Section 42 Income Average Guidance Changes

In 2018, Section 42 was amended to establish a third minimum set-aside option for LIHTC projects known as the average income test.  The purpose of the average income test is to promote income diversity in LIHTC properties, allowing them to serve a broader range of AMI households with different income levels.  Subsequently, guidance was released in 2020 that stated that to meet the average Income set-aside, a project needed to have 40% or more of its units as rent-restricted and occupied by qualified households, with unit income designations per the regulations, and the average area median income (AMI) of all low-income units not exceeding 60% of AMI. This included a “cliff test,” where even one over-income unit could by nature cause a project to lose all LIHTC credits.  This created hesitancy in the market to use the average income approach in establishing new projects. 

However, as of October 2022, the IRS and Treasury released final regulations providing clarity to LIHTC stakeholders.  The new regulations eliminated the cliff test and simplified the minimum set-aside requirement. Now, as long as a project has at least 40% of its units designated as low-income units with an average AMI of 60% or less, it will meet the minimum set-aside test. This means that income averaging projects can maintain compliance with the minimum set-aside by ensuring that at least 40% of their units are designated for low-income households with an average AMI of 60% or lower. 

This change has significant implications for syndicators and developers, as it may eliminate the need to underwrite a cushion to the 60% AMI ceiling, even for 100% LIHTC projects. This means that projects with high concentrations of low-income units or those utilizing the income averaging approach can potentially maximize the cash flow benefits offered by the average income set-aside, as they no longer need to account for potential loss of credits due to the cliff test.