Understanding the Applicable Fraction: A Key Driver of Low-Income Housing Tax Credits and Compliance
In the world of Low-Income Housing Tax Credits (LIHTC), there are several essential factors for Developers to understand in order to maximize their tax credits. These factors have been established by Internal Revenue Code Section 42. One of the most critical metrics to track is the applicable fraction. The applicable fraction affects project feasibility, investor returns, and long-term compliance. Understanding the applicable fraction allows LIHTC developers to maximize the financial success of a project while also maintaining compliance with the LIHTC program throughout the compliance period.
What Is the Applicable Fraction?
Put simply, the applicable fraction is the portion of the building that qualifies as low-income housing. Therefore, this is the portion of the building for which tax credits are able to be claimed.
The applicable fraction is defined as the lesser of:
- The Unit Fraction: percentage of units that are designated as low-income units.
- Low-income units ÷ Total residential units
- The Floor Space Fraction: percentage of square footage taken up by the low-income units.
- Low-income unit square footage ÷ Total residential square footage
Because the applicable fraction is calculated as the lower of the unit fraction and the floor space fraction, both the number and size of the LIHTC units are important. Developers must keep both factors in mind as they create projections for the LIHTC tax credits. Due to the nature of the applicable fraction, developers will not secure more tax credits by simply designating a high quantity of small units as low-income units.
Example
Consider a residential building with the following characteristics:
Total units: 100
Low-income units: 80
Total square footage: 100,000 square feet
Low-income square footage: 70,000 square feet
Calculation
- First, calculate the unit fraction:
80 ÷ 100 = 80%
- Next, calculate the floor space fraction:
70,000 ÷ 100,000 = 70%
The applicable fraction is the lesser of the two, which is 70%. Therefore, even though 80% of the units are designated as low-income, only 70% of the building’s eligible costs will be considered qualified basis. The qualified basis of the project is the portion of development costs for which tax credits can be taken.
Practical Takeaways
- Be intentional about the building design strategy: Early in the development phase of the project, building design and unit mix decisions should be made with the applicable fraction in mind, to ensure neither the unit fraction nor floor space fraction are lower than desired.
- Coordinate with accountants early: Financial modeling should incorporate applicable fraction assumptions to avoid surprises later.
- Track overall funding: The tax credits are often a significant portion of the funding for any respective project. If the applicable fraction is less than expected and decreases, the tax credits will decrease, and the funding structure of the deal may need reworked.
- Track compliance continuously: It is essential to keep all low-income designated units in compliance. Changes in tenant eligibility or unit designation can cause the applicable fraction to change which could cause tax credit recapture.
By proactively managing these factors, developers can better position their projects to maximize tax credits and maintain compliance throughout the life of the project.
McKonly & Asbury, LLP is a leader in accounting for affordable housing entities. Our team has the specialized knowledge to help you ensure you comply with industry requirements. For more information on these services and more, be sure to visit our Affordable Housing page, and don’t hesitate to contact us.
About the Author
Luke Brautigam, CPA is an Assurance Manager, specializing in serving nonprofit organizations and affordable housing entities. He provides audit, assurance, and advisory services to a broad range of mission-driven entities, includi… Read more
