How Tax Returns for LIHTC Properties are Analyzed for Audit Potential
The IRS §42 Audit Guide provides guidance for analyzing tax returns before contacting taxpayers to determine the specific tax credit issues that should be audited. Prior to any actual audit, the IRS will examine 8609s, any 8823s that have been issued against the property, annual 8609-As, partnership balance sheets, K-1s, and prior and subsequent year tax returns.
Review of 8609s
When reviewing the 8609s, the IRS will examine the following issues:
*Amount of credit allocated, to ensure that no more than this amount was claimed in any one year;
*Eligible Basis and Qualified Basis. They will also review the amount of qualified basis allowed by the State Agency in order to determine the maximum annual tax credit. The service will confirm that the amount of eligible basis shown on the 8609-As (Annual Statement for Low-Income Housing Credit), matches the eligible basis shown on Part II of the 8609. This is particularly important, since it indicates that the IRS will permit “excess basis” to be used in the calculation of annual credits.
*Type of Allocation: the 8609 should clearly indicate whether the building is new construction, an existing building, or an existing building that has been rehabilitated (in which case each building will have two 8609s), and whether federal subsidies were used to build or rehabilitate the building.
*Tax-Exempt Bonds: The IRS will confirm that if tax-exempt bonds were used in financing the building, the credits are limited to the 30% (also known as the 4%) credits.
*Nonprofit Set-Aside: if the credits were issued from the nonprofit set-aside, the nonprofit entity must (1) own an interest in the property, and (2) materially participate in both the development and operation of the project throughout the 15-year compliance period.
*Credit Period – BINs, Dates, and Elections: the IRS will examine each 8609 to determine the credit period for the building/project. This will require a review of Line 5 (placed in service date), Line 10a, the first year of the credit period, Line 8b, the multiple building project election, and Line 10c, the minimum set-aside election.
*Form 8823, Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition: any 8823s that have been issued against the property will be reviewed to identify issues that should be addressed during an audit. The findings reported by the state agency on an 8823 are considered to be correct unless otherwise proven to be incorrect. While the IRS may use the information on an 8823 to make adjustments to the credit, they will not project the state agency’s sample results to the entire population of low-income units. In other words, if the state reviews 20 units out of 100 (20%) and finds all ten to be out of compliance, the IRS will only adjust the credit for the ten units; they will not assume that all 100 units are out of compliance.
*Form 8609-A, Annual Statement for Low-Income Housing Credit: the owner of a LIHTC project files this form each year to compute the annual credit for the year.
- The form cannot be completed unless the state agency has issued an 8609;
- The IRS will examine the form to ensure
- Eligible basis on the 8609, Line 7 and 8609-A are the same;
- The credit percentage on the 8609-A and 8609, Line 2, match; and
- 8609-A, Line 15 does not exceed the maximum permitted annual credit as shown on the 8609, Line 1b.
*Land Values: The IRS will examine the value of the land as shown on the project’s balance sheet. The value should be reasonable and comparable to land record valuations. Extremely low values will raise a red flag since the cost of land is not includable in eligible basis and owners naturally want to maximize eligible basis.
Other items the IRS will review prior to the actual audit include:
- Accounts receivable and payable;
- Schedule K and K-1;
- Prior and subsequent year tax returns;
- Related returns – these are tax returns that have a relationship to the tax return under audit. Returns are considered related if an adjustment to one return requires adjustment to the other return. Returns are also considered related for audit purposes if the returns are for entities that a taxpayer controls and can manipulate to divert income or camouflage transactions; and
- General Partner (GP) – Additional 42 Projects. If the entity under audit owns the §42 project, it is likely that it is a flow-through entity and the general partner is the project’s developer. The Service will determine whether the GP is also the GP for other §42 projects. If significant noncompliance is identified, the examination may be expanded to the other projects.
Initial Information Document Request
Owners of LIHTC properties should keep all records relating to the tax credits for at least six years after the due date (with extensions) for filing the federal income tax return for that year. The records for the first year of the credit period must be retained for at least six years after the due date (with extensions) for filing the federal income tax return for the last year of the compliance period. Prior to audit, the IRS will request – at a minimum – the following documents:
- Partnership Agreement;
- Syndication Prospectus/Offering Memorandum;
- Documentation of partners capital contributions;
- Credit Allocation Application;
- Market Study;
- Credit Allocation Award/Contract or Carryover Allocation;
- Extended Use Agreement;
- All Forms 8609 issued to the Taxpayer;
- Internal Audit Reports (including any third party reviews); and
- All Forms 8823 (including documentation of any corrective action taken);
- Tax returns for the tax year prior to the earliest year under audit and all tax returns for years after the tax years under audit;
- Work papers used to prepare the tax return under audit;
- Depreciation schedules;
- Final Cost Certification, with supporting documents;
- Documentation of all financing sources;
- Financial reports;
- Development contracts or agreements for the acquisition, construction, or rehabilitation of the project;
- Documentation of cost allocation between land and improvements;
- For years under audit, rent rolls identifying the households and family size for each low-income unit; and
- Documentation of internal controls in place to ensure that qualified households occupy the low-income units.
If the first year of the compliance period is audited, the following information will be requested:
- Certificates of Occupancy, which will establish when the units were first available for occupancy;
- A schedule showing when each low-income unit was initially occupied/qualified;
- Computation of the applicable fraction, including the calculation for each month of the first year of the credit period; and
- A list of any units that were first occupied by qualified residents after the end of the first year of the credit period and documentation of when such units were qualified (“2/3” units).
Since the audit will include a review to ensure that tenants were not charged rent or fees not permitted by the program, the following information will be requested:
- Rents charged for low-income and market units;
- Units occupied by employees or security personnel;
- Rent computations based on unit sizes;
- Sources of any rent subsidies, such as Section 8;
- Utility allowances and documentation of the computation;
- Fees for services provided to tenants in addition to housing –g., providing meals or cleaning services in assisted living housing;
- Other income from related activities –g., vending machines, laundry facilities, or charges for cable/satellite television;
- Other income sources such as from the commercial use of a portion of the property –g., cell phone tower on the roof of a building;
- Documentation of funds received from other sources –g., federal grants or subsidies received during the year, additional capital contributions, or loans.
The Guide is very detailed with regard to the information that should be requested prior to an audit, and serves as a general outline for the type of documentation that owners should retain and preserve.