United States Tax Court

United States Tax Court

162 T.C. No. 3

23RD CHELSEA ASSOCIATES, L.L.C., RELATED 23RD CHELSEA

ASSOCIATES, L.L.C., TAX MATTERS PARTNER,

Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

—————

Docket No. 22382-19.

Filed February 20, 2024.

—————

C, a partnership, constructed a residential rental

property in New York City during 2001 and 2002.

Construction was financed by a loan from the New York

State Housing Finance Agency (HFA). The HFA funded

the loan by raising $110 million in bonds, some of which

were tax exempt under I.R.C. § 103. C claimed low-income

housing credits (LIHCs) under I.R.C. § 42 for tax years

2003 through at least 2009. In calculating the yearly

credit, C included in the property’s “eligible basis” (as

defined in I.R.C. § 42(d)) a portion of the various financing

costs it incurred in connection with the HFA loan,

including bond fees that the HFA passed on to C.

In a notice of final partnership administrative

adjustment for tax year 2009, R determined that C should

not have included any of the financing costs in eligible

basis. R accordingly proposed to reduce C’s LIHC for tax

year 2009 and also proposed an increase in tax under the

credit recapture provisions of I.R.C. § 42(j) with respect to

tax years 2003–08.

Held: The term “adjusted basis” in I.R.C. § 42(d)(1)

has the meaning given to it in I.R.C. § 1011(a), and

Served 02/20/24

2

accordingly the uniform capitalization rules of I.R.C.

§ 263A apply.

Held, further, all financing costs, including bond

fees, incurred “by reason of” the taxpayer’s construction of

residential rental property, see Treas. Reg. § 1.263A1(e)(3)(i), and before the end of the first year of the credit

period, see I.R.C. § 42(d)(1), are includible in eligible basis

for purposes of the LIHC. This is true whether or not the

bondholders are exempt from federal income tax under

I.R.C. § 103 on the bond interest.

Held, further, R’s proposed adjustments are not

sustained.

—————

James P. Dawson and Alan S. Cohen, for petitioner.

Frederick C. Mutter and Mimi M. Wong, for respondent.

OPINION

COPELAND, Judge: On September 30, 2019, the Commissioner

of Internal Revenue (Commissioner) issued a notice of final partnership

administrative adjustment (FPAA) for tax year 2009 to Petitioner,

Related 23rd Chelsea Associates, L.L.C., the tax matters partner (TMP)

for 23rd Chelsea Associates, L.L.C. (23rd Chelsea). This case is a

partnership-level action under the Tax Equity and Fiscal Responsibility

Act of 1982 (TEFRA), 1 based on a timely Petition filed by the TMP. In

the FPAA the Commissioner determined that 23rd Chelsea overstated

the “eligible basis” of its residential rental property for purposes of the

section 42 low-income housing credit (LIHC). See I.R.C. § 42(d)(1).

Accordingly, the Commissioner proposed decreasing the LIHC credit

amount claimed by 23rd Chelsea for tax year 2009 by $20,079 (i.e., the

1 TEFRA, Pub. L. No. 97-248, §§ 401–407, 96 Stat. 324, 648–71, codified at

sections 6221 through 6234, was repealed for returns filed for partnership tax years

beginning after December 31, 2017. Unless otherwise indicated, statutory references

are to the Internal Revenue Code, Title 26 U.S.C. (I.R.C. or Code), in effect at all

relevant times, regulation references are to the Code of Federal Regulations, Title 26

(Treas. Reg.), in effect at all relevant times, and Rule references are to the Tax Court

Rules of Practice and Procedure. Some dollar amounts are rounded.

3

amount allocable to the alleged overstatement of eligible basis). The

Commissioner also proposed a recapture amount of $49,568, reflecting

the portion of the credits claimed in tax years 2003 through 2008

allocable to the alleged overstatement. See I.R.C. § 42(j).

The parties submitted this case fully stipulated for decision

without trial, pursuant to Rule 122.

After concessions by the

Commissioner (as described below), the issues for our decision are

(1) whether, for purposes of the LIHC, the eligible basis in a qualified

low-income residential building includes financing costs 2 related to the

issuance of bonds (whether taxable or tax-exempt) 3 whose proceeds were

lent to the taxpayer as financing for the construction of the building and

(2) if not, whether section 42(j) requires a credit recapture from the

taxpayer that included such financing costs in its eligible basis in prior

tax years. These are questions of first impression for our Court.

Background

The following facts are based on the pleadings and the parties’

First Stipulation of Facts, including the attached Exhibits. Both 23rd

Chelsea and the TMP are Delaware limited liability companies with a

principal place of business in New York, New York.

I.

