Section 42 of the Internal Revenue Code, the Low-Income Housing Tax Credit, gives investors a dollar-for-dollar federal tax credit spread over 10 years in exchange for equity in rental housing that stays affordable for at least 30 years. The credit is earned by the building, sized by its qualified basis, and paid for with continuous compliance: miss the income limits, rent caps, or unit-quality rules during the 15-year compliance period and the IRS can claw the credits back with interest.1Office of the Law Revision Counsel. 26 USC 42 – Low-Income Housing Credit
Who Actually Claims the Credit
Developers almost never use LIHTC credits themselves. The standard structure is a limited partnership or LLC in which the developer is the general partner and outside investors are limited partners. The limited partners put up equity and receive nearly all of the credits and depreciation losses. Syndicators pool investor capital and place it across multiple projects.
The buyers are overwhelmingly corporate. Banks and insurance companies have steady federal tax liability and can use credits directly, and C corporations are not subject to the passive activity rules that constrain individual investors. Pricing per dollar of credit has historically ranged from about $0.80 to over $1.00 depending on market conditions and project risk. That equity typically funds 40 to 70 percent of total development cost, with debt and other subsidies filling in the rest.
The Income Tests Every Project Must Meet
Before the first building is placed in service, the developer picks one of three minimum set-aside tests. The choice is permanent for the life of the project.2Office of the Law Revision Counsel. 26 USC 42 – Low-Income Housing Credit – Section 42(g)(1)
- 20/50: at least 20 percent of residential units go to tenants earning no more than 50 percent of area median gross income, adjusted for household size.
- 40/60: at least 40 percent of units go to tenants at or below 60 percent of area median gross income.
- Average income: at least 40 percent of units are income-restricted, each one designated in 10-percent increments from 20 to 80 percent of area median income, and the average of those designations cannot exceed 60 percent.
HUD publishes the area median gross income figures annually by metro area and non-metro county. The 20/50 and 40/60 tests date to the program’s creation; the average income test was added in 2018 and lets a single project mix deeply affordable units with units at 80 percent of area median, as long as the property-wide average stays at or below 60 percent.3Internal Revenue Service. Revenue Ruling 2020-4 The flexibility comes with more record-keeping, because every designation has to be tracked and the average must hold at all times.
Rent Caps and the Utility Allowance
Gross rent on a LIHTC unit cannot exceed 30 percent of the income limit that applies to that unit. For a unit designated at 60 percent of area median income, the ceiling is 30 percent of that 60 percent figure.4Office of the Law Revision Counsel. 26 USC 42 – Low-Income Housing Credit – Section 42(g)(2) The income figure assumes a household size of 1.5 persons per bedroom, not the actual household. A two-bedroom is treated as a three-person unit for rent-ceiling purposes; a one-bedroom is treated as 1.5 persons. Actual occupants do not change the calculation.
Gross rent includes tenant-paid utilities. If a tenant pays their own electric, gas, or water, the owner must subtract an estimated utility cost from the rent ceiling. Buildings with HUD-assisted tenants use the local public housing authority schedule; other buildings may use the housing authority schedule, a written estimate from the utility company, or an estimate from the state housing finance agency. A utility company estimate applies to all similarly sized units in the building. When the utility allowance rises, the owner may have to cut rent to stay under the cap, and that cash flow hit is where many projects get squeezed.
Unit Quality and What Happens When Tenant Income Rises
LIHTC units must be habitable under local standards and comparable in size and quality to any market-rate units in the same project. Comparability covers floor plans, finishes, appliances, and access to common areas. Clustering low-quality units into the affordable pool is not allowed, and state monitoring agencies check this on physical inspection.
A tenant who qualifies at move-in and later earns more does not automatically knock the unit out of the low-income count. The unit keeps its status as long as it stays rent-restricted. The trigger is 140 percent of the applicable income limit. Once a tenant’s income crosses that line, the unit is “over-income,” and the owner must rent the next available comparable unit in the building to a qualifying low-income tenant to keep the property compliant.5eCFR. 26 CFR 1.42-15 – Available Unit Rule The rule runs project-wide across all buildings treated as a single project, and owners must make reasonable efforts to fill vacant low-income units with qualified tenants before renting any at market rate. Skipping this step can reduce qualified basis and cost credits.
How the Annual Credit Amount Is Calculated
Three numbers multiplied together produce the annual credit: eligible basis, applicable fraction, and credit percentage.
