How the Low-Income Housing Tax Credit Works

The Low-Income Housing Tax Credit (LIHTC) works by trading a federal tax break for long-term affordable rents. A developer who wins credits from a state agency sells them to investors, usually banks. The investors pay cash up front and claim the credits against their federal income taxes over 10 years. That cash, called equity, pays for a large share of construction. The property can then borrow less, and with smaller loan payments it can charge rents that lower-income households can afford. In return, the owner must rent to income-qualified tenants at capped rents for at least 30 years.

Congress created the credit in the Tax Reform Act of 1986, and it lives in Section 42 of the Internal Revenue Code. The Congressional Research Service (CRS) calls it the federal government’s primary tool for developing affordable rental housing. HUD’s database counts 55,345 projects and 3.9 million housing units placed in service from 1987 through 2024.

The Basic Mechanics

From Washington to the states to developers

The credit moves through three layers:

1. Federal allocation to states. Each year, every state receives authority to award credits based on its population. In 2025 the amount was $3.00 per resident, with a minimum of $3,455,000 for small states, according to CRS. With the 12% increase that took effect in 2026, the IRS set the 2026 figures at $3.416 per resident and a $3,953,600 small-state minimum.
2. State allocation to developers. A state housing finance agency awards credits to specific projects through a competitive process. Credits a state fails to award within two years go to a national pool and are redistributed to states that used all of theirs.
3. Developers to investors. The developer sells the 10-year stream of credits for equity, then builds and operates the property under recorded affordability rules.

How the credit amount is calculated

The credit is based on development costs, not on rents or tenant incomes. The starting point is eligible basis, which is roughly the depreciable cost of the building, excluding land. That figure is multiplied by the applicable fraction, the share of the property that is low-income (measured by units or floor space, whichever is smaller). The result is the qualified basis. Multiply the qualified basis by the credit rate and you get the annual credit, which is claimed each year for 10 years.

Projects in a qualified census tract (a lower-income neighborhood designated by HUD) or a difficult development area (a high-cost area relative to incomes) can receive a 30% basis boost, which raises the credit by up to 30%. Since 2008, states may also designate individual projects that are not bond-financed as eligible for the boost.

A state agency may award no more credit than a project needs to be financially feasible, checking that need at application, at allocation, and when the building opens.

9% Credits vs. 4% Credits

There are two kinds of credit. CRS describes them as designed to deliver a subsidy worth about 70% and 30% of a project’s qualified basis, measured in present value.

The actual rates once floated monthly with interest rates, and Treasury’s formula kept them below 9% and 4% for years until Congress set permanent floors.

The 9% credit is scarce. Each state’s annual authority is fixed, so developers compete on the state’s scoring criteria.

The 4% credit is not capped by the state’s per-person allocation. A project receives it if enough of its cost is financed with tax-exempt private activity bonds, issued by a state or local agency (see tax-exempt multifamily housing bonds). Those bonds are limited by a separate state volume cap. The required share of bond financing was long 50% of the cost of the building and land, a rule known as the 50% test; a 2025 law lowered it, as described below. Because the 4% credit is worth less, these deals carry more debt and often need gap financing from state or local sources.

The Qualified Allocation Plan

Every state must publish a Qualified Allocation Plan (QAP), the rulebook for awarding credits. State government must approve it after a public process, so the QAP is where most policy choices about the credit get made.

Federal law sets a floor. A QAP must give preference to projects that:

• serve the lowest-income tenants;
• stay affordable the longest; and
• are in qualified census tracts and contribute to a concerted community revitalization plan.

Its selection criteria must also cover a list of factors. These include project location, local housing needs, sponsor characteristics, tenants with special housing needs, public housing waiting lists, families with children, eventual tenant ownership, energy efficiency, and historic character. At least 10% of each state’s credits must go to projects in which a qualified nonprofit has an ownership interest and materially participates. Before awarding credits, the agency must also require an independent market study. It must notify the chief executive of the local government, such as a mayor, and give that official a chance to comment.

Beyond that floor, states set their own priorities, such as deeper income targeting, longer affordability terms, or particular populations and places.

Syndication and Investor Equity

To claim credits, an investor must own part of the property. Deals are usually structured as a limited partnership or LLC. The developer acts as general partner, with a small ownership stake and day-to-day control. The investor acts as limited partner, with most of the ownership and a passive role. Firms called syndicators often pool investors into funds and charge fees for arranging and managing the investment. This process is called syndication.

Investors pay less than face value for each dollar of credit. CRS reports that in normal markets, prices typically range from the mid-80s to the low-90s in cents per credit dollar. Investors may also get tax losses from depreciation and interest. Banks provide most of the investment, partly because LIHTC investments count favorably under the Community Reinvestment Act.

Suppose a new building has a qualified basis of $10 million and receives a 9% credit. It generates $900,000 in credits a year for 10 years, or $9 million in total. If an investor paid a hypothetical $0.88 per credit dollar, the project would raise about $7.9 million in tax credit equity. A first mortgage and other sources fill the rest of the capital stack.

