood, clarified and implemented.
There is still a lot to learn about this recent and evolving addition to the LIHTC program available as of March 23, 2018. States are not required to include IA in their programs, but those that do need to issue their own guidelines and incorporate them into the QAPs. As of June, only eight states have completed this task. (See charts on pages 20 and 21.)
The potential societal advantage of income averaging is that it can address two issues in affluent metro markets: alleviate the affordable housing shortage for extremely and very low-income households while also providing LIHTC rental housing for moderate-income workforce families. For owners, the higher rents of higher area median income (AMI) residents can offset the rents of extremely low-income residents to make a property that was once fiscally unfeasible worth considering. By providing greater income mixing potential, IA enables developers to more specifically address the housing needs of a community.
So let’s look at the concept of IA, with examples of just how it works and at associated economic aspects.
What is Income Averaging (IA)?
IA is a third minimum set-aside option added to the two existing tests used to qualify for LIHTC. Previously, owners of new developments would elect a minimum set-aside so that either:
- 20 percent of the units were rent restricted and occupied by tenants with incomes less than (or equal to) 50 percent of the AMI (often referred to as“20-at-50”); or
- 40 percent of the units were rent restricted and occupied by tenants with incomes less than (or equal to) 60 percent AMI (“40-at-60”).
On the surface, IA is similar to the 40-at-60 option in that 40 percent of the units need to be rent restricted. However, the 60 percent AMI does not need to be met by every rent restricted tenant, but instead serves as an average of the tenants’ imputed AMIs.
Tenants with AMIs up to 80 percent meet the IA criteria if they are balanced by lower AMI households, and the overall AMI average achieved is no greater than 60 percent.
Income averaging thus provides additional flexibility. While including moderate-income households with AMIs in the 60 to 80 percent range, it still promotes targeting to very low-income households. The result is that it encourages more mixed-income housing.
How does IA averaging work?
IA is based on the distribution of designated income/rent levels of units in a building and not on resident incomes.
As developers apply to qualify for LIHTC they designate unit income limits. These are in ten percent increments beginning with 20 percent AMI and rising up to 80 percent. The average of all the affordable units must be 60 percent AMI.
The designation of an 80 percent unit allows the owner the flexibility to establish offsetting limits in many ways to best match the prospective tenant pool in the community. They could, for example, set one other unit at 40 percent to achieve an average of 60, or they could set two units at 50.
As the number of affordable units in a property increases, the number of permutations to achieve IA also increases, and there could be tens (if not hundreds) of ways for owners to designate unit income limits.
It is anticipated that the allowance of higher AMI, higher rent units will encourage more lower AMI, lower rent units. And that is the potential benefit of this program – it addresses a current and growing urban concern by providing more housing for both extremely low-income and workforce residents.
Renters who fall between increments are rounded off to the higher level. A household with an AMI greater than 70 percent but less than (or equal to) 80 percent can move into a unit designated as an 80 percent AMI unit. However, a household with a 65 percent AMI, for example, could move into a unit designated as a 70 percent AMI unit or a unit designated as an 80 percent AMI.
IA and workforce housing
Many essential workers (such as police officers, teachers, nurses and ENT professionals) who make moderate incomes face challenges in finding affordable, available and adequate rental housing close to their places of employment. While the moderate-income population covers the broad 60-120 percent AMI range, IA will help the hardest hit 60-80 AMI workforce households—particularly in some of the more affluent metropolitan areas. IA incentivizes mixed-income housing. By electing the IA option, an owner can help not only alleviate the workforce housing problem, but in doing so, can also help extremely low-income and very low-income renters where the lack of affordable and available units is acute. For example, if a developer designates two units at 30 percent, it will allow three units at 80 percent or six units at 70 percent (among other permutations).
Mixed-Income Housing
As a graduate student in Chicago in the 1990s, the topic of mixed-income housing was a hot topic. The idea of combatting residential segregation and eliminating concentrated poverty (e.g., in Cabrini-Green, a large Chicago public housing project built in the 1940s) was touted, by some, as not only a way to improve the prospects for low-income families, but also a way to provide low-risk ventures for investors (with stable rates of return). Mixed-income housing was viewed as a win-win situation. The evidence on the advantages of different types of mixed-income housing is well documented. A nice review of the literature is in: Levy, McDade and Dumlao (2010), “Effects from Living in Mixed-Income Communities for Low-Income Families: A Review of the Literature,” The Urban Institute.
Choice Paralysis
In classical microeconomic theory, we assume that adding a new option to an existing menu of options (without removing an existing one) leads to improvement.
If, in our case, a developer feels that the 20-at-50 or the 40-at-60 option is better than the IA option, he/she will choose one of these options and will not be any worse off than if IA did not exist. On the other hand, if he/she chooses the IA option, it must mean that it dominates the other two, and the developer is thus better off. Economists thus say that an additional option will lead to a “Pareto” Improvement or a change in allocation that harms no one but helps at least some people.
However, more isn’t always better. Behavioral experiments have shown that the relationship between choice and wellbeing is complicated. Too many choices can lead to choice paralysis and the fear of regret. (See: Barry Schwartz (2006), “More Isn’t Always Better,” Harvard Business Review: Volume 84, Issue 6, or listen to his TED Talk titled “The Paradox of Choice” at https://www.ted.com/talks/barry_schwartz_on_the_paradox_of_choice).
As illustrated above, by adding IA as a third option, we are in effect adding many options – as many as the possible permutations allow. This means that owners don’t face three choices, but many more – possibly leading to choice paralysis.
Moreover, by adding the IA election option, additional bureaucratic and administrative costs may outweigh the benefits. This is an issue that must be faced with the new IA housing credit option – especially as additional state agencies provide guidance on how to implement IA.
What’s next?
IA is in its infancy. While it provides an additional tool for providing affordable rental housing, it may take time to catch on and to become a common consideration of developers and owners accustomed to other formulas. It will also take some time before benefits dominate costs.
Developers who want to take advantage of IA will require detailed market analyses to help them integrate this option into their demand analyses and penetration rate methodologies, as well as to navigate the many choices and permutations in electing which set-aside option to use, and how to best implement IA, if elected.