Eligible Basis
Eligible basis is the total depreciable cost of the building and related facilities, minus land. It includes hard construction costs, architectural and engineering fees, contractor overhead, and reasonable construction-period financing costs. Commercial space and facilities not available to tenants are excluded. Federal grants and below-market federal loans reduce eligible basis, which is one reason federally subsidized deals draw the 4 percent rate rather than 9 percent.6Office of the Law Revision Counsel. 26 USC 42 – Low-Income Housing Credit – Section 42(d)
For acquisition-rehab deals, the purchase price of an existing building can be included, but only if the seller did not place the building in service in the previous 10 years. This blocks quick flips that generate fresh credits without meaningful improvement. Rehabilitation costs qualify separately and must clear a floor: the greater of a per-unit dollar amount (starting at $6,000 and adjusted annually for inflation since 2009) or 20 percent of the building’s adjusted basis.7Office of the Law Revision Counsel. 26 USC 42 – Low-Income Housing Credit – Section 42(e)(3)
Projects in a Qualified Census Tract or Difficult Development Area designated by HUD get a 30 percent boost. Eligible basis can be increased to 130 percent of its otherwise calculated amount, which pushes up the credit and makes high-cost locations viable.8Office of the Law Revision Counsel. 26 USC 42 – Low-Income Housing Credit – Section 42(d)(5)(B)
Applicable Fraction and Qualified Basis
Eligible basis is multiplied by the applicable fraction, which is the share of the building dedicated to low-income use. The fraction is the lesser of two ratios: low-income units divided by total residential units, or low-income floor space divided by total residential floor space. A 100-percent-affordable project has an applicable fraction of 100 percent.
The product is qualified basis, the amount the IRS recognizes for generating credits. Any drop in the applicable fraction during the 15-year compliance period reduces qualified basis for that year and can trigger recapture of previously claimed credits.
The 9 Percent and 4 Percent Rates
Two credit rates apply, and the gap between them drives project economics.
- The 9 percent credit applies to new construction or substantial rehabilitation that is not federally subsidized. The statute targets a present value equal to 70 percent of qualified basis over 10 years.
- The 4 percent credit applies to acquisition costs of existing buildings and to any eligible costs financed with tax-exempt bonds or other federal subsidies, targeting a present value of 30 percent of qualified basis over 10 years.9Office of the Law Revision Counsel. 26 USC 42 – Low-Income Housing Credit – Section 42(b)
The IRS publishes the exact applicable percentages monthly. As of September 2025, the formula produced 8.03 percent for the 70-percent-present-value credit and 3.44 percent for the 30-percent-present-value credit.10Internal Revenue Service. Revenue Ruling 2025-17 Both rates have permanent statutory floors: 9 percent was fixed by the PATH Act in 2015, and a 4 percent floor was set by the Consolidated Appropriations Act of 2021. When the formula produces a lower number, the floor applies, so most projects today receive exactly 9 percent or 4 percent.11Congress.gov. An Introduction to the Low-Income Housing Tax Credit
First-Year Proration and the Forms
The credit period starts in the tax year the building is placed in service, and the first year’s credit is prorated by month. A building placed in service in October generates three months of credit that first year. The rest is not lost; it rolls into an eleventh year, and the owner still receives the full 10 years of credit value.
The credit is claimed on IRS Form 8586, using the allocation information from Form 8609 issued by the state housing finance agency. No Form 8609, no credits.12Internal Revenue Service. About Form 8586 – Low-Income Housing Credit13Internal Revenue Service. About Form 8609 – Low-Income Housing Credit Allocation and Certification
How Projects Get Credits: State Allocation
The federal government does not hand out LIHTC credits directly. Each state receives an annual per-capita allocation ceiling. For 2026, the ceiling is the greater of $3.416 per resident or a small-state minimum of $3,953,600. The statute provides for annual inflation adjustments, and beginning in 2026 adds a 12 percent increase on top of those adjusted amounts.14Office of the Law Revision Counsel. 26 USC 42 – Low-Income Housing Credit – Section 42(h)(3)
State housing finance agencies distribute that pool through a competitive process governed by the state’s Qualified Allocation Plan. The QAP scores applications on state priorities: deeper income targeting (units at 30 percent of area median), high-opportunity locations, special-needs populations, energy efficiency. It must be approved by the governor after public comment.
The competitive scramble is for the 9 percent credit only. Projects financed primarily with tax-exempt bonds qualify automatically for the 4 percent credit outside the annual ceiling, though they still must comply with the QAP and receive a state determination.
Applications include architectural plans, financial projections, and proof of site control. High-scoring, financially viable projects receive a reservation, which is conditional. If the project cannot be placed in service by year-end, the agency issues a carryover allocation to buy time. The final allocation, and Form 8609, come only after the building is built and occupied and the agency reviews actual costs and tenant certifications.13Internal Revenue Service. About Form 8609 – Low-Income Housing Credit Allocation and Certification
The 15-Year Compliance Period and Extended Use
Claiming the credit is the beginning of the obligation, not the end of it. The property must stay in compliance with every LIHTC requirement for a 15-year compliance period starting in the first year credits are claimed. Any drop in qualified basis during that period can trigger recapture of credits already claimed.