Building Construction

23rd Chelsea was formed on June 6, 2000. Between June 2000

and March 2001, 23rd Chelsea purchased real property and

development rights on West 23rd Street, New York, New York. On or

about June 1, 2001, 23rd Chelsea began construction to develop the

property into a 313-unit 4 multifamily residential apartment complex

called the Tate, including recreational facilities, a business center, and

2 The parties refer to the financing costs included in 23rd Chelsea’s calculation

of eligible basis as “bond fees.” However, that calculation includes costs not directly

related to the bonds (e.g., loan issuance costs), so for clarity this Opinion refers to such

costs collectively as “financing costs.”

Hereinafter, bonds whose interest payments are not taxable to the

bondholders under section 103 are referred to as “tax-exempt bonds,” and bonds whose

interest payments are not excludable under section 103 are referred to as “taxable

bonds.”

3

4 There is some evidence in the record that 314, rather than 313, units were

constructed. This discrepancy does not affect our disposition of the case.

4

retail space. Construction lasted approximately 14 months, and the

Tate was placed in service on August 13, 2002.

The Tate’s construction was funded entirely by a 31.5-year, $110

million loan from the New York State Housing Finance Agency (HFA).

The HFA raised these funds through two bond issuances, the first on

May 31, 2001, composed of 31.5-year bonds, and the second on July 1,

2002, composed of 30.4-year bonds. 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 taxexempt status of the tax-exempt bonds and qualify the Tate for the

LIHC. The HFA also required 23rd Chelsea to fully secure the loan and

related repayment obligations by obtaining a letter of credit from

Bayerische Hypo-und Vereinsbank AG (Hypo Bank) (or another bank

acceptable to the HFA). 23rd Chelsea duly obtained a letter of credit

from Hypo Bank, which agreed to lend 23rd Chelsea up to $54.1 million

between May 31, 2001, and May 31, 2006, solely for the purpose of

making principal or interest payments on the loan financed by the

HFA’s 2001 bond issuance. A subsequent letter of credit from Hypo

Bank, dated July 1, 2002, increased 23rd Chelsea’s credit limit to

$111.2 million (to also reflect the 2002 bond issuance). 23rd Chelsea

never drew on either letter of credit.

Of the $110 million of bond proceeds ultimately lent to

23rd Chelsea, it spent $107,444,441 by December 31, 2003, including

$5,745,837 in financing costs stemming from the bond issuances.

II.

Calculation of Eligible Basis

23rd Chelsea claimed an LIHC with respect to the Tate of

$593,961 in each tax year from 2003 through at least 2009. See infra

note 10. The partnership calculated this credit using an eligible basis

(as defined in section 42(d)) of $93,165,121, determined as follows:

$60,792,972 of “hard” construction costs (including material and labor

for concrete, masonry, plumbing, electrical, etc.); $1,218,320 of financing

5

costs; $9,654,186 of other “soft” costs (architecture and engineering fees,

insurance payments, etc.); and a 30% increase pursuant to section

42(d)(5)(C), 5 which increases the LIHC for buildings in areas with a high

concentration of low-income residents or a high poverty rate, see

§ 42(d)(5)(C)(ii), or high construction, land, and utility costs, see

§ 42(d)(5)(C)(iii). The Tate’s hard costs included $1,204,362 of union

dues and pension contributions, paid by 23rd Chelsea on behalf of

workers for one of its construction subcontractors.

The financing costs consisted of the following components and

amounts:

Component

Description

Total

Amount

Amount Included

by 23rd Chelsea in

Eligible Basis

Origination Fee

Paid to Hypo Bank in

connection with letter of credit

$841,696

$193,232

HFA Financing

Fee

Paid to HFA in connection with

loan agreement

880,000

26,789

NYS Bond Fee

Paid to New York State

Department of Taxation, on

HFA’s behalf, in connection

with bond issuances

698,250

16,524

Rating Agency

Fee

Paid to reimburse HFA for

obtaining bond ratings

3,000

55

Multi-Year

Processing Fee

Paid to HFA in connection with

loan agreement

25,000

956

Underwriter

Fee

Paid to bank that underwrote

and remarketed the bonds

253,000

6,768

Underwriter

Expenses

Paid to reimburse underwriting

bank for expenses

17,109

461

Trustee Fee

Paid to reimburse HFA for bond

trustee’s fee

7,000

128

Printing and

Binding Costs

Paid to reimburse HFA for

producing bond documents

6,000

110

5 This citation is given for tax year 2003, the first year of the Tate’s credit

period. The provision is currently codified at section 42(d)(5)(B).

