U.S. Tax Court: Bond Fees, Financing Costs Are Includible in LIHTC Eligible Basis

The ruling reverses a longstanding Technical Advice Memorandum the IRS issued in 2000.

The U.S. Tax Court recently held that a developer properly included in its “eligible basis,” for purposes of computing the low-income housing tax credit, its financing costs incurred in the construction of its LIHTC site. The financing costs included bond fees regardless of whether or not the bondholders are exempt from federal income tax on the bond interest under Section 103 of the Internal Revenue Code.

What Happened

Construction of the LIHTC project, a 314-unit apartment building located on 23rd Street in Manhattan, began in August 2001. One month later, the September 11 attacks occurred which delayed construction activity for months. The high land costs and interest costs on the financing made it financially infeasible for the construction of the project to be delayed, so the developer put together a work force that was able to complete the project on schedule. However, this resulted in an unusual construction payment schedule where costs were directly incurred by the client and not by contractors.

The construction was financed with a loan from the New York State Housing Finance Agency (HFA), which funded the loan at least partially using bonds that were tax-exempt under Section 103. Under Section 103, most bonds issued by government agencies are tax-exempt. This means interest on these bonds are excluded from gross income for federal tax purposes.

The developer claimed LIHTCs for 2003 through at least 2009. And for purposes of determining the property’s “eligible basis,” the taxpayer included a portion of the various financing costs it incurred in connection with the HFA loan, including bond fees that the HFA passed on to the developer. However, the IRS argued that the developer wasn’t entitled to include any of the financing costs in the property’s eligible basis for purposes of computing its LIHTCs.

An audit was eventually triggered because the general partner failed to sign Part Two to the Form 8609 that was submitted to the IRS. Form 8609 is the IRS document that credit allocating agencies give to property owners as evidence that the owner is eligible to claim LIHTCs. As a result of the audit, the IRS made a final adjustment of approximately $2.2 million of costs. Specifically, the IRS challenged inclusion of union dues paid on behalf of a contractor. The IRS later conceded on this issue.

However, the IRS also challenged the inclusion of bond issuance and other financing fees related to the construction period in eligible basis. These fees include bond fees imposed by the state agency, origination and letter of credit fees (which are provided as security for the bonds imposed by the bank that provided a letter of credit), underwriters’ fees and expenses, and bank and state agency servicing fees. The dispute over the financing fees were further complicated because New York State had issued both taxable bonds and tax-exempt bonds to finance the construction of the project.  

Tax Court’s Decision

The IRS challenged the developer’s inclusion of all of the financing costs related to the construction period in eligible basis, regardless of the financing source. The U.S. Tax Court rejected the IRS’s position and held that bond issuance and related financing costs incurred in connection with the development of a LIHTC project are includible in eligible basis, regardless of whether the bonds are taxable or tax-exempt. The Tax Court determined that these costs could be included in the eligible basis as indirect costs. According to the court, “For purposes of determining eligible basis in section 42, bond issuance costs are allocable to residential rental property, provided that they were incurred by reason of construction or production.”

The ruling reverses a longstanding Technical Advice Memorandum (TAM) first issued by the IRS in 2000 (TAM 200043015). This TAM held that bond issuance costs incurred in connection with tax-exempt volume cap bonds were not includible in eligible basis because such costs don’t constitute residential real property under Internal Revenue Code Section 142, which provides for the tax exemption of bonds issued to finance affordable housing.

• 23rd Chelsea Associates L.L.C. v. Commissioner, 162 T.C. No. 3 (February 2024).

Identifying Costs Included in Eligible Basis

Low Income Housing Tax Credits are taken over a 10-year period and are calculated according to the eligible basis of the site, which includes the cost of new construction/rehabilitation or the cost of acquisition of an existing building. The concept of eligible basis is unique to the LIHTC program because it’s tied to the credits that can be claimed.

As a tax credit site manager, you have the important responsibility of maintaining a site’s eligible basis to preserve the owner’s tax credits. The eligible basis of a building is determined at the end of the first year of the credit period, and as long as there’s no reduction in the eligible basis amount upon which the credit is based, the site is in compliance. Although you’re not responsible for calculating eligible basis, knowing what it entails and how tax credits are calculated may help you maintain the eligible basis of a site and keep your site in compliance.

Here are the characteristics of costs that can be included in a site’s eligible basis calculations. Internal Revenue Code (IRC) Sections 103 and 168 and supplemental definitions and requirements provided by Section 42 cover the characteristics of the costs that can be included in a site’s eligible basis.

Related to residential housing. To be eligible for eligible basis, a cost must be for residential housing. Eligible basis doesn’t include commercial space. Residential rental property may qualify for the credit even though a portion of the building in which the residential rental units are located is used for a commercial use such as commercial office space. But no portion of the cost of such nonresidential rental property may be included in eligible basis.

