Understanding the 'Suitable for Occupancy' Requirement
As an owner or manager, it’s important to keep your designated low-income units qualified as such under tax credit rules. Unless a site is deep rent skewed, a LIHTC site must have either 20 percent of the units rent-restricted and occupied by a household with income at or below 50 percent of the area median income (AMI), or 40 percent of the units rent-restricted and occupied by a household with income at or below 60 percent of AMI.
Generally, a low-income or rent-restricted unit qualifies for the tax credit when tenant eligibility is verified and certified; the rent for the unit is restricted; its residency is non-transient; the unit is recorded as a LIHTC unit; the tenant is recertified annually if the unit is in a mixed-income site; the unit is available to the public on a non-discriminatory basis; and the unit is suitable for occupancy.
Your site’s low-income unit must be continuously suitable for occupancy in accordance with state or local codes in order for low-income housing tax credits to be claimed. If any low-income unit at an LIHTC project isn’t suitable for occupancy, the site may become ineligible for continued tax credits, the amount of the tax credit could be reduced, or previously allowed tax credits could be recaptured.
We’ll go over how suitability for occupancy is assessed and the related situation of what to do when a unit becomes uninhabitable because it’s destroyed due to casualty loss such as fire, flood, or any other disaster.
Legal Requirements
Under Internal Revenue Code §42(i)(3)(B), a unit will not be treated as a low-income unit unless the unit is suitable for occupancy and used other than on a transient basis. Also, a low-income unit must be suitable for occupancy under regulations prescribed by the Secretary of the Treasury and taking into account local health, safety, and building codes.
Annual certifications. One way the IRS makes sure your site’s low-income units are suitable for occupancy is through your site’s annual certification to your state agency. Under Treasury Regulation 1.42-5(c)(1)(vi), an owner must certify annually to the state agency that, for the preceding 12-month period, the site was operated in compliance with Internal Revenue Code Section 42 requirements. As part of the certification, the owner must disclose whether the buildings and low-income units at the site were suitable for occupancy, taking into account local health, safety, and building codes (or other habitability standards). In addition, the owner must disclose whether the state or local government unit responsible for making local health, safety, or building code inspections issued a violation report for any building or low-income unit for the site. If a violation report or notice was issued by the governmental unit, the owner must attach a statement summarizing the violation report or notice or a copy of the violation report or notice to the annual certification submitted to the state agency and explain whether the violation has been corrected.
Once the certification is submitted, the state agencies review it. And the owner is considered to be in noncompliance if the certification is inaccurate, incomplete, or the owner discloses noncompliance with any of the 12 specific requirements that include the suitable for occupancy requirements listed in the certification.
State agency inspections. Another way the IRS is made aware that your low-income units are not all suitable for occupancy is through state agency inspections. State LIHTC allocating agencies are required to physically inspect LIHTC sites throughout the entire 15-year compliance period.
Your state housing agency has a choice of which standards it may use when inspecting your tax credit site. Your agency may use local building, safety, and health codes. Or it may use HUD’s Uniform Physical Condition Standards (commonly known as “UPCS”). The UPCS inspection protocol was developed by REAC to ensure that housing is “decent, safe, sanitary and in good repair.” REAC conducts approximately 20,000 annual inspections of rental housing that’s owned, insured, or subsidized by HUD using the UPCS inspection protocol.
Your state housing agency is required to inspect your site at least once every three years. For a new site, your state housing agency must conduct its first inspection by the end of the second calendar year after the site’s placed-in-service year.
If you manage a multi-building site and your state agency hasn’t adopted UPCS protocols, all LIHTC buildings must be inspected by the end of the second calendar year in which the last building at your site was placed in service. If your state agency, however, has adopted UPCS protocols, it doesn’t have to inspect all LIHTC buildings. In the eyes of the IRS, HUD’s oversight of the REAC program substitutes for an all-buildings requirement for inspection.
The frequency of inspections under the REAC protocol is based on inspection scores. But even with an outstanding score, inspections performed under this protocol are required at least once every three years. REAC scores are based on a scale of 0-100 that reflects the physical condition of a property, inspectable area, or sub-area. A passing score is 60 or above, and your most recent score will determine when your next inspection will occur. A score of 90 to 100 means your next inspections will occur in three years; 80 to 89 is every two years; and 79 and below means your site will be inspected every year under the REAC protocol.
It’s important to note that HUD’s standards don’t supersede or preempt local health, safety, and building codes. A LIHTC site must continue to satisfy the local health, safety and building codes. In addition, the state agency must also review any local health, safety, or building code violations reports or notices retained by the taxpayer.
