Key Takeaway

On October 7, 2025, the IRS will publish its long-awaited final regulation governing the Average Income Minimum Set-Aside Test for the Low-Income Housing Tax Credit (LIHTC). The rule clarifies how owners identify and report "qualified groups" of units, how redesignations are handled, and how corrections may be made—significantly reducing the risk of total project disqualification ("the cliff effect").

Background

Since 1986, Section 42 has required owners to elect one of several "minimum set-aside" tests. For decades, only the 20-50 and 40-60 tests were available. The 2018 Consolidated Appropriations Act added a third option—the Average Income Test—allowing a mix of units at varying income levels, so long as at least 40% of units are restricted and the average imputed income limit does not exceed 60% of AMGI.

Temporary rules issued in 2022 attempted to implement this test but left unresolved how to handle post-year-end discoveries of noncompliant units.

What the Final Regulation Does

• Annual Identification of Qualified Groups of Units
  Owners must record and report to their state agency the "qualified group" of units used both for the average income set-aside and for calculating applicable fractions. Records must be retained consistent with §1.42-5(b)(2).
• Agency Flexibility on Reporting
  State agencies may allow taxpayers to submit either one list or two (one for set-aside compliance and one for applicable fractions). Examples in the regulation illustrate acceptable approaches.
• Designation & Redesignation of Income Limits
  Owners must record each unit’s imputed income limit in their books and annually communicate these designations to the agency. Any changes must also be recorded and reported, with the original designations retained.
• Correction & Waiver Procedures
  • Taxpayer-discovered errors: up to 180 days after discovery to submit a corrected qualified group or other fix.
  • Agency-discovered errors: standard §1.42-5 correction period (90 days plus possible six-month extension).
  • Agency waiver authority: Agencies may waive procedural failures in writing within the applicable time frame.

What’s New Compared to Prior Guidance

1. Explicit Permission to Submit Corrected Qualified Groups
   Owners can now remove a noncompliant unit and adjust the group to maintain the 60% average without retroactively changing income designations.
2. Streamlined Reporting Options
   Agencies may accept a single combined list instead of two separate lists, thereby reducing paperwork.
3. Aligned Deadlines
   The correction and waiver timelines now track the familiar §1.42-5 notice and correction procedures.
4. Removal of Temporary Rules
   The temporary regulations issued with the 2022 rule are formally withdrawn.

Effective Date

The new provisions apply to taxable years beginning on or after the publication date (October 7, 2025). Taxpayers may elect to use the rules early for prior years if applied consistently.

Why It Matters

These changes provide owners and investors with greater certainty and flexibility to preserve credits when a unit falls out of compliance. Agencies gain clearer authority to manage reporting formats and waivers, while investors and syndicators benefit from reduced risk of the "cliff effect."

Bottom Line for Our Clients

If you’ve elected the Average Income Test, you’ll need to:

• Maintain detailed contemporaneous records of unit designations and qualified groups.
• Follow your state agency’s reporting format (one list or two).
• Act promptly—within 180 days of discovery—to correct any reporting failures.

What You Should Do Now

Immediate Action Checklist for Owners Using the Average Income Test

• Review unit designations now to ensure your records match the requirements of §1.42-19.
• Consult with your state agency to determine whether it requires one list or two for annual reporting.
• Prepare a plan for corrections so you can submit a revised qualified group within 180 days if needed.
• Train site staff on how to document and communicate any changes in imputed income limitations.
• Coordinate with your investor/syndicator to keep them informed of how you’re implementing the new rule.

This proactive approach will help preserve your credits, avoid compliance headaches, and demonstrate to investors and agencies that you are ahead of the curve.