IRC 42: Low-Income Housing Tax Credit Explained

The Low-Income Housing Tax Credit (LIHTC), established under Section 42 of the Internal Revenue Code, is the primary federal incentive for developing affordable rental housing. By offering tax credits to developers, it encourages private investment in projects that serve low-income tenants. Since its creation in 1986, LIHTC has financed the majority of affordable housing developments across the U.S.

Understanding how these tax credits are awarded and maintained is essential for developers, investors, and property managers. Eligibility, compliance requirements, and the risks of noncompliance all influence the success of LIHTC-funded projects.

Eligible Projects

To qualify for LIHTC, a development must be a rental property. Owner-occupied homes and condominiums do not qualify unless structured as long-term rentals. Eligible properties include multifamily apartment buildings, townhomes, and single-family rental developments that meet affordability requirements.

Projects must maintain affordability for at least 30 years, though some states impose longer restrictions. Properties must be newly constructed or undergo substantial rehabilitation, with the latter requiring a minimum investment. As of 2024, this threshold is the greater of $7,800 per low-income unit or 20% of the building’s adjusted basis.

Geographic location also affects eligibility. Developments in Qualified Census Tracts (QCTs) or Difficult Development Areas (DDAs) may receive additional tax credit allocations to offset higher costs. QCTs are areas where at least 50% of households earn below 60% of the area median income, while DDAs are locations with high construction costs relative to income levels.

Credit Allocation and Qualified Basis

State housing finance agencies (HFAs) administer LIHTC allocations, distributing a fixed amount of credits annually based on a per capita formula set by the IRS. For 2024, this allocation is $2.75 per resident, with a minimum small-state allocation of $3,185,000. Developers compete for these credits through a Qualified Allocation Plan (QAP), which outlines state-specific priorities such as housing for seniors, supportive housing for individuals with disabilities, or developments in high-need areas.

The amount of tax credits a project can claim is determined by its qualified basis, which is calculated by multiplying the project’s eligible basis—the depreciable costs of construction or rehabilitation—by the percentage of units reserved for low-income tenants. The eligible basis includes hard costs like materials and labor, as well as soft costs such as architectural fees and developer overhead, but excludes land acquisition. Projects in QCTs or DDAs may receive a 30% boost to their eligible basis.

The credit rate depends on whether the project is financed with tax-exempt bonds. Developments using these bonds qualify for the 4% LIHTC, while those without such financing may receive the 9% LIHTC. The 9% credit covers a larger portion of development costs and is highly competitive, whereas the 4% credit is non-competitive but requires at least 50% of the project’s financing to come from tax-exempt bonds. The IRS has set a minimum floor of 9% for the 9% credit.

Rent and Income Thresholds

Affordability under LIHTC is determined by income limits and rent restrictions. The Department of Housing and Urban Development (HUD) updates income thresholds annually based on Area Median Income (AMI). Tenants must generally earn no more than 60% of AMI, though some projects set lower thresholds, such as 50% of AMI.

Rents in LIHTC properties are capped at 30% of the designated income limit, including an assumed utility allowance. For example, if the 60% AMI limit for a two-person household is $50,000, the maximum monthly rent for a one-bedroom unit would be $1,250 before utility adjustments.

The LIHTC program also allows income averaging, permitting developments to include households earning up to 80% of AMI as long as the overall average income of all LIHTC units remains at or below 60% of AMI. This flexibility broadens tenant eligibility and supports mixed-income communities. Property managers must verify tenant eligibility at move-in and conduct annual recertifications in certain cases to ensure compliance.

Extended Use Term

LIHTC properties must remain affordable for at least 30 years, including an initial 15-year compliance period followed by a 15-year extended use phase. Many states require longer affordability commitments, sometimes up to 50 years.

During the extended use period, property owners must continue to meet income and rent restrictions. While noncompliance during the first 15 years can trigger tax credit recapture, violations in the extended use phase do not result in IRS penalties. Instead, enforcement shifts to state housing finance agencies, which can impose administrative sanctions, restrict future LIHTC participation, or take legal action to ensure compliance.

Recapture Provisions

Noncompliance during the initial 15-year compliance period can trigger tax credit recapture, requiring developers or investors to repay a portion of previously claimed credits. Recapture is typically triggered by violations such as renting units to ineligible tenants, charging rents above allowable limits, or failing to maintain habitability standards.

If a violation occurs, the IRS can reclaim up to one-third of the total credits claimed over the previous 10 years, plus interest. The recapture amount is based on the percentage of noncompliant units. Developers and investors mitigate this risk through strict compliance monitoring, regular tenant income certifications, and property inspections.

If a property is sold during the compliance period, the new owner assumes responsibility for maintaining LIHTC requirements. If the buyer fails to uphold these obligations, the original owner may still be liable for recapture unless a qualified contract process is initiated. This process allows owners to request that the state housing finance agency find a buyer willing to maintain affordability restrictions. If no buyer is found within a year, the property may be released from LIHTC obligations, though state-specific restrictions apply. Given the financial consequences of recapture, investors and syndicators often require developers to provide guarantees ensuring continued compliance.