The Low-Income Housing Tax Credit is the largest federal program for building and preserving affordable rental housing in the United States. It lives in Section 42 of the Internal Revenue Code, which is why developers and investors often call it “Section 42 housing.” For owners and their investors, the credit is also one of the most technical areas of the tax code, and a single misstep in the first year can reduce the credit or trigger recapture years later.
This guide explains how the Low-Income Housing Tax Credit actually works: where the credit comes from, how it is calculated, the difference between the 9% and 4% credits, and the compliance obligations that follow a property for decades. If you are evaluating a deal, closing on an allocation, or preparing for your first year in service, this is the foundation you need.
What Section 42 and the LIHTC Are
Congress created the Low-Income Housing Tax Credit in the Tax Reform Act of 1986 and made it permanent in 1993. Rather than funding affordable housing through direct federal spending, the program delivers a dollar-for-dollar reduction in federal income tax to the investors who fund qualifying rental projects.
The Internal Revenue Service oversees the credit, but it does not hand it out. Each year the IRS allocates a per-capita volume of 9% credit authority to the states. The U.S. Department of Housing and Urban Development tracks the resulting properties in its national LIHTC database, which has recorded millions of credit-supported units since the program began. State housing finance agencies then award those credits to specific projects through a competitive process governed by a Qualified Allocation Plan, or QAP. The QAP sets each state’s priorities, so the same deal can score very differently in Ohio than it does in Texas or New York.
Because the credit has real cash value, developers typically sell it. A limited partnership or limited liability company owns the property, and an investor is admitted as the limited partner or investor member holding roughly 99.99% of the interests. That investor contributes equity up front in exchange for the stream of tax credits and losses. The syndicated equity is what makes rents affordable, since the owner needs less debt to fund construction.
How the Credit Is Calculated
The credit is not based on a property’s value or its rents. It is built from development cost through a specific sequence.
First comes eligible basis, which is generally the depreciable cost of the residential portion of the building. Land is excluded, as are most permanent financing costs and reserves. Certain properties in a designated Qualified Census Tract or Difficult Development Area receive a 30% boost to eligible basis.
Next is qualified basis, calculated by multiplying eligible basis by the applicable fraction. The applicable fraction is the lesser of the share of units that are rent-restricted and occupied by qualifying households, or the share of residential floor space those units represent. A project that reserves only part of its units for low-income tenants earns credits on only that portion.
Qualified basis is then multiplied by the applicable percentage to produce the annual credit. That annual amount is claimed every year for 10 years, which is why the program is often described as a 10-year credit period even though the affordability restrictions last much longer.
The 9% Credit Versus the 4% Credit
Section 42 provides two credit rates, and the difference drives how most deals are structured.
The 9% credit is intended to deliver roughly 70% of a project’s eligible basis in present value over the 10-year period. It generally applies to new construction and substantial rehabilitation that are not financed with federal subsidies. The 9% credit is scarce and competitive, because it is capped by each state’s annual volume. A fixed minimum rate of 9% is now set in statute, which removed years of uncertainty when the rate floated monthly.
The 4% credit targets roughly 30% of eligible basis in present value and typically applies to acquisition costs and to projects financed with tax-exempt private activity bonds. The 4% credit is not drawn from the state’s competitive 9% ceiling. Instead, a project qualifies as of right when tax-exempt bonds finance a required share of the aggregate basis of the buildings and land. That share was historically 50%, long known as the 50% test, but the One Big Beautiful Bill Act enacted in 2025 lowered the threshold to 25% for buildings placed in service after December 31, 2025, as long as a portion of the basis is financed with bonds issued after that date. The Consolidated Appropriations Act of 2021 established a 4% minimum rate as well, which improved the economics of many bond deals.
Choosing between a competitive 9% allocation and a 4% bond structure is one of the earliest and most consequential decisions in an affordable housing transaction, and it affects everything from the capital stack to the cost certification your CPA will later prepare.
Set-Aside Tests and the Rent Restrictions
To qualify, an owner must commit to one of the minimum set-aside tests. The traditional options are the 20-50 test, where at least 20% of units are occupied by households earning no more than 50% of area median income, and the 40-60 test, where at least 40% of units serve households at or below 60% of area median income.
