In this issue: Confronting one of the most confusing aspects of the tax credit program – the difference between the minimum set-aside and the applicable fraction. How to income-qualify a Sec. 8 household into Sec. 42 is also discussed.
Q Can you explain the difference between a minimum set-aside and an applicable fraction? We are managing a tax credit development, and everyone is confused. What do we need to know about either of these?
– At Minimum I Am a Fraction Confused
A Dear At Minimum: We can give you the basic differences here, but either one of these topics could hold you spellbound for hours if you want to know everything that can be known about them.
Federally, there are two elections from which an owner selects: either the 20/50 set-aside or the 40/60 set-aside. The reason this is called the “minimum” set-aside is because it demonstrates the lowest percentage of units that must be placed into the tax credit program in order to apply for a tax credit award from your state housing finance agency. It works like this:
Under the 20/50 program, at least 20% of the units in a project must be placed into the tax credit program. So that’s what the 20 in the 20/50 means. Yes, you can select a higher percentage of units on the project to be low-income – many owners elect to have 100% of their units placed into the tax credit program, but that’s an “applicable fraction” decision, which we will discuss in a few paragraphs. At minimum, 20% must be low-income. Any percentage less than 20% means tax credits will not be available for the project.
The maximum income and rent restriction on all tax credit units under this 20/50 election is 50% of area median gross income (AMGI), so that’s where the 50 in the 20/50 originates.
Under the 40/60 program, you have probably already guessed that at least 40% of the units in a project must be placed into the tax credit program. By agreeing to put at least 40% into the program, a project is permitted to increase its maximum rent and income limit for qualifying households to 60% of AMGI. Of the two federal elections, the 40/60 is the most common choice.
The minimum set-aside is a project assignment. If a project is unable to meet the 20% or 40% minimum requirement by the end of the first year of the credit period, the project is disqualified as a tax credit project. This makes meeting the minimum requirements an important accomplishment during the project’s first year.
Measuring the minimum set-aside is accomplished on a unit-by-unit basis. For example: If a 100-unit project (regardless of the number of buildings) is under the 20/50 program, at least 20% of the units must be low-income and all low-income units must be at 50% of AMGI or less. If the same project is under the 40/60 program, then at least 40% of the units in the project must be low-income, and all low-income units must be at 60% of AMGI or less for income and rent purposes.
But wait – this gets even more interesting. The Internal Revenue Service (IRS) Form 8609, Low Income Housing Credit Allocation Certification, for each building assumes that the owner is making each building its own project. If an owner wants to make each building part of a multiple-building project, they must make this election on the 8609. If they do not elect this, then each building is its own project. This means that each building must demonstrate that the minimum set-aside has been met in the one-building project.
The applicable fraction is a building-by-building computation that is measured on both the numbers of residential units and the square footage. (The definition of a building in Sec. 42 is based on the Building Identification Number the state housing finance agency assigns.)
It is used to determine the total number of units in each building that will be low-income.
Owners are awarded tax credits for a building based on the eligible costs multiplied by the applicable fraction. The higher the percentage of units and square feet in a building that is set aside for tax credit units, the more tax credits the owner receives. The highest possible applicable fraction for a building is 100%.
Typically, owners set the applicable fraction for buildings higher than the minimum set-aside so that, from an owner’s perspective, meeting the minimum requirement is usually assumed to occur as the buildings in the project reach for the higher goal. Once the fraction has been set, it must be met and maintained in each building for the entire compliance life of each building. The IRS Form 8609 Schedule A Annual Statement shows a building’s applicable fraction. If units fall out of compliance and that compliance failure is repetitive or is not corrected, the applicable fraction is lowered and tax credits cannot be claimed on affected units. This is why owners focus more attention on the applicable fraction in each building and not the minimum set-aside.
If a project contains buildings that are all 100% tax credited (100% applicable fraction), measuring square footage becomes a moot point. If, however, the applicable fraction in a building is set at less than 100%, the square footage measurement must be watched very carefully.