6

Hypo Bank

Servicing Fee

Paid to Hypo Bank in

connection with letter of credit

81,200

79,892

HFA Servicing

Fee

Paid to HFA in connection with

loan agreement

75,793

74,572

HFA

Application Fee

Paid to HFA in connection with

loan agreement

60,000

2,295

Engineer

Consultants

Cost

Paid to engineers retained by

Hypo Bank and HFA in

connection with letter of credit

113,574

111,744

Appraisal Fee

Paid to Hypo Bank in

connection with letter of credit

17,500

4,017

Financial

Adviser Fees

Paid to reimburse HFA and

Hypo Bank for financial adviser

fees

30,000

4,018

Letter of Credit

Commitment

Fee

Paid to Hypo Bank in

consideration for its extending

the letter of credit

693,000

681,835

Guaranty Fee

Paid in connection with a

guaranty, required by Hypo

Bank and made by a company

related to 23rd Chelsea, of any

draws on Hypo Bank’s letter of

credit

77,000

—

Title Insurance

Paid to title insurer engaged for

bond issuances

390,024

14,924

Refinancing

Costs

Paid in connection with

refinancing the HFA loan in

2003

1,476,691

—

$5,745,837

$1,218,320

Totals

—

The parties stipulated that 23rd Chelsea incurred the amounts shown

in the “Total Amount” column for the purposes listed in the

“Description” column (i.e., the parties agreed that the fees and expenses

listed in the table were 23rd Chelsea’s financing costs incurred related

to the issuance of the HFA bonds that funded 23rd Chelsea’s loan).

The HFA either directly or indirectly required 23rd Chelsea to

pay each component of the financing costs—other than the Refinancing

Costs—as a condition of the HFA’s issuing and maintaining the loan.

(For instance, although the HFA did not directly require 23rd Chelsea

to pay an origination fee to Hypo Bank, the HFA required 23rd Chelsea

7

to secure a letter of credit from Hypo Bank, which in turn required an

origination fee.) 23rd Chelsea included each component of the financing

costs in eligible basis only to the extent that it deemed that component

to relate to both (1) the portion of the real estate composed of residences

and common areas and (2) costs incurred during the construction period

(approximately June 1, 2001, to August 13, 2002). Therefore, 23rd

Chelsea first reduced each cost component by 1.61%, the percentage of

the bond proceeds allocated to the health club and retail space. It then

removed all fee amounts paid (or deemed paid) for services occurring

after the construction period. For many of the cost components, this

second step involved prorating lump-sum payments over the months

during which the HFA loan, the bonds, and/or the Hypo Bank letter of

credit remained (or were projected to remain) outstanding, then tallying

only the amounts prorated for the months of the construction period.

23rd Chelsea’s computation of eligible basis includes only financing

costs that were paid before the Tate was ever placed in service.

In 2004, 23rd Chelsea presented to the HFA an independently

audited final cost certification, which included a detailed calculation of

eligible basis. (That calculation explicitly included in eligible basis a

portion of the financing costs totaling $1,218,320, as detailed in the table

supra pp. 5–6.) The HFA was responsible for allocating to the Tate no

greater amount of LIHC than an amount “necessary for the financial

feasibility of the project and its viability as a qualified low-income

housing project.” See I.R.C. § 42(m)(2)(A). The HFA was also

responsible for specifying the maximum qualified basis 6 that 23rd

Chelsea could use for computing its LIHC. See I.R.C. § 42(h)(7)(D). The

HFA did not dispute 23rd Chelsea’s calculation of eligible basis,

qualified basis, or LIHC amount.

III.

The FPAA

In the FPAA the Commissioner determined that 23rd Chelsea’s

eligible basis in the Tate included neither the $1,204,362 of union dues

and pension contributions (paid on behalf of one of 23rd Chelsea’s

subcontractors) nor the $1,218,320 of financing costs that 23rd Chelsea

had included. The Commissioner therefore proposed decreasing the

LIHC credit amount claimed by 23rd Chelsea for tax year 2009 by

$20,079, i.e., the amount of the claimed credit allocable to the alleged

6 Qualified basis is a specified percentage of eligible basis. See infra pp. 10–11.

Therefore, the HFA was effectively responsible for specifying the Tate’s maximum

eligible basis.

8

overstatement of eligible basis. The Commissioner also proposed, under

section 42(j), recapturing $49,568 of the credits taken for tax years 2003

through 2008.

The Commissioner now concedes that 23rd Chelsea properly

included the full amount of the union dues and pension contributions in

eligible basis. 7 Therefore, we must decide only whether $1,218,320 of

the financing costs was properly included—and, if some or all of that

amount was not, whether 23rd Chelsea is subject to the credit recapture

provisions of section 42(j). As discussed below, 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.

Discussion

I.

Jurisdiction

The Tax Court is a court of limited jurisdiction and may exercise

jurisdiction only to the extent authorized by Congress. Judge v.

