Taxpayer Properly Added Bond Fees to Basis for Purposes of Low-Income Housing Credit

(Parker Tax Publishing March 2024)

In a case of first impression, the Tax Court held that a partnership that built a residential rental property the construction of which was financed in part using tax-exempt bonds was permitted to include all financing costs, including bond fees, in the building's basis for purposes of the Code Sec. 42 low-income housing credit. The court found that the term "adjusted basis" in Code Sec. 42(d)(1) has the meaning given to it in Code Sec. 1011(a), and accordingly the uniform capitalization rules of Code Sec. 263A apply; further, under those rules, the financing costs were indirect costs incurred "by reason of" the construction of the building. 23rd Chelsea Associates, L.L.C. v. Comm'r, 162 T.C. No. 3 (2024).

Background

23rd Chelsea Associates, L.L.C. was formed in 2000. Between June 2000 and March 2001, 23rd Chelsea purchased real property and development rights on West 23rd Street in New York City. In June 2001, 23rd Chelsea began construction to develop the property into a 313-unit multifamily residential apartment complex called the Tate, including recreational facilities, a business center, and retail space. Construction lasted approximately 14 months, and the Tate was placed in service on in August 2002.

The Tate's construction was funded entirely by a $110 million loan from the New York State Housing Finance Agency (HFA). The HFA raised these funds through two bond issuances, one in 2001 and the other in 2002. The 2001 issuance comprised $26 million of tax-exempt bonds and $27.5 million of taxable bonds. The 2002 issuance comprised $73 million of tax-exempt bonds. Of the proceeds from the 2002 issuance, $16.5 million was used to redeem a portion of the outstanding 2001 taxable bonds, and the rest was remitted to 23rd Chelsea.

As a condition of initiating the loan, the HFA required 23rd Chelsea to agree to certain restrictions on the eventual tenant mix (by income level) and the rental rates for low-income tenants. These restrictions were designed to (among other things) preserve the tax-exempt status of the tax-exempt bonds and qualify the Tate for the low-income housing credit under Code Sec. 42 (LIHC).

For each of its tax years from 2009 through 2009, 23rd Chelsea claimed an LIHC with respect to the Tate. In 2004, 23rd Chelsea presented to the HFA an independently audited final cost certification, which included a detailed calculation of its "eligible basis" in the Tate under Code Sec. 42(d). The calculation explicitly included in eligible basis a portion of the financing costs totaling $1,218,320. The HFA did not dispute 23rd Chelsea's calculation of eligible basis.

In a 2019 final partnership administrative adjustment (FPAA), the IRS determined that 23rd Chelsea's eligible basis in the Tate did not include the $1,218,320 of financing costs and therefore, Chelsea overstated its basis by that amount. The IRS proposed to decrease 23rd Chelsea's LIHC credit amount for 2009 by $20,079, the amount allocable to the alleged overstatement of eligible basis, and to recapture $49,568, reflecting the portion of the credits claimed in tax years 2003 through 2008 allocable to the alleged overstatement. 23rd Chelsea challenged the FPAA in the Tax Court.

The issues for the Tax Court were: (1) whether, for purposes of the LIHC, the eligible basis in a qualified low-income residential building includes financing costs related to the issuance of bonds (whether taxable or tax-exempt) whose proceeds were lent to the taxpayer as financing for the construction of the building; and (2) if not, whether Code Sec. 42(j) requires a credit recapture from the taxpayer that included such financing costs in its eligible basis in prior tax years. These were questions of first impression for the Tax Court.

Calculation of the LIHC

Under Code Sec. 42(a)(2), the low-income housing credit (LIHC) is reserved for "qualified low-income buildings." In order to be a qualified low-income building, the building must (1) consist of "residential rental property" that satisfies at least one of two tests relating to rent restrictions and tenant income levels; (2) satisfy one of the two tests for at least 15 years after it is placed in service; and (3) be eligible for the modified accelerated cost recovery system (MACRS) of Code Sec. 168.

The LIHC for a given building is prorated over a ten-year credit period beginning in the tax year the building is placed in service or, at the taxpayer's election, the following tax year. During each year of the credit period the taxpayer receives a credit equal to an "applicable percentage" of the building's "qualified basis." The building's qualified basis is calculated as a fraction of its "eligible basis" under Code Sec. 42(d). Code Sec. 42(d)(1) defines the "eligible basis" of a new building as its "adjusted basis" as of the close of the first tax year of the credit period. The term "adjusted basis" is not defined in Code Sec. 42.

