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The Low-Income Housing Tax Credit has three minimum set-aside options, but since March 2018 the third one, the average income test, has quietly become the most powerful tool in the program for mixing incomes inside a single property. It is also the option most likely to generate compliance findings when owners treat it as a paperwork exercise rather than a year-by-year unit designation discipline. This explainer walks through how the average income set-aside works under the final regulations at 26 CFR 1.42-19, what owners must designate and report each year, and where the common failure points sit.
Every LIHTC project must satisfy one minimum set-aside election, made on IRS Form 8609. The two legacy options are the 20-50 test, under which at least 20 percent of units must be rent-restricted and occupied by households at or below 50 percent of area median gross income, and the 40-60 test, under which at least 40 percent of units must serve households at or below 60 percent of area median income. The Consolidated Appropriations Act of 2018 added a third option for allocations made after March 23, 2018: the average income test, codified at Section 42(g)(1)(C).
Under the average income test, at least 40 percent of the residential units in the project must be rent-restricted and occupied by households whose incomes do not exceed the imputed income limitation designated for each unit. For certain projects described in Section 142(d)(6), the 40 percent threshold drops to 25 percent. The designations are the heart of the option: each low-income unit gets its own imputed income limitation, chosen from a fixed menu, and the average of the designations across the qualified group of units cannot exceed 60 percent of area median gross income.
Section 42(g)(1)(C)(ii)(III) limits valid designations to seven levels: 20, 30, 40, 50, 60, 70, or 80 percent of area median gross income. A designation outside that list, or a unit without a timely designation, does not count. The averaging math runs across the qualified group of units the taxpayer identifies each year, not necessarily every low-income unit in the project, which gives owners genuine flexibility. A project can pair deeply affordable units at 20 or 30 percent of area median income with units at 70 or 80 percent, and the average income test is satisfied as long as the average of the designated limitations in the qualified group stays at or below 60 percent and at least 40 percent of the project's units are in a qualifying group.
A worked example from the final regulations makes the mechanics concrete. An owner of a ten-unit building targeting full low-income occupancy designates five units at 80 percent and five units at 40 percent. The average of the designations is exactly 60 percent, the group qualifies, and the building satisfies the set-aside. Change one of the 40 percent designations to 30 percent, and the owner gains headroom that could absorb a designation increase elsewhere, or a mis-designation discovered mid-year, without breaking the test.
The practical consequence for underwriters: the average income option is what allows a tax credit property to serve households up to 80 percent of area median income while still counting those units toward the set-aside and the applicable fraction. In high-cost markets, that band can be the difference between units that lease and units that sit empty, because the 60 percent cap under the legacy 40-60 test can price below what a property needs from its top-end units.
The final regulations impose a recurring discipline that catches owners off guard. For each taxable year in the extended use period, the taxpayer must identify a qualified group of units satisfying the set-aside, and a qualified group used for determining the applicable fraction of each building. Those identifications must be recorded in the owner's books and records, retained for at least the record-retention period required under 26 CFR 1.42-5(b)(2), and communicated annually to the state housing credit agency in the time and manner the agency requires.
Agencies have wide latitude on format. Some require a single annual list of all low-income units with their imputed income designations; some accept a change-only statement after the first full report; some require two separate lists, one for the set-aside group and one for the applicable fraction group. Owners operating in multiple states should not assume one agency's reporting template satisfies another's.
A unit's imputed income limitation must be designated before the unit is first occupied as a low-income unit, or before it is first occupied under a changed income limit. For an occupied unit whose designation changes mid-year under the permitted-change rules, the changed designation must be recorded no later than the end of the taxable year in which the change occurs. Designations are continuous: absent a permitted change, the imputed income limitation of a unit does not move.
The regulations do allow changes in defined circumstances. These include changes permitted by IRS forms, instructions, or published guidance; changes permitted by the state agency through public written guidance applicable to all average income projects under its jurisdiction; changes required or appropriate to enhance protections under fair housing, disability, and violence-against-women laws; tenant moves between units, in which case designations effectively follow the household; and changes made to restore compliance when units lose low-income status or a designation change would otherwise push the qualified group's average above 60 percent. That last restoration rule is the owner's safety valve: a market-rate unit can be designated, or other designations lowered, to pull the average back into compliance, subject to the qualification of current tenants under any new lower limit.
