Easement relocation costs enter housing-credit basis

Plain-English summary

A partnership developing a low-income apartment building had to relocate a third party’s sign easement before the city would issue building permits for the approved residential design. The IRS concluded that the relocation costs had a direct and specific connection to constructing the building, rather than merely to the underlying land. They therefore were indirect production costs capitalizable to the building under section 263A and, assuming the building would be depreciated as residential rental property, were includible in its eligible basis for the low-income housing credit. The costs begin to be depreciated when the building is placed in service.

Ruling snapshot

• Question: Are city-required easement relocation costs capitalizable to a low-income residential building and includible in its housing-credit eligible basis?
• Outcome: Approved, assuming the building is depreciated as residential rental property under section 168.
• Key authorities: IRC §§ 42(d), 168, 263, and 263A; Treas. Reg. §§ 1.263(a)-1, 1.263(a)-2, and 1.263A-1 through -2.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201515007 Third Party Communication: None
Release Date: 4/10/2015 Date of Communication: Not Applicable
Index Number: 42.03-00, 167.13-05, 168.00-
00, 263.01-00, 263A.02-10 Person To Contact:
---------------------------
ID No. ------------------
Telephone Number:
-------------------------- ----------------------
--------------------- Refer Reply To:
--------------------------------------- CC:ITA:B07
------------------------------------------------- PLR-120247-14
--------------------------------- Date: November 4, 2014

LEGEND

A=                     ---------------------------------------
                       ------------------------

State =                -------------------------

City =                 -----------------------------------

LLC 1 =                --------------------------------------

LLC 2 =                ----------------------------------

Affiliate =            ---------------

Date 1 =               ---------------------

Date 2 =               ---------------

Date 3 =               -----------------------

Date 4 =               -----------------

Date 5 =               --------------

Date 6 =               ------------------

Amount 1 =             ----------------
                                             2

PLR-120247-14

X= ----------------------------------------------------------

Dear -----------------

   This letter is in response to a letter dated May 12, 2014, and subsequent

correspondence, submitted on A’s behalf requesting a letter ruling on whether
certain easement relocation costs incurred by A in constructing a low income
residential rental building are includible in eligible basis for purposes of section
42(d)(1) of the Internal Revenue Code.

FACTS

   A represents that the facts are as follows:

   A is a limited partnership, duly organized, validly existing, and in good

standing under the laws of the State. A is governed by an Amended and
Restated Agreement of Limited Partnership dated Date 1, as amended, pursuant
to which LLC 1, a State limited liability company, acts as the Administrative
General Partner of A, and LLC 2, a State limited liability company, acts as the
Managing General Partner of A.

  A is constructing a single building, 76-unit low-income residential rental

complex (the “Project") at a site in City. A, through Affiliate, opened escrow for
acquisition of the land underlying the Project and began negotiations with City
regarding the design of the Project in Date 2. Affiliate acquired the site and took
ownership in Date 3. The site was zoned for commercial use and, therefore, A
was required to obtain a Conditional Use Permit (CUP) to allow for residential
development.

     In Date 4, the City Council of City issued a resolution approving the final

design of the Project and construction of the Project, subject to the satisfaction of
a number of conditions. One of these conditions was that a specific third-party
easement (the "Easement") on the land underlying the Project be relocated
before City would issue any building permits for the Project. Had A elected a
different use for the site that did not require a CUP (such as the development of a
commercial building), it would have been able to undertake construction without
the City-imposed requirement of relocating the Easement. However, A desired to
construct a residential rental building and City was unwilling to recommend
and/or approve any designs that did not require relocation of the Easement for
initiating construction.

