My fellow NYC dirt lawyers will recognize the colophon of a highrolling organization in 23rd Chelsea Associates, L.L.C., Related 23rd Chelsea Associates, L.L.C., Tax Matters Partner, 162 T.C. 3, filed 2/20/24. For more, see my blogpost “Don’t Give a Sham – Part Deux,” 8/11/14.

And unsurprisingly the highrollers looked southward to find The Right Dawson, their trusty attorney.

Were the Relateds baseless when they included in their Section 42(d) eligible basis for low income housing credits some of the financing costs incurred by their lender, the New York State Housing Finance Agency, in issuing the tax-exempt bonds whose proceeds funded the mortgage loan, and placing the loans itself?

IRS says yes, but Judge Elizabeth A. (“Tex”) Copeland says no, IRS is off-base.

The Relateds carefully allocated expenses between construction and post-construction costs, and between residential and non-residential spaces in the buildout. Judge Tex Copeland has a schedule, 162 T. C. 3,  at pp. 5-6. Note what’s missing (I’ll tell you below if you missed it).

IRS at first disallowed the union pension and welfare contributions paid by the Relateds on behalf of a subcontractor, but folded. IRS did insist that $1.2 million in HFA’s financing cost pass-alongs should be excluded.

“…the Commissioner has offered two arguments to support his determination that the financing costs (including bond fees) were not includible in eligible basis: one relevant to all the costs and one limited to those costs allocable to the tax-exempt bonds. Our ultimate holding does not rest on the distinction between taxable and tax-exempt bonds.” 162 T. C. 3, at p. 8.

If you’re interested in computing the eligible basis for LIHCs, see 162 T. C.3, at pp. 9-11.

Section 42(d)(1) says the credit is computed on the “adjusted basis as of the close of the 1st taxable year of the credit period.” Great, except that the only “adjustment” specified in Section 42(d) is to exclude the adjusted basis of any nonresidential property. The Relateds did that.

Judge Tex Copeland turns to Sections 1011, 1012, and 1016. These are the income-tax-wide rules of general application. And Section 263A requires capitalization of direct and indirect costs of producing real property.

“It follows from these provisions, taken together, that the adjusted basis of taxpayer-produced real property (before any reduction for depreciation) typically equals the sum of the property’s direct costs and its properly allocable share of indirect costs. We reach this conclusion as follows: (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. See I.R.C. § 1016(a)(1). Therefore, the [buildout]’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. See I.R.C. § 42(d)(4)(A).” 162 T. C. 3, at p. 12. (Footnote omitted).

In 2 Cir, indirect costs are included in basis only if they are but-for costs, that is, but for not paying these costs the construction wouldn’t have happened.

“Treasury Regulation § 1.263A-1(e)(3)(i) acknowledges that certain indirect costs may be allocable to both production activities and activities not subject to section 263A, in which case taxpayers must make a ‘reasonable allocation of indirect costs’ between the former and the latter. However, 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 section 263A. In fact, we note that section 263A(f)(1) confirms that interest on loans used to finance the production of property generally must be capitalized under the rule of section 263A(a), although Congress has provided that the latter rule applies only to interest ‘paid or incurred during the production period’ and allocable to property with ‘a long useful life,’ such as residential property…. Section 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.” 162 T. C. 3, at pp. 13-14.

We dirt lawyers all know that the most important part of any building is money.

IRS says the financing is separate, and the costs thereof should be dealt with per Section 167, hence they aren’t subject to MACRS, which all LIHC projects must be. Judge Tex Copeland says Section 263A supersedes that. And that financing costs are intangible is irrelevant; there’s a laundry list of intangible costs that Section 263A requires be capitalized in a real estate construction deal, that is, added to basis. 162 T. C.3, at pp. 16-17.

IRS claims legislative history shows Congress didn’t want tax-exempt bond costs included in LIHC adjusted basis. But Section 42 already reduces the LIHC to the extent tax-exempt bond proceeds were used in construction; if Congress wanted a tighter rein, they could have said so.

Of course you’ll find this opinion in extenso on The Other DAWSON.

A Taishoff “Good Job, First Class” to The Right Dawson.

Oh, before I forget: the item missing on the schedule at pp. 5-6? Legal fees. I hope the lawyers got paid.