Commissioner, 88 T.C. 1175, 1180–81 (1987); Naftel v. Commissioner,

85 T.C. 527, 529 (1985). We are without authority to enlarge upon that

statutory grant.

See Phillips Petrol. Co. & Affiliated Subs. v.

Commissioner, 92 T.C. 885, 888 (1989). We nevertheless always have

jurisdiction to determine whether we have jurisdiction over a matter

brought before us. Hambrick v. Commissioner, 118 T.C. 348 (2002). And

we must assure ourselves of our jurisdiction even when not asked to by

the parties. Brannon’s of Shawnee, Inc. v. Commissioner, 69 T.C. 999,

1004 (1978).

Under the default rules of Treasury Regulation § 301.7701-2(a)

and (c)(1), noncorporate entities with more than one member (such as

limited liability companies) are treated as partnerships for federal tax

purposes.

Because 23rd Chelsea’s TMP filed the Petition for

readjustment of partnership items within 90 days of the Commissioner’s

FPAA, we have jurisdiction under section 6226(f) to determine all of

23rd Chelsea’s “partnership items” for tax year 2009. Section 6231(a)(3)

defines “partnership item” as “any item required to be taken into

7 The Commissioner initially disputed these amounts because 23rd Chelsea

had not provided satisfactory evidence that the amounts were in fact paid for

construction labor.

9

account for the partnership’s taxable year . . . to the extent regulations

prescribed by the Secretary provide that . . . such item is more

appropriately determined at the partnership level than at the partner

level.” Treasury Regulation § 301.6231(a)(3)-1(a)(1)(i) provides that

partnership items include the partnership aggregate, and each partner’s

share, of items of income, gain, loss, deduction, or credit of the

partnership. Thus, 23rd Chelsea’s allowable LIHC for tax year 2009

(a credit) and the alleged recapture amount (an income item) are both

partnership items subject to redetermination in this proceeding.

II.

Computation of the LIHC

Congress added the LIHC to the Code to incentivize construction

and rehabilitation of residential rental units for low-income tenants.

See H.R. Rep. No. 99-841 (Vol. II) (Conference Report), at II-85 (1986)

(Conf. Rep.), reprinted in 1986-3 C.B. (Vol. 4) 1, 85. The credit is

reserved for “qualified low-income building[s].” I.R.C. § 42(a)(2). These

are buildings that meet the following three requirements:

1.

The building consists of “residential rental property” that

satisfies at least one of two tests relating to rent

restrictions and tenant income levels. See I.R.C. § 42(c)(2),

(g). 8

2.

The residential rental property satisfies one of the two

tests (whichever is elected by the taxpayer) for at least 15

years after it is placed in service. I.R.C. § 42(c)(2)(A), (i)(1).

3.

The building is eligible for the modified accelerated cost

recovery system (MACRS) of section 168 (as amended in

Sec. 42(g)(1). In general.—The term “qualified low-income housing

project” means any project for residential rental property if the project meets

the requirements of subparagraph (A) or (B) whichever is elected by the

taxpayer:

(A) 20-50 test.—The project meets the requirements of

this subparagraph if 20 percent or more of the residential units

in such project are both rent-restricted and occupied by

individuals whose income is 50 percent or less of area median

gross income.

(B) 40-60 test.—The project meets the requirements of

this subparagraph if 40 percent or more of the residential units

in such project are both rent-restricted and occupied by

individuals whose income is 60 percent or less of area median

gross income.

8

10

1986).

See I.R.C. § 42(c)(2)(B) (providing that “the

amendments made by section 201(a) of the Tax Reform Act

of 1986” must apply to the building); Tax Reform Act of

1986, Pub. L. No. 99-514, § 201(a), 100 Stat. 2085, 2121–37

(amending section 168).

The LIHC for a given building is prorated over a period of ten

years (credit period), beginning in the tax year the building is placed in

service or, at the taxpayer’s election, the following tax year. I.R.C.

§ 42(a), (f)(1). During each year of the credit period, the taxpayer

receives a credit equal to an “applicable percentage,” specified annually

by the Internal Revenue Service (IRS), of the building’s qualified basis

(discussed below). I.R.C. § 42(a). The applicable percentage is

calculated so that the discounted present value of the ten annual credit

amounts (as measured from the end of the credit period’s first year)

equals 70% of qualified basis for certain new buildings. I.R.C. § 42(b).

However, if the building is funded at least in part with proceeds from

tax-exempt bonds, then unless the taxpayer excludes from eligible basis

the proceeds of those bonds, the applicable percentage is calculated so

that the discounted present value of the ten credits equals only 30% of

qualified basis. I.R.C. § 42(b)(2)(B)(ii), 9 (i)(2). (Because the Tate was

ultimately financed in part by tax-exempt bonds, 23rd Chelsea

computed its LIHC using the lower applicable percentage.)

way:

A building’s qualified basis is generally computed in the following

1.