The IRS pointed out that under Code Sec. 42 a building must be to subject to MACRS in order to be a "qualified low-income building." The IRS then argued that the costs of obtaining bond proceeds should be capitalized into the underlying loan, and thus are subject to depreciation under Code Sec. 167 but not to MACRS under Code Sec. 168 - rendering those bond costs ineligible to be part of the "qualified low-income building" for purposes of Code Sec. 42. Code Sec. 167(a) allows depreciation deductions generally for "exhaustion, wear and tear . . . of property used in the trade or business," while the accelerated deductions of Code Sec. 168 are reserved for "tangible property" under Code Sec. 168(a).

Analysis

The Tax Court held that the Tate's eligible basis included all the financing costs that were (1) allocable to the residential rental property, (2) a but-for cause of the Tate's construction, given 23rd Chelsea's decision to finance construction with the HFA loan, and (3) incurred by the end of 23rd Chelsea's 2003 tax year (i.e., the first year of the credit period). In the court's view, the record clearly indicated that the amount of financing costs includible in the Tate's eligible basis was at least the amount that 23rd Chelsea actually included (i.e., $1,218,320).

Since Code Sec. 42 does not expressly define adjusted basis, the court looked to Code Sec. 1011(a), which provides the default rule that the adjusted basis for determining gain or loss from the sale or other disposition of property is generally the property's cost, adjusted as provided in Code Sec. 1016. The court found that Code Sec. 263A clarifies this definition as it applies to taxpayer-produced real property (or other tangible property) such as the Tate. Under Code Sec. 263A(a) and (b)(1) and Reg. Sec. 1.263A-1(c), the "direct costs" and the allocable share of "indirect costs" must be added to the property's basis. Therefore, the court determined that the Tate's eligible basis was the sum of 23rd Chelsea's direct construction costs and a properly allocable share of the indirect construction costs, minus costs allocable to portions of the building that were not "residential rental property" at the end of the first year of the credit period.

For taxpayer-produced real or tangible property such as the Tate, Reg. Sec. 1.263A-1(e)(2)(i) defines direct costs as the sum of direct material costs and direct labor costs. Indirect costs are defined in Reg. Sec. 1.263A-1(e)(3)(i) as all costs other than direct material costs and direct labor costs. The court found that under the regulation, such costs are properly allocable to taxpayer-produced property when the costs directly benefit or are incurred by reason of the performance of production activities. In Robinson Knife Mfg. Co., Inc. v. Comm'r, 600 F.3d 121 (2d Cir. 2010), the Second Circuit held that for indirect costs to be incurred by reason of the performance of production activities, the costs must be a "but-for" cause of the taxpayer's production activities.

In the court's view, at least $1,218,320 of the financing costs (which included bond fees) were a but-for cause of the Tate's construction, given 23rd Chelsea's decision to finance construction by borrowing from the HFA. Specifically, the court found that all amounts of the financing costs that 23rd Chelsea included in its computation of eligible basis were necessary to induce the HFA to initiate and/or maintain the loan used for construction of the Tate. Moreover, the court found that the amount of each cost component that 23rd Chelsea allocated (by proration or otherwise) to the construction and production period was incurred during that period, i.e., before the Tate was ever placed in service. Therefore, the court concluded that 23rd Chelsea incurred at least $1,218,320 of the financing costs "by reason of" the Tate's construction.

The court noted that under Reg. Sec. 1.263A-1(e)(3)(i) certain indirect costs may be allocable to both production activities and activities not subject to Code Sec. 263A, in which case taxpayers must make a "reasonable allocation of indirect costs" between the former and the latter. However, the court found that nothing in this regulation indicates that the costs of obtaining financing for production activities are necessarily allocable to a separate "financing" activity not subject to Code Sec. 263A. The court determined that in fact, under Code Sec. 263A(f)(1) interest on loans used to finance the production of property generally must be capitalized under the rule of Code Sec. 263A(a). Code Sec. 263A(f) thus indicates that financing costs allocable to the production period are not per se allocable to a "financing" activity separate and apart from production.

Therefore, the court held that for purposes of Reg. Sec. 1.263A-1(e)(3)(i), the costs of obtaining financing for production activities are not allocable to a separate "financing" activity (ostensibly not subject to Code Sec. 263A) insofar as those costs are allocable to the production period. Rather, the court found that 23rd Chelsea's financing of the Tate's construction through loans funded by bond issuances was an "indivisible part" of the construction to the extent that the financing was allocable to the production period. Accordingly, the court concluded that under Code Sec. 263A(a)(2)(B) and Reg. Sec. 1.263A-1(e)(3)(i), 23rd Chelsea was required to capitalize into the Tate's basis the incurred financing costs that were a but-for cause of production. The court therefore did not uphold the IRS's proposed adjustments in the FPAA, and did not reach the question of whether the credit recapture provisions of Code Sec. 42(j) would apply to 23rd Chelsea.

For a discussion of the rules for determining the amount of the low-income housing credit, see Parker Tax ¶105,105.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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