A third option, income averaging, was added in 2018. It lets owners designate units at a range of income limits from 20% to 80% of area median income, as long as the units average no more than 60%. Income averaging gives developers flexibility to serve a broader mix of residents, but it also adds compliance complexity, because the average must be maintained over time.
Rents in the restricted units are capped. The maximum rent is tied to the imputed income limit for the unit and includes a utility allowance, so the rent a tenant actually pays plus utilities cannot exceed the cap. Getting utility allowances and unit designations right in year one matters, because errors flow into the qualified basis and the credit.
The Credit Period and the Compliance Period
Two different clocks run on every LIHTC property, and confusing them is a common and costly mistake.
The credit period is the 10 years over which the owner claims the annual credit. It generally begins when the building is placed in service, though owners can elect to defer the start to the following year.
The compliance period is 15 years. During those 15 years the property must continuously meet the set-aside, rent, and habitability requirements, or the IRS can recapture a portion of credits already claimed plus interest. On top of the 15-year compliance period, Section 42 requires an extended use agreement that adds at least 15 more years, creating a minimum affordability term of 30 years. Many state agencies require even longer commitments through their QAPs.
Because recapture risk lasts the full 15 years, annual monitoring, accurate tenant files, and clean financial reporting are not optional. They protect the investor’s return and the owner’s credit.
The Key Tax Forms
A handful of IRS forms structure the credit’s life cycle. Form 8609 is the allocation and certification document; the state agency issues it, and the owner completes Part II and files it with the first-year return to make binding elections such as the set-aside choice. Form 8586 is used to claim the annual credit, which flows through to investors on their Schedule K-1. Form 8611 reports recapture when a property falls out of compliance.
Before the agency will issue Form 8609, it almost always requires a final cost certification prepared by an independent CPA. That certification verifies the development costs that make up eligible basis and effectively sets the credit the project will receive. For a deeper look at that process, see our guide to the LIHTC cost certification and the 25% bond test.
Where a CPA Fits In
Section 42 rewards precise accounting from the first dollar of development cost through the last year of compliance. A CPA experienced in affordable housing supports an owner at several points: modeling eligible basis during underwriting, preparing the final cost certification that unlocks Form 8609, auditing the partnership’s annual financial statements for investors and lenders, preparing the partnership tax return, and helping management maintain compliance so credits are never put at risk.
Pease Bell works with developers, syndicators, and operators across the affordable housing sector, including projects that layer LIHTC with HUD financing and project-based rental assistance. You can learn more on our affordable housing and real estate industry pages.
Frequently Asked Questions
What is Section 42 housing?
Section 42 housing refers to rental properties financed with the Low-Income Housing Tax Credit, which is authorized by Section 42 of the Internal Revenue Code. Owners agree to limit rents and reserve units for income-qualified households in exchange for federal tax credits claimed over 10 years.
What is the difference between the 9% and 4% LIHTC?
The 9% credit delivers about 70% of eligible basis in present value and is awarded competitively for new construction and substantial rehabilitation. The 4% credit delivers about 30% and generally applies to acquisition costs or projects financed with tax-exempt bonds that meet the 50% test.
How long do LIHTC restrictions last?
The credit is claimed over a 10-year credit period, but the property must stay compliant through a 15-year compliance period. An extended use agreement adds at least another 15 years, for a minimum of 30 years of affordability, and many states require longer.
What triggers LIHTC recapture?
Recapture is triggered when a property fails to maintain its minimum set-aside, exceeds allowable rents, or otherwise falls out of compliance during the 15-year compliance period. The IRS can recover a portion of previously claimed credits plus interest, reported on Form 8611.
What is a LIHTC cost certification?
A cost certification is an independent CPA’s verification of the development costs that make up a project’s eligible basis. State housing finance agencies generally require it before issuing Form 8609, because those costs determine the final credit amount.
Who allocates Low-Income Housing Tax Credits?
The IRS allocates 9% credit authority to the states on a per-capita basis, and each state’s housing finance agency awards credits to specific projects under its Qualified Allocation Plan. The 4% credit tied to tax-exempt bonds is available as of right rather than through the competitive process.