Determine the building’s eligible basis, which equals its

adjusted basis at the end of the first year of the credit

period (but prior to any reduction for depreciation), less any

amount of basis allocable to property that is not residential

rental property (although the basis allocable to common

areas is included). I.R.C. § 42(d)(1), (4).

2.

Increase the eligible basis by 30% if the building is in an

area with a high concentration of low-income residents, a

high poverty rate, or high construction, land, and utility

costs. I.R.C. § 42(d)(5)(C).

3.

The qualified basis equals the eligible basis multiplied by

the “applicable fraction,” which is the lower of (i) the

fraction of residential rental units that are rent restricted

9 The provision is currently codified at section 42(b)(1)(B)(ii).

See supra note 5.

11

and occupied by low-income tenants or (ii) the fraction of

residential rental floor space allocated to such low-income

units. I.R.C. § 42(c)(1), (i)(3). 10

Section 42 also provides for the recapture, in certain

circumstances, of some of the credits allowed for prior years. The

recapture provisions apply if, at the end of any year during the 15-year

compliance period (beginning with the first year of the credit period), the

building’s qualified basis is lower than it was at the end of the previous

year. 11 I.R.C. § 42(j)(1).

III.

23rd Chelsea’s Eligible Basis

The only part of 23rd Chelsea’s computation of its LIHC for tax

year 2009 that the Commissioner disputes (after conceding the union

dues and pension contributions) is the inclusion of $1,218,320 of the

financing costs in eligible basis. We must look to the terms of section 42

to resolve the dispute. Section 42(d)(1) provides that “[t]he eligible basis

of a new building is its adjusted basis as of the close of the 1st taxable

year of the credit period.” Section 42(d)(4)(A) clarifies that “the adjusted

basis of any building shall be determined without regard to the adjusted

basis of any property which is not residential rental property.” There is

no other statutory exclusion from eligible basis that the Commissioner

argues is relevant to this case.

Section 42 does not expressly define “adjusted basis,” so we look

to section 1011(a), which provides the default rule that “[t]he adjusted

basis for determining the gain or loss from the sale or other disposition

of property, whenever acquired, shall be the basis (determined under

10 23rd Chelsea computed its annual credit of $593,961 as follows: (1) The Tate

had a preliminary eligible basis of $71,665,478 (the sum of hard costs and soft costs

that 23rd Chelsea determined to be eligible); (2) pursuant to section 42(d)(5)(C), the

preliminary eligible basis was increased by 30%, to $93,165,121; (3) the eligible basis

was multiplied by an applicable fraction of 18.32% (39,863 square feet of low-income

housing units divided by total square footage of 217,613), yielding a qualified basis of

$17,067,850; and (4) the qualified basis was multiplied by an applicable percentage of

3.48% designated by the IRS for tax year 2002, see Rev. Rul. 2002-48, 2002-2 C.B. 239,

241, yielding an LIHC of $593,961. Although 23rd Chelsea elected to begin the credit

period in 2003, the applicable percentage generally corresponds to the year in which

the building is placed in service (here, 2002). See I.R.C. § 42(b)(2)(A).

11 This may occur if, for instance, the applicable fraction decreases by reason

of fewer units being reserved for low-income tenants. Note that eligible basis cannot

change over time, since it is calculated as of the end of the credit period’s first year

(here 2003).

12

section 1012 . . . ), adjusted as provided in section 1016.” 12 Section 1012,

in turn, provides that “[t]he basis of property shall [generally] be the

cost of such property.” Section 263A then clarifies this definition of basis

as it applies to taxpayer-produced real property (or other tangible

property) such as the Tate. That section provides that “the direct costs

of such property” and “such property’s proper share of those indirect

costs . . . part or all of which are allocable to such property” must be

“capitalized.” I.R.C. § 263A(a) and (b)(1). Treasury Regulation

§ 1.263A-1(c)(3) explains that “capitalize,” in the case of real property,

means “to charge to a capital account or basis,” while Treasury

Regulation § 1.263A-1(c)(1) provides, in relevant part, that “taxpayers

must capitalize their direct costs and a properly allocable share of their

indirect costs to property produced.” (Emphasis added.)

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. 13 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 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. See I.R.C. § 42(d)(4)(A). 14

For taxpayer-produced real or tangible property such as the Tate,

Treasury Regulation § 1.263A-1(e)(2)(i) defines “direct costs” as the sum

of “direct material costs” and “direct labor costs.” Treasury Regulation

§ 1.263A-1(e)(3)(i) provides that “[i]ndirect costs are defined as all costs

12 Our recourse to section 1011 and its compatriots is supported not only by the

fact that those sections function (by their terms) as rules of general application for

Subtitle A (Income Taxes) of the Code but also by the reference to section 1016 in

section 42(d)(4)(D): “The adjusted basis of any building shall be determined without

regard to paragraphs (2) and (3) of section 1016(a) [dealing with depreciation,

amortization, and the like].”

