Municipal-district repayments are not tax-exempt bond interest

Plain-English summary

A real estate developer advanced money to special municipal districts that financed and built public infrastructure for its development. The developer treated the advances as common-improvement costs included in the basis of lots held for sale, even though the districts issued notes and bonds in exchange. The IRS advised that this substance-over-form treatment was proper because the improvements supported the development and repayment depended on its success. Consistency required all repayments, including amounts labeled interest, to reduce estimated common-improvement costs or become ordinary income after lot sales ended. None of the repayments qualified as tax-exempt interest under section 103.

Ruling snapshot

• Question: May the developer treat advances evidenced by municipal notes or bonds as development costs, while treating designated interest repayments as tax-exempt bond interest?
• Outcome: Advice given
• Key authorities: IRC §§ 103, 1011, 1012, 1016, 461; Treas. Reg. §§ 1.103-1(a), 1.1016-2(a); Rev. Proc. 92-29

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201537022
       Release Date: 9/11/2015
       CC:ITA:B05:MLOsborne
       POSTS-126047-14

UILC: 460.03-09, 103.00-00

date: May 29, 2015

 to:   Associate Area Counsel (Denver)
       (Small Business/Self-Employed)

       Tamara L. Kotzker
       Attorney (Denver, Group 1)
       (Small Business/Self-Employed)

from: Associate Chief Counsel
(Income Tax & Accounting)

       John M. Aramburu
       Senior Counsel, Branch 5
       (Income Tax & Accounting)

subject: Treatment of Recovery of Expenses

       This Chief Counsel Advice responds to your request for assistance dated January 30,
       2015. This advice may not be used or cited as precedent.


       LEGEND

       Taxpayer                                     =        ---------------------------------------------------------------
       -----------------------------------------------------------------------------------------------------------------
       State A                                      =        ------------
       Year 1                                       =        ------
       Years 2 through 14                           =        -------------------------
       x                                            =        -----
       Parcel                                       =        --------------
       $y                                           =        -----------------
       Special Districts                            =        ---------------------------------------------------------------
       -----------------------------------------------------------------------------------------------------------------

POSTS-126047-14 2

Service Plan = ---------------------------------------------------------------

$z = ---------------

ISSUES

1. May Taxpayer, a real estate developer, treat amounts advanced to a special
   municipal district for the construction of infrastructure for Taxpayer’s
   development as, in substance, costs of developing its real property, although, in
   form, the amounts advanced are loans to the district, evidenced by bonds.

2. If Taxpayer treats its advances as costs of developing its real property, may
   Taxpayer treat repayments designated as “interest” on the bonds as tax-exempt
   under § 103 or must Taxpayer treat all repayments, whether designated as
   interest or principal, as a reduction of cost or income, consistent with its
   treatment of the advances as costs of developing lots held for sale.

CONCLUSIONS

1. Taxpayer properly treated amounts advanced to a special municipal district for
   the construction of infrastructure for Taxpayer’s development as costs of
   developing its real property.

2. Taxpayer must treat any repayments from the district, whether designated as
   interest or principal, as a reduction of cost or income. No portion of the payments
   is tax-exempt interest under § 103.

FACTS

Taxpayer is an S corporation, organized in State A. Taxpayer uses an overall accrual
method of accounting. Taxpayer is in the business of acquiring unimproved real estate,
subdividing the land, and selling the improved parcels to third-party home builders or
commercial developers.

In Year 1, Taxpayer entered into option contracts to purchase approximately x acres of
real property (the Parcel) located in a township of State A for a total of approximately
$y. In Years 4 through 6, Taxpayer exercised its options and purchased the complete
Parcel.

As early as Year 1, in anticipation of purchasing and developing the Parcel, Taxpayer
began working with the local township, with the goal of turning the Parcel into a mixed-
use (commercial and residential) development. The local township tentatively approved
the mixed-use development, subject to the proviso that Taxpayer provide the public
POSTS-126047-14 3

infrastructure, such as water, wastewater, streets, that was necessary for the
development.