   The Easement granted the grantee an easement and right to maintain on

the land underlying the Project an existing pylon sign and electrical conduit. In
Date 5, Affiliate, on behalf of A, reached agreement with the grantee of the
Easement for the relocation of the Easement. Pursuant to the agreement,
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Affiliate, on behalf of A, paid Amount 1 in relocation consideration to the grantee
along with paying all of the costs necessary to relocate the infrastructure
supporting the existing pylon sign (the “Relocation Costs”). Absent City's
condition requiring the relocation of the Easement in order to obtain all building
permits necessary to construct the Project, Affiliate, on behalf of A, would not
have relocated the Easement and, thus, would not have incurred the Relocation
Costs associated with the Easement relocation.

    A purchased the site from Affiliate on Date 1. The purchase agreement

for the site between A and Affiliate is effective as of Date 6, which is more than
three years before Date 1. A needed to establish control over the site in order for
A to apply for low-income housing tax credits with X. A established control over
the site as of Date 6. During the 3-year period between Date 6, and the closing
date, Date 1, A applied for such low-income housing tax credits and obtained
financing for the Project.

    At closing A reimbursed Affiliate for all costs incurred by Affiliate on behalf

of A prior to Date 1, including the payment of Amount 1 to the grantee of the
Easement. A recorded this reimbursement amount, including the payment of
Amount 1 to the grantee of the Easement, in A’s construction work in progress
account. The Project had not been placed in service as of the date A submitted
this letter ruling request.

RULINGS REQUESTED

   A requests that the Internal Revenue Service issue the following rulings:

   1. The Relocation Costs incurred by A to relocate the Easement are

indirect costs within the meaning of section 1.263A-1(e)(3)(i) of the Income Tax
Regulations, and are capitalizable to the basis of the Project’s residential rental
building under section 263A.

   2. The Relocation Costs incurred by A to relocate the Easement are

includible in the eligible basis of the Project’s residential rental building under
section 42(d)(1).

LAW AND ANALYSIS

Issue 1

    Section 263(a) provides that no deduction is allowed for any amount paid

out for new buildings or for permanent improvements or betterments made to
increase the value of any new property or estate.
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 Section 1.263(a)-1(d)(1) provides that capital expenditures include

amounts paid to acquire or produce a unit of real or personal tangible property.

   Section 1.263(a)-2(d)(1) provides that a taxpayer must capitalize amounts

paid to acquire or produce a unit of real or personal property (as determined
under section 1.263(a)-3(e)), including leasehold improvements, land and land
improvements, buildings, machinery and equipment, and furniture and fixtures.
Example (8) of section 1.263(a)-2(d)(2) illustrates the coordination of the above
rules with section 263A as follows: J constructs a building. J must capitalize
under section 1.263(a)-2(d)(1) the amount paid to construct the building. See
section 263A for the costs required to be capitalized to the real property
produced by J.

   Section 263A provides, in part, that direct costs and a properly allocable

portion of indirect costs of real or tangible personal property produced by a
taxpayer must be capitalized to the property produced. See also section 1.263A-
1 (a)(3)(ii).

    Section 263A(g)(1) provides that the term "produce" includes construct,

build, install, manufacture, develop, or improve. See also section 1.263A-
2(a)(1)(i). Property produced may include land, buildings, land improvements,
and other tangible property owned by the taxpayer for federal income tax
purposes. See section 1.263A-2(a)(1)(ii).

  Section 1.263A-1(c)(1) provides that to determine capitalizable costs,

taxpayers must allocate or apportion costs to various activities, including
production activities. After section 263A costs are allocated to the appropriate
production activities, these costs generally are allocated to the items of property
produced during the taxable year and capitalized to the items that remain on
hand at the end of the taxable year.

   Section 1.263A-1(c)(3) provides that capitalize means, in the case of

property that is inventory in the hands of a taxpayer, to include in inventory costs
and, in the case of other property, to charge to a capital account or basis.

    Section 1.263A-1(e) provides rules for determining the direct and indirect

costs that are required to be capitalized to property produced. Section 1.263A-1
(e)(2)(i) provides that direct costs consist of direct material and direct labor.
Section 1.263A-1(e)(3)(i) defines indirect costs as all costs other than direct
material costs and direct labor costs. Indirect costs are properly allocable to
property produced when the costs directly benefit or are incurred by reason of
the performance of production activities. Indirect costs allocable to production
activities then must be allocated among the properties produced.