13 We ignore adjustments for depreciation pursuant to section 42(d)(4)(D).

14 Although the Tate’s construction was financed in part by tax-exempt bonds,

23rd Chelsea did not elect under section 42(i)(2)(B) to exclude those bond proceeds from

eligible basis. Instead, 23rd Chelsea chose to have the discounted present value of its

credits equal 30% of qualified basis rather than 70%. See I.R.C. § 42(b)(2)(B).

13

other than direct material costs and direct labor costs” and that they are

properly allocable to taxpayer-produced property “when the costs

directly benefit or are incurred by reason of the performance of

production . . . activities.” The U.S. Court of Appeals for the Second

Circuit 15 has 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.” Robinson Knife Mfg. Co.,

Inc. & Sub. v. Commissioner, 600 F.3d 121, 131–32 (2d Cir. 2010), rev’g

and remanding T.C. Memo. 2009-9; see also City Line Candy & Tobacco

Corp. v. Commissioner, 624 F. App’x 784, 787 (2d Cir. 2015) (“[Robinson

Knife] requires capitalization only of costs that are a ‘but-for cause’ of

the taxpayer’s production or sales activity.” (quoting Robinson Knife

Mfg. Co. v. Commissioner, 600 F.3d at 131–32)), aff’g 141 T.C. 414

(2013).

Here, we hold that 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, 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 $110 million

loan used for construction of the Tate. Moreover, 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, 23rd

Chelsea incurred at least $1,218,320 of the financing costs “by reason

of” the Tate’s construction within the meaning of Treasury Regulation

§ 1.263A-1(e)(3)(i), as interpreted by the Second Circuit.

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

15 This case is appealable to the Second Circuit absent a contrary stipulation

by the parties. See I.R.C. § 7482(b)(1)(E). Therefore, we follow all Second Circuit

precedent that is squarely on point. See Golsen v. Commissioner, 54 T.C. 742, 757

(1970), aff’d, 445 F.2d 985 (10th Cir. 1971).

14

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 like the Tate. 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.

Therefore, we hold that for purposes of Treasury Regulation

§ 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 section 263A) insofar as those costs are allocable to the

production period. Rather, 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 that financing was allocable

to the production period. City Line Candy & Tobacco Corp., 141 T.C.

at 431 n.20 (finding that the taxpayer’s purchase of cigarette tax stamps,

a legal prerequisite of reselling the cigarettes, was an “indivisible part”

of the taxpayer’s resale activity); cf. Anschutz Co. v. Commissioner, T.C.

Memo. 2006-40, 91 T.C.M. (CCH) 860, 867–68 (holding that the

taxpayer, which had installed fiberoptic cable or conduit for its own

future use simultaneously with installing cable or conduit for third

parties, must make a reasonable allocation of indirect costs between its

production activities and its long-term contract activities, the latter of

which are excluded from section 263A by section 263A(c)(4)),

supplemented by T.C. Memo. 2006-124.

Accordingly, under section 263A(a)(2)(B) and Treasury

Regulation § 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. Accordingly, the Tate’s eligible basis includes 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). The record clearly indicates that the amount

of financing costs includible in the Tate’s eligible basis was at least the

amount that 23rd Chelsea actually included (viz, $1,218,320). 16

16 We note that Treasury Regulation § 1.263A-2(a)(3)(i) generally provides that

taxpayers must capitalize into taxpayer-produced property all indirect costs properly

15

IV.

The Commissioner’s Arguments

The Commissioner offers two arguments against 23rd Chelsea’s

position.

A.

Depreciation Provisions

First, the Commissioner notes that the LIHC statute requires a

building to be subject to MACRS in order to be a “qualified low-income

building.” See I.R.C. § 42(c)(2)(B). The Commissioner then argues that

the costs of obtaining bond proceeds should be capitalized into the

underlying loan and thus are subject to depreciation under section 167

but not to MACRS under section 168—rendering those bond costs

ineligible to be part of the “qualified low-income building” for purposes

of section 42. Section 167(a) allows depreciation deductions generally

for “exhaustion, wear and tear . . . of property used in the trade or

business,” while the accelerated deductions of section 168 are reserved

for “tangible property.” I.R.C. § 168(a). (Accordingly, all section 168

deductions are section 167 deductions, but not all section 167 deductions

are section 168 deductions.)

