An IRS Chief Counsel Memorandum issued on May 22, 2019 takes a hard line regarding the noncompliance of common area for purposes of §42 Low-Income Housing Credit.
The memo was prepared by the Office of Associate Chief Counsel (Passthroughs and Special Industries) in response to a request for clarification from an IRS Program Manager for Technical Issues. While this is an IRS internal document, and cannot be cited as precedent, it does provide clear guidance regarding how the IRS may approach the issue of common area noncompliance during an audit, or as a result of the issuance of an 8823 by a Housing Credit Agency (HCA).
Clarification was requested relating to three issues:
- Should the noncompliance of a common area in a qualified low-income building, based on a failure of the inspection standards under §1.42-5(d) of the Income Tax Regulations or any requirements under §42, be treated as a change in the eligible basis of the building in the taxable year in which the noncompliance occurs?
- If the noncompliance of a common area in a qualified low-income building is treated as a change in the eligible basis of the building in the taxable year in which the noncompliance occurs, for purposes of determining if recapture under §42(j) is appropriate, is the change a reduction in the amount of the total costs attributable to the specific common area that was included in the eligible basis of the building, or in the amount of the costs attributable only to the noncompliant portion of the common area?
- As an alternative, should the noncompliance of a common area be treated as a change in the applicable fraction of the building, as if one of the low-income units located the closest to the non-compliant common area was out of compliance?
The IRS concluded “yes” for issue #1. Common area violations are an eligible basis issue. Issue #2 is where the IRS has taken a very hard line. As stated in the Memo, “For purposes of determining recapture under §42(j), a change in the eligible basis of a qualified low-income building… is a reduction in the eligible basis of the building… in the amount of the total costs attributable to the specific common area that was included in the eligible basis of the building. The reduction in the eligible basis is not the amount of the costs attributable only to the portion of the noncompliance common area.”
Issue #3, was addressed with a straightforward “no.” Noncompliance of a common area should not be treated as a change in the applicable fraction of a building.
Detailed Analysis of the IRS Position
Common areas in a LIHTC project are residential rental property if functionally related and subordinate to the qualified LIHTC building or project. Under §42(d)(4)(A) and (B), the eligible basis for a LIHTC building includes the adjusted basis of the property used in common areas or provided as comparable amenities to all residential rental units in the building. Therefore, if a common area of a LIHTC building is non-compliant under the inspection standards or any other requirements under §42 during the compliance period, and if the noncompliance is uncorrected as of the close of the taxable year in which the noncompliance occurs, the noncompliance should be treated, in the taxable year in which the noncompliance occurs, as a change and reduction in the eligible basis of the building. Note the use of the term “or any other requirements.” This indicates that violation of any requirement relative to common area – such as charging a fee for use of the area – will also result in a reduction in eligible basis.
In the event of a reduction in eligible basis due to noncompliance in a common area, recapture under §42(j) may be triggered. The eligible basis is the adjusted basis that was determined as of the close of the first year of the credit period. The reduction in the eligible basis is not limited to the amount of the costs attributable to only the portion of the non-compliant common area that was included in the eligible basis of the building. Instead, the eligible basis of the building is reduced by the amount of the total costs of the specific common area that caused the noncompliance. The memo provides the following example to illustrate how this will work:
- A qualified low-income building contains multiple common areas. One of the common areas is a laundry room for use by all tenants of the building without additional charge. The laundry room contains 20 laundry machines. For purposes of the LIHTC under §42, the costs of the entire laundry room ($40,000), and those of the 20 laundry machines ($10,000), were included in eligible basis (a total of $50,000) as of the close of the first year of the credit period. In June of Year 3, during the compliance period, the HCA inspected the building and discovered that ten of the laundry machines were not properly functional and, therefore, the common area (the laundry room) was deemed noncompliant. The HCA gave the owner 90 days to correct the noncompliance, but the noncompliance was not corrected and remained uncorrected at the end of Year 3. Therefore, in year 3, there is a reduction in eligible basis in the amount of the total costs of the laundry room that were included in eligible basis ($50,000), because the laundry room was noncompliant. The reduction is not limited to the amount of the costs attributable to the nonfunctional laundry machines ($5,000).
- Also, if the adjusted basis of the common area is allocated to the eligible basis of one or more buildings in the project for credit calculation purposes, such as a carport that is for use by all of the tenants of a qualified multi-building LIHTC project, the reduction in the eligible basis of the buildings will be allocated among the buildings.
This position indicates that if even a relatively small area of a common area is noncompliant, the eligible basis for the entire area is lost. For example, one parking space in a parking lot that cannot be used due to the condition of the space could result in the loss of eligible basis for the entire parking lot.
Treating the noncompliance of a common area as if one of the low-income units located closest to a noncompliant common area was out of compliance is not a valid alternative, since it does not properly and accurately account for the change caused by the noncompliance of a common area.
Reporting the Noncompliance
If common area noncompliance is discovered by the HCA, the memorandum states that the HCA should check both box 11c (violation of UPCS standards [if the violation is an inspection standard violation]), and box 11e (reduction in eligible basis) on the 8823.
This is unwelcome guidance. While we have always known that violations of the rules relating to common area could result in credit loss and recapture, it has been common practice to allocate the basis reduction to the area of the common area that was affected by the noncompliance, often using a square foot calculation. This memorandum suggests that such an approach may not be acceptable to the IRS and that any violation of common area rules may result in a loss of the entire common area from eligible basis. This is just one more reason why owners and managers must ensure that common areas remain in sound physical condition and that the rules relating to the use of common area are carefully followed.