In Year 3, the owners of Taxpayer assisted the township in the formation of two
interconnected – Service and Financing -- Special Districts. The Special Districts were
created under the law of State A, which treats such Special Districts as quasi-municipal
subdivisions of townships within State A. The township authorized the formation of the
Special Districts in Year 3, and the agreement between Taxpayer and the Special
Districts was reflected in a Service Plan. The Special Districts purport to be political
subdivisions.1

According to the Service Plan, the Special Districts will provide the necessary public
improvements. The Service District is responsible for managing the construction and
operation of facilities and improvements needed for the Parcel, while the Finance
District is responsible for providing the funding and tax base needed to support the
financing plan for capital improvements and for operations. Thus, the Special Districts
are nominally responsible for the financing, construction, and operation of the public
improvements of the Parcel.

The Service Plan, in a section called “General Financing Information and Assumptions,”
provides more information on the financing, construction, and operation of the public
improvements of the Parcel:

    The Districts anticipate obtaining financing for capital improvements
    initially through Developer advances, and then through the issuance of
    limited tax general obligation bonds or other debt instruments, including
    revenue bonds. General obligation debt will be payable from revenues
    derived from ad valorem property taxes and from other legally available
    sources. The Financing District may issue limited tax general obligation
    bonds after its determination that the assessed valuation is sufficient to
    pay debt service with reasonable mill levies. …
    …
             The financial structure contemplated in the Financing Plan
    demonstrates that the risks associated with the development of [the
    Parcel] will be borne initially by the Developer of the project. Due to the
    nature of the liabilities associated with issuance of revenue bonds and
    Developer owned debt, the entire risk of development will rest with
    Developer until such time as the Financing District develops sufficient
    assessed valuation to support the debt service requirements of the bonds
    issued.

1
For purposes of analyzing the issues in this case, we assume that the Special Districts are political
subdivisions as defined in § 1.103-1(b), although we reach no official conclusion in that regard.
POSTS-126047-14 4

Prior to the formation of Special Districts, Taxpayer paid expenses necessary for both
the formation of Special Districts and further development of the Parcel. Subsequent to
the formation of Special Districts, Taxpayer continued to pay expenses on behalf of the
Special Districts, and also advanced funds directly to Financing District. In exchange
for the advances and payments, the Financing District issued promissory notes to
Taxpayer.

Through Year 3, Taxpayer provided all of the funding that the Special Districts needed
in order to fulfill obligations under the Service Plan. During Years 4 and 5, the
Financing District issued $z of promissory notes to outside investors, which notes had
priority over the notes payable to Taxpayer.

In Year 5, the Financing District issued a bond anticipation note (BAN) to Taxpayer in
exchange for its outstanding promissory notes. The Year 5 BAN had a stated interest
rate and a maturity date in Year 10.

Subsequently, in Years 6 through 10, Taxpayer continued to advance funds to
Financing District to fund the public improvements necessary for the Special Districts to
comply with obligations under the Service Plan and to allow Taxpayer to continue to
subdivide the Parcel. The Financing District provided Taxpayer with a promissory note,
which evidenced advances from Taxpayer. In Year 10, the Financing District issued a
separate BAN to Taxpayer. The Year 10 BAN replaced the Year 5 BAN and the
outstanding promissory note. The Year 10 BAN had a stated interest rate and a
maturity date in Year 14.

Taxpayer sells lots in the Parcel to builders. Taxpayer elected to use the “alternative
cost method” described in Rev. Proc. 92-29, 1992-1 C.B. 748, to account for the
common improvement costs of its development. It treated amounts advanced to and on
behalf of Special Districts as amounts incurred for common improvement costs.2
Pursuant to Rev. Proc. 92-29, these amounts were reflected in the bases of lots sold by
Taxpayer, to the extent of each lot’s allocable share of total estimated common
improvement costs.3

On Schedules K-1 issued to its shareholders, Taxpayer reported accrued interest on the
obligations of the Financing District as tax-exempt interest income under § 103. Certain
but not all shareholders increased their basis in Taxpayer stock by these reported
amounts and, as a result, claimed losses not otherwise allowable.

Taxpayer has treated repayments designated as “principal” as a reduction of cost.
Pursuant to Rev. Proc. 92-29, this reduction in cost has been reflected as lower bases
in lots sold in the year of repayment and subsequent years.

