Favorable Average Income Set-Aside Regulations Released

Background on the Average Income Set-Aside and the Proposed Regulations

For a residential rental building to be eligible for low-income housing tax credits under Section 42 of the Code, the building must, among numerous other requirements, be part of a “qualified low-income project” no later than the close of the first year of the building’s credit period. A qualified low-income project is a residential rental project that meets one of three alternative set-aside tests. One such set-aside test is the “average income” set-aside. The average income set-aside was added to Section 42 in 2018.²

If a taxpayer elects to rely on the average income set-aside with respect to a residential rental project, the project will be eligible for low-income housing tax credits only if at least 40%³ of the residential units in the project are both rent-restricted and occupied by tenants whose income does not exceed an “imputed income limitation” (Income Limit) designated by the taxpayer with respect to that unit. In addition, the average of the Income Limits designated for the residential units in the project must not exceed 60% of area median gross income (AMGI) during any taxable year within the project’s extended use period (Designated Average Requirement). 

The Designated Average Requirement is susceptible to different interpretations. One such interpretation — and the one adopted by the Proposed Regulations — is that the Designated Average Requirement has to be satisfied with respect to all of the low-income residential units in the project. That interpretation leads to a so-called “cliff risk” under which a project can fail to satisfy the Designated Average Requirement, and therefore the average income set-aside, if a relatively small number of units within the project fall out of compliance with the Section 42 rules. 

To illustrate the cliff risk, consider a hypothetical 100-unit project consisting of the following mix of designated Income Limits:

The average of the Income Limits for all 100 units in the project is 60%. But if a single unit designated as having an Income Limit of 50% of AMGI were to fall out of compliance, the average of the Income Limits of the remaining 99 units in the project would rise above 60%, resulting in a failure of the Designated Average Requirement and thus the disallowance of low-income housing tax credits for at least one year of the credit period, if not the entire credit period. 

The Proposed Regulations acknowledged the existence of the cliff risk and addressed it by permitting taxpayers to take certain mitigating actions to avoid failing the Designated Average Requirement. But industry commentators largely criticized the mitigating actions in the Proposed Regulations as inadequate. In addition, the Proposed Regulations made the cliff risk worse by prohibiting taxpayers from changing the designated Income Limits for the project’s residential units. 

As a result of the cliff risk and the inflexible approach to the Designated Average Requirement in the Proposed Regulations, projects that currently use the average income set-aside are typically structured with a unit mix designed to provide a substantial amount of “buffer.” That is, the Income Limits designated for the units in the project intentionally average to less than 60%. The presence of this buffer is intended to reduce the risk that a project will fail the Designated Average Requirement as a result of a small number of the project’s residential units falling out of compliance with Section 42 of the Code. 

The New Regulations

Treasury and the IRS acknowledge in the preamble to the New Regulations that the Proposed Regulations did not adequately mitigate the cliff risk. The New Regulations therefore adopt a very different interpretation of the Designated Average Requirement. In particular, the New Regulations interpret the Designated Average Requirement as being satisfied if at least 40% of a project’s residential units are eligible to be low-income units and have designated imputed limitations that collectively average to 60% or less of AMGI. In addition, the New Regulations permit taxpayers to modify a residential unit’s Income Limit under certain circumstances, including for purposes of satisfying the Designated Average Requirement.

Under the New Regulations, taxpayers that elect to rely on the average income set-aside will be required to identify one or more “qualified groups” of residential units within the project. Each qualified group must consist of at least 40%⁴ of the residential units in the project, and the average of the Income Limit designations of the units within each qualified group must not exceed 60% of AMGI. Taxpayers will be permitted to designate one qualified group for purposes of establishing whether the Designated Average Requirement is satisfied, and a second qualifying group that includes additional residential units for purposes of calculating the portion (the “applicable fraction”) of the project that is eligible for low-income housing tax credits.

Applying the New Regulations to the hypothetical 100-unit project described above, in order to establish satisfaction of the Designated Average Requirement, a taxpayer would be able to designate all of the units designated as having an Income Limit at or below 60% of AMGI as part of a qualified group. That group would consist of 80% of the units in the project, and the cliff risk for this group would be largely eliminated because the average of the designated Income Limits of the units in that group could never rise above 60% even if up to 40 of the units within the group were to fall out of compliance. A taxpayer could then designate a second qualifying group for purposes of calculating the project’s applicable fraction, which could include the additional units with a designated Income Limit of 70% of AMGI. If any of the units in the first group were to fall out of compliance with Section 42 of the Code (for example, as a result of a casualty event rendering a unit uninhabitable), the taxpayer could either remove one of the units designated with an Income Limit of 70% of AMGI from the qualifying group (which would reduce the amount of credits generated by the project but not implicate the cliff risk) or, if permitted under the circumstances, redesignate the Income Limit of one or more other units in the project so as to bring the average of the Income Limits in the second qualifying group back to 60% or less of AMGI.

The New Regulations therefore adopt a far more permissive interpretation of the Designated Average Requirement and significantly reduce the cliff risk. The preamble to the New Regulations states that the New Regulations “promote certainty and administrability” by allowing “taxpayers, Agencies, and the IRS to more easily verify the status” of a project’s compliance with the average income set-aside. The New Regulations do, however, impose additional recordkeeping and reporting requirements for projects that elect to rely on the average income set-aside. According to the preamble to the New Regulations, the “increased regulatory flexibility … necessitates [additional] recordkeeping and reporting requirements to enhance administrability and certainty for the taxpayers and Agencies that will be taking advantage of the flexibility.” Under these recordkeeping and reporting requirements, taxpayers generally will be required to separately identify the units in each applicable qualified group in its books and records, and those books and records must be maintained throughout the project’s extended use period. In addition, taxpayers will be required to report these identifications annually to the applicable tax credit agency.

Effective Date of the New Regulations and Considerations for Existing Average Income Projects

The New Regulations are generally effective for taxable years beginning on or after January 1, 2023.⁵ Thus, existing projects that elected the average income set-aside and for which a credit period began in a taxable year prior to January 1, 2023, will not be able to rely on the flexibility afforded by the New Regulations for taxable years prior to January 1, 2023. For such years, the preamble to the New Regulations states that “taxpayers may rely on a reasonable interpretation of the statute in implementing the average income test for taxable years to which these regulations do not apply.”

Helpfully, however, the preamble to the New Regulations indicates that the New Regulations reflect a “revised … interpretation of the [average income] set-aside” that is based on the “plain language” of the statute. The preamble also states:

When section 42(g)(1)(C)(i) and the special rules in section 42(g)(1)(C)(ii)(I) and (II) are read together, the taxpayer satisfies the average income test if at least 40 percent of the building’s residential units are eligible to be low-income units and have designated Income Limits that collectively average 60 percent or less of AMGI. A project satisfying this minimum requirement satisfies the average income test.

Thus, it appears that the Treasury Department and the IRS are indicating that taxpayers may treat the average income set-aside as being satisfied for taxable years prior to January 1, 2023, so long as the Designated Average Requirement is satisfied with respect to any combination of the project’s residential units that make up at least 40% of the residential units in the project and for which the designated Income Limit does not exceed 60%.