Who Qualifies and What Rents Look Like

The income tests

When a property is placed in service, the owner must choose one of three minimum set-asides, and the choice cannot be undone:

• 20/50: at least 20% of units go to households at or below 50% of area median income (AMI).
• 40/60: at least 40% of units go to households at or below 60% of AMI.
• Income averaging: at least 40% of units are designated at 20%, 30%, 40%, 50%, 60%, 70%, or 80% of AMI, and the designations average no more than 60%.

Congress added income averaging in 2018. It lets a property include units for households at 70% or 80% of AMI, as long as units designated at lower levels keep the average at 60% or less. In practice, many properties restrict 100% of their units, because the credit is calculated only on the low-income share.

If a tenant’s income later rises, the unit generally stays qualified. Once a household’s income goes above 140% of the limit, however, the owner must rent the next available comparable unit to a qualifying household.

Rent limits

A restricted unit’s gross rent, meaning rent plus a utility allowance for tenant-paid utilities, cannot exceed 30% of the income limit tied to that unit. The limit assumes 1 person for a studio and 1.5 people per bedroom, so it depends on unit size rather than on who actually lives there.

Suppose the 60% income limit for a three-person household in an area were an invented $60,000. A two-bedroom unit (imputed at three people) could charge a gross rent of up to $1,500 a month, which is 30% of $60,000 divided by 12. To find the real limits for your area, use HUD’s lookup on the HUD User website. HUD publishes the limits used for tax credit properties as Multifamily Tax Subsidy Project (MTSP) income limits.

Owners also may not refuse to rent to an applicant because the applicant holds a Housing Choice Voucher.

Compliance and How Long Affordability Lasts

The first 15 years are the compliance period. If a property falls out of compliance during that time, the IRS can recapture part of the credits already claimed. That risk falls on investors, which gives them a strong reason to watch the property. State agencies monitor compliance through tenant file reviews and site inspections and report violations to the IRS.

A recorded agreement then adds an extended use period of at least 15 more years, for a minimum of 30. Low-income tenants can enforce that agreement in state court. States can require longer terms, and federal law directs them to prefer projects that commit to the longest periods.

There is an important exception. After year 14, an owner may ask the state agency to find a buyer willing to keep the property affordable at a formula price. This is called a qualified contract request. If the agency cannot produce a buyer within a year, the extended use restrictions end. Existing low-income tenants keep rent and eviction protections for three more years. The extended use agreement or state law can remove this option. The process is one route by which affordable units are lost; see expiring use.

What Changed in 2025: Public Law 119-21

The law commonly called the One Big Beautiful Bill Act, Public Law 119-21, was signed on July 4, 2025. It made two permanent changes to Section 42:

Because tax-exempt bonds are subject to a state volume cap, needing half as much bond financing per project lets that cap support more 4% deals.

The law did not change the income tests, rent limits, basis boosts, or the compliance and extended use periods. CRS reports that the Joint Committee on Taxation estimated the changes would cost $39 million in 2026, rising to $4.0 billion in 2034. Before the law, the program was estimated to cost $14.4 billion a year on average over fiscal years 2024 through 2028.

Criticisms and Debates

Supporters note that the credit lets states set local priorities and that private investors put money at risk and can lose credits if properties fall out of compliance. Critics raise several recurring concerns.

• It does not reach the lowest incomes on its own. Rents are tied to AMI-based limits, not to tenants’ actual incomes. In HUD’s tenant data as of December 31, 2023, which does not include California, about 57% of households with reported income earned 30% of AMI or less. About 41% of households with reported rent and income paid more than 30% of income for rent, and about 15% paid more than half. About 48% of households received rental assistance, most often HUD project-based rental assistance or housing vouchers. That shows how often the credit relies on a second subsidy to serve extremely low-income renters.
• Costs and complexity. The Government Accountability Office (GAO) studied projects completed from 2011 to 2015. Among the 12 allocating agencies it reviewed, median per-unit costs for new construction ranged from about $126,000 in Texas to about $326,000 in California. It also reported that the IRS does not require agencies to collect and report cost data, and that agencies did not capture the full fees paid to syndicators.
• Thin federal oversight. In 2016, GAO reported that IRS oversight of allocating agencies remained “minimal.” It found the IRS had recorded in its database only about 2% of the noncompliance information it had received since 2009.
• Where projects are built. QAP preferences can favor revitalizing poor neighborhoods or building in higher-opportunity areas, and that tension can raise fair housing issues. In Texas Department of Housing and Community Affairs v. Inclusive Communities Project (2015), a case about how Texas allocated credits in the Dallas area, the Supreme Court held that disparate impact claims can be brought under the Fair Housing Act.
• Affordability that can expire. Thirty years is long but not permanent, and the qualified contract process can end restrictions before the 30 years are up.
• A gap for workforce households. With limits topping out at 60% of AMI, or 80% for individual units under averaging, the credit generally cannot serve households in the 80% to 120% band.

The Bottom Line

The LIHTC turns a 10-year federal tax credit into upfront equity that reduces the debt an apartment building must carry, in exchange for at least 30 years of income and rent limits. States control who gets the scarce 9% credits through their QAPs, while 4% credits follow tax-exempt bonds, and the 2025 law expanded both. The credit is the federal government’s primary tool for producing affordable rental housing, but it works best alongside other tools: rental assistance for the poorest tenants, gap financing for tight deals, and separate strategies for workforce households above its income limits.