However, the Commissioner overlooks the changes that Congress

made in adopting “uniform capitalization rules” (including section 263A)

in 1986. See Tax Reform Act of 1986, § 803(a), 100 Stat. at 2350–55.

Those new rules displace prior law where inconsistent. The Senate

Finance Committee provided helpful background on the changes:

The committee believes that the present-law rules

regarding the capitalization of costs incurred in producing

property are deficient in two respects. First, the existing

rules may allow costs that are in reality costs of producing,

acquiring, or carrying property to be deducted currently,

rather than capitalized into the basis of the property and

recovered when the property is sold or as it is used by the

taxpayer. This produces a mismatching of expenses and

the related income and an unwarranted deferral of taxes.

Second, different capitalization rules may apply under

allocable to the property “without regard to whether those costs are incurred before,

during, or after the production period.” Here, the parties have not asserted that

indirect costs incurred outside the production period might qualify for capitalization

and inclusion in eligible basis. Consequently, we have not addressed the issue of

preproduction or postproduction costs under section 263A and decline to do so on our

own.

16

present law depending on the nature of the property and

its intended use. These differences may create distortions

in the allocation of economic resources and the manner in

which certain economic activity is organized.

The committee believes that, in order to more

accurately reflect income and make the income tax system

more neutral, a single, comprehensive set of rules should

govern the capitalization of costs of producing, acquiring,

and holding property, including interest expense, subject

to appropriate exceptions where application of the rules

might be unduly burdensome.

S. Rep. No. 99-313, at 140 (1986), as reprinted in 1986-3 C.B. (Vol. 3) 1,

140.

The Tate is tangible business property subject to wear and tear

and thus eligible for MACRS under section 168. Section 42(d)(1)

accordingly directs us to find the Tate’s adjusted basis at the end of the

first year of the credit period, which—under section 263A and the

accompanying regulations, as discussed above—includes the financing

costs incurred for production. The fact that 23rd Chelsea’s bondfinanced loan from the HFA was not tangible property is irrelevant,

because the related costs were indirect costs “incurred by reason of” the

Tate’s construction. See Treas. Reg. § 1.263A-1(e)(3)(i).

The regulations under section 263A specifically enumerate

several categories of capitalizable indirect costs that, but for section

263A, might otherwise be deducted or capitalized into an intangible

asset (and then either amortized or depreciated under section 167 but

not under MACRS). See, e.g., Treas. Reg. § 1.263A-1(e)(3)(ii)(M)

(requiring capitalization into taxpayer-produced property of “the cost of

insurance on plant or facility, machinery, equipment, materials,

property produced, or property acquired for resale,” which if prepaid

might otherwise be capitalized into an intangible asset); 17 id.

subdiv. (ii)(P) (requiring capitalization into taxpayer-produced property

of “[e]ngineering and design costs,” some of which might otherwise be

capitalized into intellectual property); id. subdiv. (ii)(T) (requiring

capitalization into taxpayer-produced property of “[b]idding costs,” i.e.,

17 For instance, in Johnson v. Commissioner, 108 T.C. 448, 488 (1997), aff’d in

part, rev’d in part, and remanded on another issue, 184 F.3d 786 (8th Cir. 1999), we

required the taxpayer to capitalize and amortize the portion of a premium for excess

loss insurance coverage that was allocable to tax years after the year of payment.

17

“costs incurred in the solicitation of contracts [to produce property],”

which might otherwise be capitalized into the contracts solicited); id.

subdiv. (ii)(U) (requiring capitalization into taxpayer-produced property

of “[l]icensing and franchise costs,” including “fees incurred in securing

the contractual right to use a trademark, corporate plan, manufacturing

procedure, special recipe, or other similar right,” which might otherwise

be capitalized into the license or franchise right). Therefore, when we

look to the uniform capitalization rules, we discover that the plain

statutory text, the legislative history, and the regulations all belie the

Commissioner’s argument that 23rd Chelsea should have capitalized

the financing costs into an intangible asset rather than the Tate.

B.

Legislative History

The Commissioner next argues that even if some portion of the

financing costs is includible in the Tate’s adjusted basis for purposes of

depreciation deductions under sections 167 and 168, the legislative

history of section 42 shows that the portion of the costs allocable to the

tax-exempt bonds is not includible in the Tate’s eligible basis for

purposes of the LIHC. 18 The Commissioner’s argument proceeds as

follows:

1.

2.

3.

Section 42(d)(4)(A) provides that generally “the adjusted

basis of any building shall be determined without regard to

the adjusted basis of any property which is not residential

rental property.”

The Conference Report at II-89, 1986-3 C.B. (Vol. 4) at 89,

states that “[r]esidential rental property for purposes of the

low-income housing credit has the same meaning as

residential rental property within Code section 103.”

