What is Section 42 of the Internal Revenue Code?

Section 42 of the Internal Revenue Code governs the Low-Income Housing Tax Credit (LIHTC) program, the federal government’s primary method for encouraging the development of affordable rental housing. Established in 1986, the program provides a direct, dollar-for-dollar reduction in federal income tax liability. Unlike a deduction that reduces taxable income, a tax credit directly lowers the tax owed.

The program is a public-private partnership where the authority to allocate credits is given to state housing agencies. These agencies award credits to private developers, who sell them to investors to raise equity for their housing projects. This capital reduces the debt needed to finance a project, allowing the property to offer lower rents to qualified tenants.

Understanding the Low-Income Housing Credit

The LIHTC program has two primary types of credits. The 9% credit is a competitive credit used for new construction and substantial rehabilitation projects that do not receive other federal subsidies. The 4% credit is an “as-of-right” credit, meaning qualifying projects receive it, and is used for acquiring existing buildings or for projects financed with tax-exempt bonds. A project cannot receive both types of credits.

The annual tax credit value is determined by a calculation starting with the project’s eligible basis. This includes depreciable costs like construction and architectural fees but excludes non-depreciable costs like land, loan interest, and marketing. The eligible basis represents the total cost that would qualify for credits if the entire property were for low-income housing.

From the eligible basis, the qualified basis is calculated by multiplying the eligible basis by the “applicable fraction.” The applicable fraction is the lesser of the low-income unit ratio or the low-income floor space ratio. For example, if a project with a $10 million eligible basis has 80 of 100 identical units for low-income tenants, its applicable fraction is 80%, resulting in a qualified basis of $8 million.

The final step applies the applicable percentage (the “9%” or “4%” figure) to the qualified basis to determine the annual credit amount. The IRS sets the actual rates monthly to provide a 10-year stream of credits with a present value equal to 70% of the qualified basis for the 9% credit or 30% for the 4% credit. This annual credit is distributed to the owner each year for a 10-year credit period.

Project Eligibility Requirements

To qualify for tax credits, a project owner must choose a minimum set-aside test, which dictates the proportion of units reserved for low-income tenants. The chosen test establishes the income and rent limits for the property and must be maintained for a 15-year compliance period to avoid penalties.

There are three primary set-aside tests. The “20-50” test requires at least 20% of units to be occupied by tenants with incomes at or below 50% of the Area Median Income (AMI), adjusted for family size. The “40-60” test requires at least 40% of units to be occupied by tenants with incomes at or below 60% of the AMI.

A third option is the “Income Averaging” test, introduced in 2018. At least 40% of the units must be occupied by tenants whose incomes average no more than 60% of the AMI. This allows for income diversity, as units can serve tenants with incomes up to 80% of AMI if balanced by units for tenants at lower income levels to maintain the 60% average.

In addition to income limits, the designated units must be “rent-restricted.” This means the gross rent, including a utility allowance, cannot exceed 30% of the unit’s imputed income limitation. For instance, in a project using the 40-60 test, the maximum rent is 30% of the 60% AMI level. Property owners must verify household income upon initial occupancy to confirm they meet the chosen test’s standards.

The State Allocation and Application Process

The administration of tax credits is decentralized. The federal government allocates tax credit authority to each state annually, based on population. For 2025, this amount is $3.00 per capita, with a minimum allocation of $3,455,000 for small states. Each state’s Housing Finance Agency (HFA) manages the distribution of these credits.

Each HFA develops a Qualified Allocation Plan (QAP) detailing its housing priorities and the criteria for scoring and ranking applications for the competitive 9% credit. Developers must study the state’s QAP to craft a successful application. The QAP uses a point system, awarding preferences for projects that serve specific populations, are in certain locations, or include features like energy efficiency.

The application for 9% credits is a competitive process. Developers submit detailed proposals proving financial viability and alignment with the QAP’s scoring criteria. Applications are reviewed in annual funding rounds, and because of the limited pool of credits, only the highest-scoring projects receive allocations.

The process for the 4% credit is different. These credits are available to projects financed with a significant portion of tax-exempt private activity bonds. While developers do not compete for these credits, the state HFA must approve the bond financing for the project to receive the 4% credit allocation.

Long-Term Compliance Obligations

LIHTC property ownership is governed by several time periods. The credit period is the 10-year span when the owner can claim tax credits, beginning in the year the building is placed in service. Overlapping this is the 15-year compliance period, during which the project must adhere to all LIHTC rules, including the chosen set-aside test and rent restrictions.

Failure to maintain compliance during the 15-year period can lead to credit recapture. This allows the IRS to demand the owner pay back a portion of claimed tax credits with interest. State HFAs monitor projects through annual certifications and inspections to verify compliance.

Projects are also subject to an extended use period. This commitment, recorded in the property’s deed, requires units to remain affordable for at least 30 years. After year 15, the state HFA continues to monitor the property to enforce this agreement. An owner can request to exit the agreement after 15 years through a Qualified Contract process, which requires the HFA to first seek a buyer who will maintain the affordability restrictions.