Check for Five Conditions to Count Unit as Low Income in Monthly Applicable Fraction

To help the owner of your site determine how many credits it may claim for a building, you must first calculate an “applicable fraction” for each month of the first year of the building’s compliance period. The applicable fraction is the percentage of a building dedicated to low-income residential rental units. Under Internal Revenue Code (IRC) Section (§) 42(c)(1)(B), the applicable fraction is the smaller of the unit fraction or the floor space fraction.

Each monthly applicable fraction tells what portion of the building was low income during that month of the year. Under IRC §42(f)(2), there is a special rule for determining the applicable fraction for the first year of the credit period. The amount of credits the owner may claim for the first year is based on the average of each month’s applicable fraction, known as the “prorated fraction.” In other words, for the first year, the prorated fraction is the sum of the monthly applicable fractions divided by 12.

Although calculating the applicable fraction isn’t very complex, managers sometimes make mistakes when deciding which units to count as low income in a particular month. If you count units that don’t belong, the owner of your site could get into trouble with the IRS for claiming more credits than it deserves. And if you mistakenly ignore certain units that belong in your calculations, you may cause the owner to forgo some of the credits it was allocated.

To avoid problems, check that a unit meets the following five conditions before you count it as low income in your calculations of a building’s monthly applicable fraction. Here are the conditions you must check for.

Condition #1: Unit Is in Building That’s Been in Service for Full Month

To count any unit of a particular building as low income in that building’s monthly applicable fraction, the building must have been placed in service for at least a full month. According to the IRS, this means you may include a unit in a certain month’s applicable fraction only if the building’s placed-in-service (PIS) date is the first day of that month (or earlier). If the PIS date is any other day of that month, you can’t include any of the building’s units in its applicable fraction for that month. You would instead need to wait until the following month before including units in the monthly applicable fraction.

For example, suppose a tax credit site has two buildings. Building A was placed in service on March 2, 2016, and Building B was placed in service a day earlier, on March 1, 2016. Building A’s units can’t be counted as low income in the applicable fraction for March because Building A wasn’t in service for a full month. Building A’s units satisfy this first condition in April and may be counted as low income in that month’s applicable fraction if the units satisfy the other three conditions described below.

As for Building B, because it was in service for the entire month of March, its units satisfy the first condition that month and could be eligible to be counted as low income in March’s applicable fraction, assuming they met the other four conditions.

Condition #2: Unit Was Rented to Qualified Low-Income Household

You can include a unit in a building’s monthly applicable fraction only if the household occupying that unit is a qualified low-income household or if the unit was last occupied by a qualifying tenant and currently made available for rent. To be qualified, households must earn no more than a certain percentage of area median gross income, such as 40, 50, or 60 percent. This percentage is determined by agreement between a tax credit owner and its state housing agency when the owner applies for tax credits.

To determine whether a household is qualified, use the rules in the HUD Handbook to complete an initial certification (with verifications) of a household’s income. If an empty unit in your building stays empty or if you rent an empty unit to a market-rate household, that unit won’t satisfy this second condition. So you can’t count it as low-income in the building’s monthly applicable fraction.

Condition #3: Unit’s Rent Doesn’t Exceed Tax Credit Limit

If you rent a unit to a qualified low-income household, the rent charged must be restricted. If you charge more than the maximum, the IRS won’t consider that unit low income and you can’t count it as such in your building’s monthly applicable fraction.

The maximum rent you can charge is based on 30 percent of the appropriate income limit for your area. After you calculate a unit’s gross rent, subtract its utility allowance to get the “maximum allowable rent.” This is the highest monthly rent you can actually charge households. If you charge an amount that’s equal to or less than the maximum allowable rent for a unit, you’ll satisfy this third condition for counting that unit as low income in your building’s monthly applicable fraction.

It’s important to note that non-optional fees related to services other than housing or as a condition of occupancy must be included in the gross rent [Treas. Reg. §1.42-11]. A service is optional when the service is not a condition of occupancy and there is a reasonable alternative. Charges for non-optional services such as a washer and/or dryer hookup and built-in/on storage sheds (paid month to month or in a single payment) would always be included within gross rent.

No separate fees should be charged for tenant facilities such as pools, parking, or recreational facilities if the costs of the facilities are included in the site’s eligible basis. Assuming they are optional, charges such as pet fees, laundry room fees, garage, and storage fees may be charged in addition to the rent.

Under Treasury Regulation §1.42-11(a)(3), the cost of services that are required as a condition of occupancy must be included in gross rent even if federal or state law requires that the services be offered to tenants by building owners. Refundable fees associated with renting an LIHTC unit are not included in the rent computation. For example, security deposits and fees paid if a lease is prematurely terminated are one-time payments that are not considered in the rent calculation.

However, required costs or fees, which are not refundable, are included in the rent computation. These include fees for month-to-month tenancy and renter’s insurance.

Condition #4: Unit Is Suitable for Occupancy

In order to be treated as an LIHTC unit, the unit must be suitable for occupancy. The IRS Code provides authority for the IRS to determine whether the housing is suitable, considering local health, safety, and building codes. Units must be free of health and safety hazards. Suitability for occupancy is assessed according to either the Uniform Physical Conditions Standards (UPCS) established by HUD or local inspection standards. The standards to be used are identified in your state agency’s Qualified Allocation Plan.

Specifically, under HUD’s UPCS, each unit within a building must be structurally sound, habitable, and in good repair. The unit must be free from health and safety hazards, functionally adequate, operable, and in good repair. This includes all areas and aspects of the dwelling unit such as the bathroom, call-for-aid (if applicable), ceiling, doors, electrical systems, floors, hot water heater, HVAC, kitchen, lighting, outlets/switches, patio/porch/balcony, smoke detectors, stairs, walls, and windows. Where applicable, the unit must have hot and cold running water, including an adequate source of potable water. Also, the unit must include at least one battery-operated or hard-wired smoke detector in proper working condition on each level of the unit.

Condition #5: Household Occupied Unit by Last Day of Month

According to IRS Revenue Ruling 2004-82, a unit is treated as a low-income unit for the entire month if an income-qualified tenant resides in the rent-restricted unit on the last day of the month. However, the building must have been placed in service for the full month. In other words, you may move a household into a low-income unit as late as the last day of the month without losing the right to count the unit as low income in that month’s applicable fraction. Therefore, if a unit satisfies the other four conditions, you can count it as low income in a certain month’s applicable fraction no matter when during that month a household moves into the unit.

Although this IRS ruling gives you maximum leeway, keep in mind that waiting until the last day of a month to let a household occupy a unit can be risky. If things don’t go as planned and the household doesn’t sign its paperwork and pick up the keys until the first day of the next month, the owner won’t be entitled to claim credits for that unit until that next month.