For instance, a building of 10 units, each measuring 1,000 square feet has a total square footage of 10,000. If the owner determines that only 80% of the units and square feet will be tax credited, eight units and 8,000 square feet must always be low-income space. The remaining two units are typically market-rate units.
This becomes more complex when a building has 10 units of different sizes. For example, if there are five one-bedroom units at 800 square feet and five two-bedroom units at 1,200 square feet, the 10 units comprise 10,000 square feet. But an 80% applicable fraction must be met by combining enough units and square feet to total eight units and 8,000 square feet. Owners may be tempted to put all five of the one-bedroom units into the applicable fraction, and three of the five two-bedroom units. The benefit is that two of the two-bedroom units would remain available for market-rent units.
The problem in this example is that the eight units (five one-bedroom and three two-bedroom units) would not total the required 8,000 square feet (4,000 square feet plus 3,600 square feet is 7,600 square feet, 400 square feet short of the total). The IRS awards tax credits on the lesser of the unit or square footage fraction.
Owners and managers must be careful to select units that will meet the square footage requirement and to maintain enough low-income units and square footage throughout the federal compliance period. In our example, it would take four one-bedrooms and four two-bedrooms to accomplish this.
If you do not know what your minimum set-aside is for a project, ask for copies of the 8609 forms for each building. If you do not know what your applicable fraction is, ask for copies of the 8609A for each building.
Q Last week we became aware that we are going to begin managing a 264-unit Sec. 8 project that is being rehabbed into Sec. 42. The owners want all of the units certified as tax credit eligible by the end of April. Since both programs use Sec. 8 to qualify families, is there really any paperwork to do or can we just rely on the Sec. 8 certification as of the most recent year for each household?
– Great Expectations
A Dear Great: My response will go one of two ways depending on whether or not you have project-based assistance.
Here’s how it works:
If you have project-based assistance, you will need to conduct a full certification on each unit by the end of April in order to determine eligibility. That’s a considerable amount of paperwork to accomplish in only a few weeks. You should not expect every Sec. 8 unit to qualify for Sec. 42 for two reasons: increases in income and students.
Increases in income: Over the course of time, a Sec. 8 family’s income may increase. Their portion of the rent payment will be adjusted, and it is possible that, over time, their income could rise above the eligible maximum tax credit income limit. You cannot require a Sec. 8 family to vacate a unit just because they are not tax credit eligible, so be careful.
Students: The tax credit program has rules that exclude full-time student families except under very specific circumstances as outlined in the Internal Revenue Code (IRC 42(i)(3)(D). Sec. 8 has its own student rules, which are different from Sec. 42. You will want to Sec. 42 student certify each unit at the same time that you complete the new Sec. 42 certification process.
If you have PHA-based assistance (vouchers): The process is quite different and less dependent on your efforts than on the public housing authority (PHA). In this case, you may rely on certifications that were completed by the PHA. The IRS has provided a procedure for this in 42(f)(2)(A) which is further documented in Treasury Regulation 1.42-5(c)(iii) and b(1)vii. Very simply, the PHA can document tenant income eligibility by providing a “statement to the owner declaring that the tenant’s income does not exceed the applicable income limit.”
As with project-based assistance, the same issue with students arises when working with the PHA to certify eligibility. Since Sec. 8 has a different definition of student eligibility, all households need to be screened with a tax credit student eligibility form. Make certain that each household completes this form. If all the family members are full-time students, their eligibility for Sec. 42 must be verified through one of the four Sec. 42 qualifying exceptions. If the household is determined to be an ineligible full-time student household, tax credits will not be available until such time as a Sec. 42-qualified family occupies the unit.
Have you got a compliance question that is keeping you up at night? Contact firstname.lastname@example.org and get it answered. All questions presented in this column and in TheoPRO’s Weekly On-Line Compliance Advisor are real questions, and all are answered by Ruth personally. See www.icomply 42.com for more information.