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In 23rd Chelsea Associates LLC v. Commissioner, No. 22382-19 (Feb. 20, 2024), the Tax Court (court) held in favor of the taxpayer in a case of first impression, finding that a partnership correctly included financing costs from issuing bonds in the eligible basis of a building project when calculating the low-income housing credit (LIHC) under IRC Section 42.

Facts

23rd Chelsea, a partnership, constructed a residential rental property (project) in New York City during 2001 and 2002, financing the project with a loan from the New York State Housing Finance Agency (HFA). The loan was funded by $110 million in taxable and tax-exempt bonds.

23rd Chelsea claimed LIHCs for 2003 through 2009. The eligible basis used in calculating the LIHC included the financing costs incurred with the loan, including the bond fees. To receive the loan, 23rd Chelsea had to fully secure the loan and its repayment obligations with a letter of credit from a bank.

23rd Chelsea claimed an LIHC of almost $600,000 for each year from 2003 to 2009. The eligible basis used for calculating this credit included financing costs, which included fees for HFA financing, bond issuance and the bank's letter of credit. Each component of the financing costs was included in the eligible basis to the extent that component related to both (1) the portion of the real estate composed of residences and common areas, and (2) costs incurred during the construction period. The HFA required 23rd Chelsea to pay most of these financing costs as a condition of issuing and maintaining the loan.

The IRS issued a final partnership administration adjustment (FPAA) for 2009 disputing the inclusion of $1.2 million in financing costs in the eligible basis used to calculate the LIHC. The IRS also proposed recapturing the portion of the credits based on the financing costs.

Issues before the court

The court said there were two questions of first impression:

• Whether the eligible basis, for purposes of the LIHC calculation, can include financing costs from the issuance of bonds (taxable or tax-exempt) whose proceeds were lent to the taxpayer to finance the project
• If not, whether IRC Section 42(j) requires a credit recapture from the taxpayer equal to the financing costs in the eligible basis in prior tax years

The court found for the taxpayer, thereby rendering the second issue moot.

Court analysis

The court looked to IRC Section 42 to resolve the issue of whether the eligible basis included the financing costs from the bonds. Under IRC Section 42(d)(1), the "basis of a new building is its adjusted basis as of the close of the 1st taxable year of the credit period." Because the statute does not define "adjusted basis," the court applied the default rule under IRC Section 1011(a), which determines the adjusted basis under IRC Section 1012. Under this section, a property's basis generally equals its cost. The court then applied IRC Section 263A and its regulations, which apply to taxpayer-produced real property and require the property's direct costs and the allocable share of its indirect costs to be capitalized.

Taking all these provisions together, the court said "(1) the direct costs and properly allocable share of indirect costs must be capitalized to the property; (2) 'capitalize' means to charge to a capital account or basis; and (3) basis is adjusted for any expenditures charged to the capital account."

The court further noted that IRC Section 263A and its regulations require 23rd Chelsea to capitalize into the project's basis the incurred financing costs that were a "but-for" cause of production. Thus, the project's eligible basis included all the financing costs that were (1) allocable to the residential rental property, (2) a but-for cause of the project's construction and (3) incurred by the first year of the credit period (2003). The $1.2 million in financing costs were necessary to induce the HFA to initiate and maintain the loan used for construction of the project. Therefore, 23rd Chelsea incurred all asserted the financing costs by reason of the project's construction, according to the court.

The court said that the same result would occur whether the bonds were taxable or tax-exempt.

IRS arguments

The court rejected the IRS's argument that (1) IRC Section 42 requires a building to be subject to modified accelerated cost recovery system (MACRS) depreciation, (2) the costs of obtaining bond proceeds should be capitalized into the underlying loan and thus are subject to depreciation under IRC Section 167 but not MACRS under IRC Section 168, and (3) therefore those bond costs are ineligible to be part of the "qualified low-income building" for purposes of IRC Section 42. The court said the building is eligible for MACRS under IRC Section 168. Therefore, the adjusted basis includes the financing costs incurred for production.

The court also rejected the IRS's legislative-history argument, saying that Congress did not explicitly exclude tax-exempt bond issuance costs from eligible basis.

Implications

The IRS's arguments adhere to a prior, dated IRS examination position (not an official pronouncement of the law) that no longer appears on the IRS's website. A new Audit Technical Guide on LIHC does not address this issue.

Taxpayers should assess their facts and the availability of possible approaches to conform to 23rd Chelsea Associates, in consultation with their advisors. This analysis includes assessment of prior filed returns and returns to be filed.

Taxpayers that are not currently including all allocable costs in the basis of self-constructed assets may seek an accounting method change under IRC Section 263A. Consideration can be given to the potential applicability of Section 12.08 of automatic Revenue Procedure 2023-24 (relating to a change to a reasonable allocation method described in Treas. Reg. Section 1.263A-1(f)(4) for self-constructed assets) to appropriately capitalize all costs relevant to the basis of self-constructed assets, including financing costs such as the bond fees at issue in 23rd Chelsea Associates. Such accounting method change will be effective beginning in the proposed tax year of change.