If you do happen to use residential space commercially, that space is no longer part of the eligible basis. So, when a building’s eligible basis goes down, the credits the owner can claim go down with it.

Model units. Model units are considered rental units under IRC Section 42; PLR 9330013, Issue #3, July 30, 1993. Model units are maintained primarily during a project’s rent-up period to show prospective tenants the desirability of the site’s units. If the site maintains full occupancy thereafter, the model can be dismantled and the unit rented. This makes economic sense because model units don’t generate rental income for a project owner. However, at a large apartment site, it’s standard industry practice to continuously maintain a model unit for marketing purposes and to be competitive. The unit can be shown immediately to prospective tenants at any time without disturbing tenants in occupied units. By increasing competitiveness, model units contribute to the economic viability of the LIHTC site.

A model unit’s cost is included in the building’s eligible basis and in the denominator of the applicable fraction when determining a building’s qualified basis. For example, an owner included the cost of a model unit in the eligible basis for a 100 percent LIHTC building with 49 units (other than the model unit). The owner anticipates that the model unit will be maintained throughout the compliance period and will never be rented to an income-qualified household. The cost of the unit should be included in the building’s eligible basis. But the maximum applicable fraction that the owner can claim is 49/50, or 98 percent.

Depreciable costs. Costs includable in eligible basis must be depreciable property under IRC Section 168. IRC Section 168(e)(2)(A) defines “residential rental property” to mean any building or structure if 80 percent or more of the gross rental income from such building or structure for the taxable year is rental income from dwelling units. Eligible costs include all “hard” construction costs and most depreciable “soft” costs, such as architectural and engineering costs, allowable developer fees, and construction loan interest.

Costs incurred within appropriate time frames. Under IRC Section 42, the buildings qualifying for the credit are:

• New buildings, the original use of which begins with the taxpayer [IRC §42(i)(4)];
• Existing buildings, which means any buildings that are not new buildings [IRC §42(i)(5)]; and
• Rehabilitated buildings—that is, the expenditures connected with rehabilitating an existing building are treated as a separate new building and don’t include the cost of acquiring the building [IRC §42(e)(1) and (2)].

The main thing to be aware of here is the timing difference between these two types of buildings. The timing of when a cost is paid or incurred affects its inclusion in the eligible basis. Under IRC Section 42(f)(1), the credit period starts with the taxable year in which the building is placed in service, or at the election of the taxpayer, the succeeding taxable year. The election is documented on Form 8609, line 10a. For new building owners, their eligible basis costs must be incurred by the close of the taxable year so elected. As a result, certain costs that may have been incurred after the close of the year (such as landscaping and common areas) can’t be considered part of eligible basis.

For existing buildings with substantial rehabilitation, the owner elects a 24-month period during which to incur and perform the substantial rehabilitation, and these eligible basis costs end on the last day of the 24-month period elected.

Federal grants. Under IRC Section 42(d)(5)(A), the eligible basis must be reduced if a federal grant is made to fund the cost of a building. Federal grants are funds that originate from a federal source and don’t require repayment.

Facility costs reasonably required for site. Residential rental property, for low-income housing credit purposes, includes residential rental units, facilities for use by the tenants, and other facilities reasonably required by the project. Under Treasury Regulation Section 1.103-8(b)(4), facilities that are functionally related and subordinate to residential rental projects are considered residential rental property. Treasury Regulation Section 1.103-8(b)(4)(iii) provides that facilities functionally related and subordinate to residential rental projects include facilities for use by the tenants, such as swimming pools and similar recreational facilities, parking areas, and other facilities reasonably required for the project. The examples included in Treasury Regulation Section 1.103-8(b)(4)(iii) of facilities reasonably required by a project specifically include units for resident managers or maintenance personnel.

Community service facility costs. As part of the Community Renewal Tax Relief Act of 2000, IRC Section 42(d)(4)(C) was added to include property used to provide services to non-tenants as part of the eligible basis used for determining the LIHTC amount. The facility must be located on the same tract of land as one of the buildings that comprises the qualified low-income housing project. And examples of such facilities include day care, career counseling, literacy training, education (including tutorial services), recreation, and out-patient clinical health care. These are specific requirements:

• The property must be located in a qualified census tract. (See former IRC Section 42(d)(5)(C)(ii) for buildings placed in service prior to July 31, 2008, and IRC Section 42(d)(5)(B)(ii) for buildings placed in service after July 30, 2008.)
• The property must be subject to the allowance for depreciation and not otherwise accounted for.
• The property must be used throughout the taxable year in providing any community service facility.
• Under IRC Section 42(d)(4)(C)(iii), a community service facility must be designed to service primarily individuals whose income is 60 percent or less of the area median income.