Section 103 (which provides an exclusion for interest on

certain state and local bonds) is statutorily linked to

section 142, which defines the term “exempt facility bond”

as “any bond issued as part of an issue 95 percent or more

of the net proceeds of which are used to provide . . . [among

other things] qualified residential rental projects.” I.R.C.

18 In his posttrial brief, the Commissioner contends that 23rd Chelsea

effectively conceded that all the financing costs were allocable to the tax-exempt bonds,

by virtue of 23rd Chelsea’s not timely raising the possibility of including in eligible

basis only a proper portion of the financing costs allocable to the taxable bonds.

However, our holding under section 263A does not distinguish between financing costs

for tax-exempt versus taxable bonds.

18

§ 142(a). Section 142(d)(1) provides that “[t]he term

‘qualified residential rental project’ means any project for

residential rental property.” (Emphasis added.)

4.

The Conference Report at II-697, 1986-3 C.B. (Vol. 4)

at 697, explains the procedure for determining whether at

least 95% of the net proceeds of a candidate exempt facility

bond were used for an exempt purpose, such as a qualified

residential rental project (95% test): “Net proceeds are

defined as proceeds less amounts invested in a reasonably

required reserve or replacement fund. (No reduction is

made for amounts paid for costs of [bond] issuance since

those amounts are not treated as spent for the exempt

purpose of the borrowing.)”

5.

Because issuance fees for tax-exempt bonds are not

deducted from net bond proceeds in determining the

proportion of such proceeds used for constructing

residential rental property for purposes of the 95% test in

section 142, they should not be treated as costs for

residential rental property (and thus should not be

includible in basis) in the context of section 42. To do

otherwise would impermissibly result in “disparate

treatment of the term residential rental property” between

the two sections, contrary to the Conference Report’s

implication that the term has the “same meaning” in both

sections.

First of all, we note that the Commissioner has not alleged any

ambiguity in the relevant text of section 42, viz: “[T]he adjusted basis of

any building shall be determined without regard to the adjusted basis of

any property which is not residential rental property.” See I.R.C.

§ 42(d)(4)(A). When statutory terms have a clear and unambiguous

meaning on their face, we do not look past that meaning to the

legislative history. As the Supreme Court has said:

In statutory interpretation disputes, a court’s proper

starting point lies in a careful examination of the ordinary

meaning and structure of the law itself. Schindler Elevator

Corp. v. United States ex rel. Kirk, 563 U.S. 401, 407 (2011).

Where . . . that examination yields a clear answer, judges

must stop. Hughes Aircraft Co. v. Jacobson, 525 U.S. 432,

438 (1999).

19

Food Mktg. Inst. v. Argus Leader Media, 139 S. Ct. 2356, 2364 (2019);

see also Sullivan v. Stroop, 496 U.S. 478, 482 (1990).

Even assuming that the legislative history the Commissioner

cites is legitimate evidence for our construction of section 42, it does not

speak against our holding as to the Tate’s eligible basis. For our holding

does not import a different meaning to the phrase “residential rental

property” in section 42 compared to section 142. The difference we find

is not in the definition but rather the requirements Congress imposed

on the use of tax-exempt funds in financing low-income housing projects.

In section 142 Congress provided (implicitly in the statute, explicitly in

the Conference Report) that 95% of bond proceeds (unreduced by bond

issuance costs) must be used in acquiring qualified residential property,

meaning that 5% may be used otherwise. By contrast, we hold that 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.

There is no

inconsistency in definition; at most, there is a difference in the allocation

of costs. But that difference violates no rule of statutory construction or

expression of congressional intent. Congress already specifically

reduced the LIHC for buildings financed with tax-exempt bonds by

mandating an applicable percentage calculated so that the discounted

present value of the ten annual credits equals 30%, rather than 70%, of

qualified basis. I.R.C. § 42(b)(2)(B)(ii). If Congress had intended to

further rein in the LIHC for such buildings by excluding tax-exempt

bond issuance costs from eligible basis, it could have said so in the

statute. We will not judicially impose such an exclusion. See Greer v.

Commissioner, 230 F.2d 490, 493–94 (5th Cir. 1956) (“We think that the

tax statutes and regulations must be applied as written and without any

equitable consideration of the desirability of offsetting prior tax

benefits.”), rev’g Brazoria Inv. Corp. v. Commissioner, 20 T.C. 690

(1953).

We therefore do not uphold the Commissioner’s proposed

adjustments in the FPAA, and we do not reach the question of whether

the credit recapture provisions of section 42(j) would apply to 23rd

Chelsea. We have considered all arguments made by the parties and, to

the extent they are not addressed herein, we conclude that they are

moot, irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered for Petitioner.