  Section 1.263A-1(f) sets forth various detailed or specific (facts-and-

circumstances) cost allocation methods that taxpayers may use to allocate direct
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and indirect costs to property produced and property acquired for resale. Section
1.263A-1(f)(2) describes a specific identification method as a type of facts and
circumstances method that traces costs to a cost objective, such as a function,
department, activity, or product, on the basis of a cause and effect or other
reasonable relationship between the costs and the cost objective.

   Section 1.263A-2(a)(3)(i) provides that, except as specifically provided in

section 263A(f) with respect to interest costs, producers must capitalize direct
and indirect costs properly allocable to property produced under section 263A,
without regard to whether those costs are incurred before, during, or after the
production period (as defined in section 263A(f)(4)(B)).

   In Von-Lusk v. Commissioner, 104 T.C. 207 (1995), the Tax Court held

that the cost of obtaining building permits and zoning variances, negotiating
permit fees, and similar activities, incurred by a real estate developer before
actual physical work began on undeveloped land are indirect costs capitalizable
under section 263A. The court found that these activities represent the "first
steps in the development of the property." The court further noted that the
pursuit of building permits and zoning variances, negotiating permit fees, and
similar activities "are ancillary to actual physical work on the land and are as
much a part of a development project as digging a foundation or completing a
structure's frame. The project cannot move forward if these steps are not taken."

   In Revenue Ruling 2002-9, 2002-1 C.B. 614, a taxpayer constructed a

new residential rental building on unimproved land located in a county that
imposed impact fees on new and expanded development. The ruling found that
because the impact fees directly benefited, or were incurred by reason of, the
taxpayer's production activity, the impact fees were indirect costs required to be
capitalizable under section 263A. In addition, because (1) the impact fees were
assessed as a result of the taxpayer's plans to construct the building, (2) the
amount of the impact fees was calculated based upon the characteristics of the
building, and (3) the impact fees generally would be refundable if the taxpayer
decided not to construct the building as planned, the impact fees were allocable
to the new residential rental building under section 263A.

    Here, A is engaged in the construction of Project, a residential rental

building. Consequently, A is a producer of real property and is subject to the
capitalization requirements under section 263A. Therefore, A must capitalize the
direct costs and a properly allocable portion of indirect costs to property
produced in the Project, without regard to whether those costs are incurred
before, during, or after the production period.

   In this case, A represents that (1) the City required the Easement on the

land underlying the Project to be relocated before the City would issue any
building permits for the Project, and (2) had A elected a different use for the site
that did not require a CUP (such as the development of a commercial building), it
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would have been able to undertake construction without the City-imposed
requirement of relocating the Easement. Both representations are material
representations.

   Although, in some circumstances, easement relocation costs may be

capitalized in whole or in part to the land, there is in this instant case a direct and
specific nexus between the Relocation Costs and the specific residential rental
building that A is constructing. City required the Easement on the land
underlying the Project to be relocated before City would issue the building
permits necessary to construct the Project. But for the condition requiring the
relocation of the Easement, A would not have incurred the Relocation Costs.
Like the costs at issue in Von-Lusk, the Relocation Costs were incurred to obtain
the building permits solely for producing the residential rental building. Like the
impact fees in Rev. Rul. 2002-9, the Relocation Costs were incurred because of
A’s plans to construct the residential rental building. Further, the scope of the
Easement relocation and, accordingly, the amount of the Relocation Costs, were
determined by the characteristics of the residential rental building. City had
authority over and approved the final design of the residential rental building
(having rejected prior designs). The approved design of the residential rental
building necessitated complete relocation of the Easement. If the approved
design had been different, then the scope and cost of the Easement relocation
would have been different. Because of these factors, a cause and effect or other
reasonable relationship exists between the Relocation Costs and the residential
rental building. Therefore, the Relocation Costs directly benefit, or are incurred
by reason of, the construction of the residential rental building and are
capitalizable indirect costs as defined in section 1.263A-1(e)(3)(i), properly
allocable to the residential rental building under a specific identification method
as described in section 1.263A-1(f).

