No More Freefalls: Treasury Department & IRS Address the “Cliff Effect” of the LIHTC Average Income Test

Introduction

On Tuesday, September 30, 2025, the Treasury Department, in connection with the Internal Revenue Service (the “IRS”), published and made effective Treasury Decision 10036 (T.D. 10036), which addresses certain pitfalls in the previous rules and recordkeeping requirements concerning the low-income housing average income test.

As described below, T.D. 10036 builds off both the final and temporary regulations codified in Treasury Decision 9967 and published in 2022 (T.D. 9967), but replaces the temporary regulations contained therein. In furtherance of doing so, T.D. 10036 was made applicable to taxable years beginning on January 1, 2023. Notably, T.D. 10036 offers opportunities to cure ineligibility caused by the discovery of a project’s failure to comply with the minimum set-asides of the average income test by creating avenues for taxpayers and public housing authorities to take corrective action.

General Background

The Internal Revenue Code (the “IRC”) outlines three minimum set-aside tests to determine the qualification of a development as a low-income housing project: the 20-50 test, the 40-60 test, and the average income test. Each test contains a separate set of criteria for the designation of a development as a low-income housing project and thereby creates the opportunity for the allocation of low-income housing tax credits. It is important to note that once a taxpayer selects a minimum set-aside test, the decision is irrevocable, and the taxpayer must comply with the requirements of such test to qualify for the allocation of low-income housing tax credits.

Background with Respect to the Average Income Test

The average income test requires that (i) at least 40% of the housing units in a development be rent-restricted and occupied by tenants whose income does not surpass the imputed income limitation that the taxpayer designated for the specific unit; and (ii) the average imputed income designations for the units not exceed 60% of annual median gross income (AMGI). As noted in the IRC, the imputed income limitations range from 20% to 80% of AMGI and escalate in 10% increments. A taxpayer must identify at least one qualified group of units in the development to meet the average income minimum set-aside test and the applicable fraction. A record of such identification needs to be documented and maintained in the taxpayer’s books and records and communicated annually to the local public housing authority (the “Local Agency”).

T.D. 10036 addresses only the average income test, but for context on the other two minimum set-aside tests, please see the 20-50 test described in 26 U.S.C. § 42(g)(1)(A) and the 40-60 test described in 26 U.S.C. § 42(g)(1)(B).

Following the introduction of the average income test in 2018 and through later revisions up to T.D. 10036, commenters raised concerns to the Treasury Department and the IRS that the regulations, as drafted, could create a potential “cliff” effect and ultimately lead to disqualification. Such “cliffs” often arise from either a reduction of the required number of low-income units below the mandatory minimum or, more likely, an increase in AMGI among the designated low-income units over the required average. In particular, commenters noted that, under the 2020 proposed regulations and the 2022 temporary regulations, if just one unit was later found to be noncompliant, project owners could lose eligibility for low-income housing tax credits under the average income test. With no mitigation measures available, the entire project would then fail the average income test.

Notable Components of T.D. 10036

In response to the above-noted concerns, T.D. 10036 provides certain corrective steps that project owners and Local Agencies may take upon the determination that a project fails to meet the requirements of the average income test. These corrective measures were authored to avoid the above-mentioned “cliffs” that strip a project of its status as a low-income housing project, thereby precluding the taxpayer, with respect to such project, from tax credit eligibility.

Under T.D. 10036, taxpayers and Local Agencies may respectively correct a failure to comply with the average income test requirements in the following manners:

1. When a taxpayer realizes that there is a failure in compliance with the requirements of the average income test, the taxpayer must provide a correction to the IRS no later than 180 days after the discovery of the failure. A taxpayer’s correction may include a revised qualified group of units;
2. When a Local Agency identifies the failure in compliance, the Local Agency must provide prompt notice to the taxpayer, and the taxpayer has 90 days from notice to correct the failure; provided, however, that the Local Agency may extend the cure period for up to 6 months if the agency finds that there is good cause shown for granting the extension; and
3. Finally, in any case, it is within the Local Agency’s discretion to waive a failure to comply with the procedural requirements of 26 C.F.R. §§ 1.42-19(c)(1), (c)(2), or (c)(3)(iv); which waiver must be in writing and occur within the applicable time periods noted in (1) and (2).

Also of note, T.D. 10036 authorizes a Local Agency’s use of discretion in establishing a certain time and manner in which a taxpayer must provide information to the Local Agency regarding low-income units within a qualified group. 26 C.F.R. § 1.42-19(c)(2)(ii) includes a variety of fact patterns that provide examples of approaches that Local Agencies may take in requiring the submission of such information.

Importance of T.D. 10036

Taken together, the curative measures outlined in T.D. 10036 provide opportunities for project owners to remedy missteps that would otherwise disqualify the project from tax credit eligibility under the average income test. These measures address longstanding concerns with respect to a project’s qualification under the average income test and ultimately create greater ability for project owners to maintain compliance and continue to earn low-income housing tax credits.