Fees as a Rent Issue in Housing Tax Credit Properties
By A. J. Johnson
Section 42(g)(2)(A) of the Internal Revenue Code states that a unit in a low-income housing tax credit project is considered rent restricted only if the gross rent does not exceed 30% of the imputed income limitation applicable under the elected minimum set-aside test. Under this test, at least 20% of the project’s units must be rented to households at or below 50% of the area median income (AMI); at least 40% rented to households at or below 60% of AMI; or (for deep rent-skewed projects) at least 25% rented to households at or below 60% of AMI.
In IRS Private Letter Ruling 9330013, the Service defined rent as a periodic charge for the right to occupy or use someone else’s property. This rent also includes the cost of utilities that are paid by a tenant, except for phone, cable, and internet (see IRS Regulation 1.42-10).
A major IRS concern related to rent has been the charging of “fees” to tenants, in addition to regular rent. If such fees, when added to rent, cause the gross rent to exceed the maximum allowable permitted under Section 42, the result is a rent overcharge, unless the fees are clearly optional to the tenant. A pattern of excess rent, if reported by a housing credit agency (HCA) to the IRS via Form 8823, may increase the risk of an IRS audit for such properties.
In its explanation of the 1986 tax act’s original LIHTC provisions (The General Explanation of the Tax Reform Act of 1986), the congressional Joint Committee on Taxation stated, “a service is optional if payment for the service is not required as a condition of occupancy.” The document further states “any charges for services that are not optional to low-income tenants must be included in gross rent for purposes of Section 42(g)(2)(A).”
In a tax credit project, the gross rent cannot exceed 30% of the imputed income limit used for the purpose of calculating Section 42 rent.
Fees charged to tenants may be either one time (normally paid prior to assuming residency) or recurring (normally paid monthly).
The most common upfront fee charged by tax credit properties is the application fee. This is charged to applicants to offset the cost of processing applications (e.g., credit reports, criminal records, etc.) The IRS has held that such fees are acceptable, as long as they only pay for the out-of-pocket costs to third parties. However, any fee in excess of third-party costs must be included as gross rent for Section 42 purposes. For example, if an applicant is charged a $35 application fee, but third-party processing costs are only $25, the $10 excess is considered rent. If the rent charged to the applicant at move-in is at (or very near) the maximum allowable Section 42 rent, excess rent has been charged and the property will be considered out of compliance.
Other types of upfront fees such as “redecoration fees,” “home prep fees,” etc. are never permitted, even if they do not result in excess rent. According to the IRS 8823 Guide, such fees are not permitted because they are essentially a charge for preparing a unit for occupancy. This task is the responsibility of the owner, and cannot be passed on to an applicant.
In addition to one-time fees, residents are often asked to pay a fee each month, mandatory or optional, in addition to regular rent. As noted above, mandatory fees (i.e. fees required as a condition of occupancy) must be included in gross rent. Examples of optional fees, which are not included in gross rent, are pet fees and fees for renting washers and dryers from the owner when a washer/dryer hook-up is included with the unit. Such fees are acceptable because they are not required as a condition of occupancy (i.e. residents may move in without pets or may use their own washers and dryers).
Examples of unacceptable recurring fees (if they create excess rent) include fees for a month-to-month lease (no additional benefit or service other than occupancy is provided), fees for use of an in-unit washer/dryer hook-up (when the resident provides their own washer and dryer), or a requirement that a resident obtain renter’s insurance (the cost of the premium must be included in gross rent).
When deciding whether an additional fee to a resident is acceptable, the key factor to determine is whether or not the charge is truly optional to the tenant. In other words, could the resident live in the apartment without paying the fee? If the answer is yes, the fee generally may be charged, even if the additional payment, when added to the stated rent, totals an amount greater than the maximum allowable gross rent. If the answer is no, the fee must be included in gross rent.
Common Area Fees
One other type of fee of concern in tax credit properties is a fee charged to residents for the use of common area space that was included in the project’s eligible basis.
IRS Regulation 1.42-5(b)(ix) says owners of tax credit properties must maintain records that show, for each year of the compliance period, “the character and use of the nonresidential portion of the building included in the building’s eligible basis under Section 42 (d) (e.g., tenant facilities available on a comparable basis to all tenants and for which no separate fee is charged for use of the facilities, or facilities reasonably required by the project).”
The General Explanation of the Tax Reform Act of 1986 states that “the allocable cost of tenant facilities, such as swimming pools, other recreational facilities, and parking areas may be included (in basis) provided there is no separate fee for the use of these facilities and they are made available on a comparable basis to all tenants in the project.”
This requirement is also outlined in IRS Regulation 1.103-8 (b)(4)(iii).
A building’s common area that is included in eligible basis will have costs prorated among residential buildings in the project that receive an IRS Form 8609. So, if a fee is charged to any resident for the use of such facilities, all residential buildings in the project that contain low-income units will be considered out of compliance.
If excess rent is charged, either as actual rent or due to an inappropriate fee, and either the housing finance agency or the owner discovers such excess rent, the issue may be corrected by lowering the rent to an acceptable level and rebating affected residents by the amount of the overcharge. Owners should be aware however, that correction might not prevent a loss of credits for units impacted by the overcharge.
There is significant risk to credits when excess rent or inappropriate fees are charged on a Section 42 property. For example, if excess rent is charged to all units in a project, the property will be deemed to have no low-income units, meaning the property will have fallen below the required minimum set-aside. In this case, all credits are lost until the minimum set-aside is once again met, and the tax credit recapture penalties can be severe. If such an event were to occur during the first year of the credit period, the result could be permanent removal from the tax credit program, since no units will have been qualified at the end of the first year of the credit period. Clearly, catastrophic loss of credits can occur due to improper fees and charges. For this reason, fees in addition to rent should never be charged without guidance from a tax credit professional.
A. J. Johnson is president of A. J. Johnson Consulting Services, Inc., a Williamsburg, VA-based full service real estate consulting firm specializing in due diligence and asset management issues, with an emphasis on low-income housing tax credit properties. He may be reached at 757-259-9920, email@example.com.
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