Casualty loss. The determination that a unit is unsuitable for occupancy is based on its physical condition, without regard for the cause of the noncompliance. In cases where a unit is destroyed by fire, flood, or any other disaster, and thus not suitable for occupancy, no credits can be claimed while the unit is being replaced unless the site is declared a major disaster area or repaired during the casualty year. However, under IRC §42(j)(6)(E), if a unit is restored within a reasonable time, credits can again be claimed and no recapture of the accelerated portion of previously claimed tax credits would occur. According to the IRS, a period of up to two years following the year in which casualty loss occurs or in which the president declares a federal disaster area is a reasonable time period to repair site damage and avoid recapture of claimed tax credits [CCA 200134006].
For a site located in an area declared a major disaster area by the president under the Stafford Act, you’ll be able to claim credits during the year in which the casualty occurred. In these circumstances, the property must still be repaired within a reasonable time period not to exceed two years from the close of the year that the casualty loss occurred, but credits can continue to be claimed even if the repairs aren’t completed by the end of the year of loss.
Record retention. Under Treasury Regulation 1.42-5((b)(3), an owner must retain the original local health, safety, or building code violation reports or notices that were issued by the state or local government unit for the state agency’s inspection. Retention of the original violation reports or notices is not required once the state agency reviews the violation reports or notices and completes its inspection, unless the violation remains uncorrected.
In addition, in cases of casualty loss, document the damage caused by the event, as well as all of the steps you take along the way to get the units or building restored and placed back in service. Evidence of the casualty loss might include photos of the damaged units, before and after appraisals, and police reports. Documenting all of the steps that were taken along the way allows you to show due diligence and your efforts in moving the process of getting the building restored as quickly as possible. Without that documentation, the process could be viewed by the IRS or by a state agency as an unreasonable delay.
How Offline Units Affect the Applicable Fraction
Under IRC §42(c)(1)(B), the applicable fraction is the smaller of the unit fraction or the floor space fraction. IRC §42(c)(1)(C) defines “unit fraction” as the fraction, the numerator of which is the number of low-income units in the building, and the denominator of which is the number of residential rental units in the building. And IRC §42(c)(1)(D) defines “floor space fraction” as the fraction, the numerator of which is the total floor space of the low-income units in such building, and the denominator of which is the total floor space of the residential rental units.
Under IRC §42(c)(1)(A), the applicable fraction is determined on the last day of the taxable year. Low-income units that are not suitable for occupancy at the end of the taxable year are not qualified low-income units and will reduce the applicable fraction used to compute the allowable LIHTC for the taxable year.
For example, suppose an owner has a 100 percent low-income building with 10 units. As part of an audit, an examiner determines that three of the 10 units were not suitable for occupancy at the end of the taxable year. Using the unit fraction method, the applicable fraction is (10-3)/10 = .7000. This figure needs to be compared to the fraction using the floor space fraction method. Suppose the building consists of five units with 1,000 square feet and five units with 1,200 square feet, for a total of 11,000 square feet. And all three of the units determined to be unsuitable for occupancy were units with 1,200 square feet. The applicable fraction using the floor space method is computed as [(2)(1,200) + (5)(1,000)] /11,000 = .6700. Therefore, the corrected applicable fraction is the smaller of the two fractions, or .6700.
Now to see how the reduced applicable fraction affects the allowable credit for that year, suppose the allowable credit is $75,000, and that on Form 8609-A filed with the tax return, the owner computed the credit as:
Eligible Basis: $833,333
Applicable Fraction: x 1.00
Qualified Basis: $833,333
Applicable Percentage: x 0.09
Allowable Credit: $75,000
When the applicable fraction is reduced to .6700, the allowable credit is $833,333 x .6700 x 0.0900 = $50,250. Thus, the adjustment to the allowable credit is $75,000 - $50,250 = $24,750. Since the adjustment resulted in a reduction of the Qualified Basis, the IRC §42(j) recapture provisions are also applied.
Suppose it’s the sixth year of the 15-year compliance period. The recapture rate is 0.333. The recapture amount from each prior year is 0.333 × $24,750 = $8,241, plus interest from the due date of the return on which the credit was claimed, to the due date of the return on which the recapture is being made. The IRS requires interest to be computed at the overpayment rate determined under Section 6621(a)(1), compounded on a daily basis. The overpayment rates are based on the short-term federal rate and are published quarterly by the IRS. For the example here, the total recapture amount would be $49,446 plus interest for the first six tax years of the site.