The final regulations also build a correction framework for procedural missteps, such as a missed identification, a late report, or a designation recorded improperly. If the taxpayer discovers the failure, it must submit a correction to the agency within 180 days of discovery. If the agency discovers it, the agency notifies the taxpayer and the taxpayer corrects within the window the agency sets under the Section 1.42-5(e) framework. Agencies may also waive a procedural failure in writing. A corrected or waived failure is treated as satisfied, which means the unit-level consequences never cascade into recapture territory as long as the underlying occupancy and rent restrictions held.
The correction framework does not excuse substantive failures. A household that did not qualify under the unit's designated limitation, or a unit leased above its rent restriction, is a compliance problem that no designation paperwork can repair.
The most common failure patterns are administrative rather than substantive. First, missing or late designations: a unit occupied before its designation is recorded cannot be counted retroactively, and the fix requires either the correction process or restructuring the qualified group. Second, treating the set-aside identification as a one-time election: the qualified group is identified every taxable year, and agencies expect the annual communication whether or not anything changed. Third, assuming the average gives room to drift: adding an 80 percent designation without removing or lowering something else can push the qualified group's average over 60 percent, and the discovery often comes during an agency file review rather than from internal monitoring. Fourth, inconsistent books and records: the designation must live in the owner's records, not only in the agency submission, and retention must match the Section 1.42-5(b)(2) period.
Not every state treats the average income option identically. Qualified allocation plans govern whether the option is available for competitive awards, how designations interact with state-imposed income targeting, and what reporting templates owners must use. Some states cap the share of units that may be designated at 70 or 80 percent; some require deeper targeting than the federal floor; some tie points or basis boosts to specific designation mixes. Owners pursuing an average income election should map the state QAP and the agency's published designation-change guidance before finalizing the unit mix, because a designation strategy that passes the federal test can still fail state conditions written into the credit award and the extended use agreement.
Owners running average income properties should build four recurring checks into the compliance calendar. At lease-up, confirm every unit's designation is recorded before first low-income occupancy. Each year, identify the qualified group for the set-aside and the group for the applicable fraction, record the identification, and submit it to the agency in its required format. At every designation change, verify the change fits a permitted category, record it by year-end, and retain both the old and new designations. And at any unit-status change, re-run the average across the qualified group immediately rather than waiting for the annual report, so a drift problem surfaces while the restoration rule can still fix it.
The average income test is the most flexible set-aside the credit has ever offered, and the regulatory framework finalized in 2022 gives owners clear mechanics for designations, changes, and corrections. Used deliberately, it supports genuine income mixing and deeper affordability in the same building. Used casually, it produces the kind of finding that surfaces years later in an agency review with limited room to maneuver. The difference is the annual discipline.
For asset managers, one final point deserves emphasis: the applicable fraction and the set-aside are related but separate computations, and the regulations allow the groups used for each to differ. An owner may identify additional units for the applicable fraction group beyond those needed for the set-aside, provided the resulting group still qualifies. That flexibility can raise the credit claim in a year when lease-up ran ahead of schedule, but only if the identifications are made, recorded, and reported with the same care as the set-aside group itself. Owners who treat the two computations as one discover the distinction during an audit, which is the most expensive time to learn it.
Regulatory references verified against 26 CFR 1.42-19 and Section 42(g)(1)(C) of the Internal Revenue Code as of October 23, 2026. State qualified allocation plan requirements vary; owners should confirm current agency guidance for their jurisdiction.
The average income test, added to the Low-Income Housing Tax Credit in 2018, lets projects serve households at up to 80 percent of area median income as long as designated units average 60 percent or below. Each low-income unit gets its own imputed income designation from a fixed menu of 20 to 80 percent, and at least 40 percent of project units must sit in a qualifying group. Owners must identify the qualifying group every taxable year, record designations before first occupancy, and report annually to the state housing credit agency. The final regulations at 26 CFR 1.42-19 permit designation changes in defined circumstances and provide correction procedures for procedural failures. State qualified allocation plans layer their own rules on top, so a designation mix that passes the federal test can still fail state conditions.
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