Issue 2

    Section 42 provides a 10-year tax credit for investment in qualified low-

income buildings placed in service after 1986. Section 42(a) provides that for
purposes of section 38, the amount of the low-income housing credit for any
taxable year in the credit period is equal to the applicable percentage of the
qualified basis of each qualified low-income building (as defined in
section 42(c)(2)).

  Section 42(b)(2) provides the applicable percentage for each qualified low-

income building.

   Section 42(c)(1)(A) provides that the qualified basis of any qualified low-

income building for any taxable year is an amount equal to (i) the applicable
fraction (determined as of the close of the taxable year) of (ii) the eligible basis of
the building (determined under section 42(d)).
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  Section 42(c)(1)(B) defines the applicable fraction for each qualified low-

income building.

   Section 42(d)(1) provides that the eligible basis of a new building is its

adjusted basis as of the close of the first taxable year of the credit period.
Section 42(d)(4)(A) provides that, except as provided in section 42(d)(4)(B) and
(C), the adjusted basis of any building is determined without regard to the
adjusted basis of any property that is not residential rental property.

     The legislative history of section 42 states that the term “residential rental

property” for purposes of the low-income housing credit has the same meaning
as it does for purposes of section 103. The legislative history of section 42
further states that residential rental property thus includes residential rental units,
facilities for use by the tenants, and other facilities reasonably required by the
project. 2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-89 (1986), 1986-3
(Vol. 4) C.B. 89.

   Rev. Rul. 2002-9 states that if a depreciation deduction is allowable under

section 167(a) for the residential rental building and it is subject to section 168,
then for purposes of section 42, the impact fees are included in the eligible basis
of a qualified low-income building.

   Because the Relocation Costs are indirect costs capitalized under

section 263A into the basis of the Project, a residential rental building, and
because A represents that it intends to construct and operate the residential
rental building to qualify the building for the low-income housing tax credit under
section 42 (thus, implying that the building will be depreciated as residential
rental property under section 168), the cost of the Relocation Costs will be
includable in the eligible basis of the residential rental building under
section 42(d)(1).

  Based solely on the facts and representations provided, and the relevant

law and analysis set forth above, we conclude that:

   1. The Relocation Costs incurred by A to relocate the Easement are

indirect costs within the meaning of section 1.263A-1(e)(3)(i), and are
capitalizable to the basis of the Project’s residential rental building under
section 263A.
2. Assuming that the Project’s residential rental building will be
depreciated as residential rental property under section 168, the Relocation
Costs incurred by A to relocate the Easement are includible in the eligible basis
of the Project’s residential rental building under section 42(d)(1).

  We note that the costs incurred by A to relocate the Easement must be

depreciated under section 168, beginning when the residential rental building is
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placed in service by A.

   Except as specifically set forth above, we express no opinion regarding

the application of any other provisions of the Code or Income Tax Regulations.
Specifically, no opinion is expressed or implied on whether the residential rental
building is depreciated as residential rental property under section 168, whether
the residential rental building is a qualified low-income building under section 42,
or whether the costs to demolish the restaurant on the land underlying the
Project are subject to section 280B.

  This ruling is directed only to the taxpayer that requested it. Section

6110(k)(3) provides that it may not be used or cited as precedent.

    In accordance with the provisions of a power of attorney on file with this

office, we are sending a copy of this letter ruling to A’s authorized representative.
We are also sending a copy of this letter to the appropriate division director.

                                             Sincerely,

                                             Kathleen Reed

                                             Kathleen Reed
                                             Chief, Branch 7
                                             Office of Associate Chief Counsel
                                             (Income Tax & Accounting)

Enclosures:
Copy of this letter
Copy for section 6110 purposes