U.S. Tax Court Holds Bond Financing Costs Are Includible in LIHTC Basis

A U.S. Tax Court decision entered on Feb. 20, 2024, in 23rd Chelsea Associates LLC v. Commissioner of Internal Revenue held that bond issuance and related financing costs incurred in connection with the development of a low-income housing tax credit (LIHTC) project are includible in eligible basis, regardless of whether the bonds are taxable or tax-exempt. The holding reverses a longstanding Technical Advice Memorandum (TAM) first issued by the IRS in 2000 (TAM 200043015), which held that bond issuance costs incurred in connection with tax-exempt volume cap bonds were not includible in eligible basis because such costs are "bad" costs that do not constitute residential real property under Internal Revenue Code Section 142, which provides for the tax-exemption of bonds issued to finance affordable housing.

The Project and Audit

23rd Chelsea Associates LLC is a development sponsored by The Related Companies LP (Related), one of the nation's largest real estate developers and owners of affordable housing. The project, known as The Tate, is a 314-unit apartment building located on 23rd Street in Manhattan, New York. Construction on The Tate commenced in August 2001. One month later, the Sept. 11 attacks, which occurred 1 mile south, stopped most 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. Related and its construction manager put together a work force that was able to complete the project on schedule. This resulted in an unusual construction payment schedule where costs were directly incurred by the client and not by contractors.

An audit was eventually triggered because the general partner failed to sign Part Two to the Form 8609 that was submitted to the IRS. Providing backup for construction costs upon audit by the IRS became highly time-consuming, but ended up with a relatively minor final adjustment by the IRS of approximately $2.2 million of costs – approximately 19 percent of which were originally included in eligible basis, because only 20 percent of the apartments were rent-restricted. Specifically, the IRS challenged inclusion of union dues paid on behalf of a contractor that were later conceded by the IRS and inclusion of bond issuance and other financing fees related to the construction period in eligible basis. The latter dispute was further complicated because New York state had issued both taxable bonds and tax-exempt bonds to finance the construction of the project. The IRS challenged the inclusion of all of the financing costs related to the construction period in eligible basis, regardless of the financing source.

The adjustment resulted in a claim of recapture of one-third of the credits claimed for the five years preceding the adjustment year of 2009. Related, which has a long history of developing low-income housing projects – none of which had been previously subject to a recapture – determined to fight the adjustment, although the cost of the challenge exceeded the approximately $70,000 deficiency at issue.

The Lawsuit

Under stipulations that were intended to limit issues before the Tax Court, the IRS ultimately conceded that union dues and payments for various directly retained workers on the project were includible in basis, given these expenses would normally be paid by a contractor. Accordingly, only two issues ended up before the Tax Court. The first issue was whether the bond issuance and other financing costs for construction of the building were includible in eligible basis. The second issue was, if such costs were not includible in eligible basis, could that determination – made after the time for adjustment of eligible basis for the first year of the tax credit period had expired – result in a recapture of housing tax credits or only affect the amount of housing tax credits that could be claimed on a tax return during the open period for review and future years. Because eligible basis is determined as of the end of the first year of the tax credit period and a recapture event under Internal Revenue Code Section 42(j) occurs if qualified basis in one year is less that the qualified basis in the prior year, there continues to be an open issue as to whether a successful challenge of eligible basis can trigger a recapture event.

The Tax Court held that 23rd Chelsea Associates was not deficient in its claim of LIHTCs and thus not subject to recapture of a portion of the credits. The Tax Court determined that these costs were includible as indirect costs that were required to be capitalized in adjusted basis under Internal Revenue Code Section 263A, regardless of whether they were incurred in connection with the issuance of taxable or tax-exempt debt and were therefore includible in eligible basis for LIHTC purposes. Because Judge Elizabeth Copeland determined that the financing and bond issuance costs were includible in eligible basis, the Tax Court did not reach the second issue on recapture. Unless appealed by the Commissioner of Internal Revenue, this decision will put an end to the more than 15-year dispute.

Please note: The authors represented 23rd Chelsea Associates LLC in the Tax Court challenge, and various Holland & Knight attorneys, led by Alan Cohen, worked on the representation throughout the audit, which commenced in 2009. Throughout the decade-long process, several attorneys, including William F. Machen and various associates, assisted with this matter.

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