State agencies conduct regular physical inspections and tenant file reviews, verifying income certifications, documentation, and rent calculations. Owners who fall out of compliance receive notice and a correction window. Unresolved problems get reported to the IRS on Form 8823.15Internal Revenue Service. Form 8823 – Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition
Beyond the 15-year compliance period, the property remains subject to an extended low-income housing commitment, a recorded restrictive covenant that keeps the affordability rules in place for at least another 15 years. Section 42 requires this commitment as a condition of receiving any credits at all. It binds future owners and gives tenants and prospective tenants the right to enforce the income and rent restrictions in state court.16Office of the Law Revision Counsel. 26 USC 42 – Low-Income Housing Credit – Section 42(h)(6)
The extended use period can end early in two narrow situations. Foreclosure will lift it, unless the IRS determines the foreclosure was arranged to circumvent the restrictions. And the owner can invoke a “qualified contract” process, asking the state agency to find a buyer willing to keep the property affordable. If the agency cannot present a qualified contract within the specified period, the restrictions can be lifted, though existing tenants retain protections for three years.
How Recapture Works
Recapture is the IRS’s clawback tool. It applies whenever qualified basis at the end of a tax year is lower than it was at the end of the prior year, whether from units lost from the low-income count, a sale without an affordability commitment, or a building becoming uninhabitable.17Office of the Law Revision Counsel. 26 USC 42 – Low-Income Housing Credit – Section 42(j)
The calculation targets the “accelerated portion” of the credits already claimed. Because the credit is delivered over 10 years but the compliance period runs 15, an owner in the early years has claimed more credit than they would have received if the same total were spread evenly across all 15 years. That gap is the accelerated portion. The owner owes it back, plus interest at the IRS overpayment rate, for each prior year affected.
The mechanics matter. Each year of the 10-year credit period delivers one-tenth of the total credit. Spread across 15 years, the annual slice would be one-fifteenth. The gap between those two shapes the exposure. Recapture risk peaks at the end of year 10, when the full credit has been claimed but only two-thirds would have vested under a 15-year schedule. By year 15 the two schedules converge and the accelerated portion is gone. Investors watch compliance most closely in the early and middle years for that reason.
Selling the property during the compliance period also triggers recapture unless the buyer signs a binding agreement with the state agency to maintain affordability. Partnership exits usually work around this by having the general partner or a related entity acquire the limited partner’s interest rather than selling the building itself.
Year 15 and What Happens Next
Year 15 is the pivot. The 10-year credit period is over, the compliance period is done, and limited partners have no further tax benefit. They typically want out.18U.S. Department of Housing and Urban Development. What Happens to Low-Income Housing Tax Credit Properties at Year 15 and Beyond
The exit is governed by partnership agreements written at the start of the deal. Many include a right of first refusal for the general partner, a qualified nonprofit, a government agency, or the tenants. Section 42 protects this arrangement and sets a minimum purchase price equal to outstanding debt plus all federal, state, and local taxes attributable to the sale. That formula often lands well below market value, because LIHTC properties carry heavy debt and the investor’s capital account has typically been ground down by years of depreciation losses.19Office of the Law Revision Counsel. 26 USC 42 – Low-Income Housing Credit – Section 42(i)(7)
General partners often “recycle” properties at year 15 by buying out the limited partner, rehabilitating the building, and bringing in new investors for a fresh round of credits. Related-party rules were loosened in 2008, dropping the relevant ownership threshold from 10 percent to 50 percent and making this strategy far more workable. The building keeps running as affordable housing, upgraded, with a new 30-year commitment.
Passive Activity Treatment for Investors
LIHTC credits are passive activity credits under Section 469, which usually limits the use of passive credits against non-passive income. The LIHTC gets a real carve-out. Individual taxpayers can use up to $25,000 of LIHTC credits (measured as the deduction equivalent) against non-passive income without having to actively participate in managing the property. And the $25,000 allowance for LIHTC credits is not subject to the phase-out that normally begins at $100,000 of adjusted gross income and eliminates the benefit entirely at $150,000.20Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited – Section 469(i)
Most LIHTC credits still end up with C corporations, which are not subject to the passive activity rules at all. Banks and other financial institutions invest in LIHTC partnerships specifically because the credits reduce federal tax liability dollar for dollar with no passive limitation. That is why the LIHTC investor market is dominated by large corporate taxpayers rather than individuals.