In the first year of a tax credit project, the applicable fraction is calculated differently than subsequent years. Calculating the applicable fraction for first-year low-income housing tax credits isn’t quite as easy as taking the months a building is in service divided by 12 months.
The IRS Explanation
Described in IRC §42(f)(2)(A), the special rule for the first year of the tax credit period is calculated by using the sum of the applicable fractions for each month (determined at the last day of each full month) of the taxable year the building was placed in service as the numerator, and the denominator is 12, for the total number of months in the year. The result of this will be an “averaged” applicable fraction that accounts for the period that the units were not yet placed in service or available for occupancy. See the example below for how to calculate the applicable fraction for each month of the year the building was in service.
To provide a more descriptive example of how to calculate the first-year applicable fraction, consider the following scenario:
A newly constructed IRC §42 building containing 10 low-income units is occupied by qualified tenants and placed in service June 25, 2020. This makes the year 2020 the first year of the credit period. Units 1-5 are 1,000 square feet and units 6-10 are 1,500 square feet, with a building total of 12,500 square feet. The chart below illustrates when units were placed in service and the appropriate credit applicable:
Even though there were two tenants occupying units in June, the applicable fraction for that month is zero. The building must be placed in service for the entire month to get credits. July is the first full month placed in service with qualified tenants occupying units, so it is the first month that will have an applicable fraction greater than zero.
The applicable fraction for this building’s first-year credits is the smaller of the unit fraction or the floor space fraction. In this scenario, the applicable fraction will be 45.67%, or the floor space fraction.
As we have demonstrated above, the calculating of the first-year applicable fraction for a low-income housing tax credit can be open to miscalculation. For this reason, it may be valuable to consult with qualified accounting experts experienced in these matters for support and consultation.