2
We do not address the issue of whether advances to and on behalf of the Special Districts resulted in
costs “incurred” within the meaning of section 461.
3
We do not address the issue of whether Taxpayer’s agreements for lot sales were long-term contracts
subject to required use of the percentage-of-completion method of accounting under § 460.
POSTS-126047-14 5

LAW AND ANALYSIS

Relevant Law

Section 103(a) provides generally that gross income does not include interest on any
state or local bond. Section 1.103-1(a) provides, in part, that interest upon obligations
of a state or any political subdivision thereof generally is not includable in gross income.

Section 1011 provides, in part, that the adjusted basis for determining gain or loss from
the sale or other disposition of property is the basis, determined under §1012, as
adjusted as provided in §1016. Section 1012 provides, in part, that the basis of the
property is the cost of such property. Section 1.1016-2(a) provides, in part, that the cost
or other basis will be properly adjusted for any expenditure properly chargeable to a
capital account, including the cost of improvements and betterments made to the
property.

The bases of lots held for sale include allocable shares of the cost of common
improvements, if (1) the basic purpose of the taxpayer in constructing the common
improvements is to induce sales of the lots, and (2) the taxpayer does not retain too
much ownership and control of the common improvements. Norwest Corp. and
Subsidiaries v. Commissioner, 111 T.C. 105, 134-35 (1998), citing Estate of Collins v.
Commissioner, 31 T.C. 238, 256 (1958). Thus, when a developer makes a payment to
a third party for common improvements for a new development -- such as payments to
utility companies to extend services to a new development or to construct a water or a
sewerage system -- the payments may be added to the bases of the developer’s lots
sold. Herzog Building Corporation v. Commissioner, 44 T.C. 694, 699-700 (1965), acq.,
1968-2 C.B. 2.

Service position with respect to common improvement costs is consistent with the cited
case law. If a person engaged in the business of developing and exploiting a real
estate subdivision constructs a facility thereon for the basic purpose of inducing the
purchase of lots, the cost of such construction is properly part of the cost bases of the
lots, even though the developer retains tenuous rights, without practical value, to the
facility constructed. Rev. Rul. 68-478, 1968-2 C.B. 330. Similarly, if a developer
constructs a facility in the subdivision for the purpose of inducing the purchase of lots
and the developer conveys all substantial rights in the facility to a utility, the cost of the
facility is properly includable in the cost basis of the subdivision. Rev. Rul. 81-83, 1981-
1 C.B. 434.

In certain cases, developers have been permitted to treat amounts that in form are cast
as advances or loans, and made in exchange for bonds or other debt instruments, as in
substance expenditures for common improvements and thus included in the bases of
lots sold. The developer in Hallcraft Homes v. Commissioner, 40 T.C. 199 (1963), aff’d,
336 F.2d 701 (9th Cir. 1964), made advances to a water utility, so that the water utility
would extend its water lines to the developer’s property. The water utility agreed to
POSTS-126047-14 6

repay the advances over a twenty-year period from sales of water to the eventual
owners of the developed properties. Although the holding addressed the issue of
whether the sale of future repayments of advances was the sale of an ordinary income
asset or a capital asset (the court finding an ordinary income asset), the court confirmed
that the advances were includable in the bases of the developer’s properties and that
all repayments were income:

  Here, in order to complete its houses so they could be sold in the ordinary
  course of its business petitioner was required to advance to the water
  company the cost of extending water service to those houses. The water
  company agreed to repay petitioner these advances over a 20-year period
  out of its sales of water to eventual owners of the houses. . . . [P]etitioner
  added the amount of the advances to the cost of houses sold in computing
  its income from the sale of the houses. . . . Petitioner agrees that the
  refunds received from the water companies are taxable as ordinary
  income, and it has so reported them prior to, subsequent to, and, in fact,
  during the year here involved.

40 T.C. at 204-05.

The developer in Herzog had included the cost of purchasing bonds from the local
municipality in the basis of its lots sold. The municipality used the proceeds to build a
sewerage system. The government challenged this treatment on the grounds that the
developer did not build the sewerage system itself, and at all times exercised full
ownership over the bonds. Ruling against the government, the Tax Court held that the
developer in substance had agreed to pay for the infrastructure and did so to make
possible the construction and sale of its homes:

  We are satisfied that petitioner’s purpose in agreeing to buy the Wheeling
  sewerage revenue bonds was to make possible the construction and sale
  of houses in the proposed subdivision, and was not to make an
  investment in the bonds. Considering this state of facts, we believe the
  soundest analysis of the case at bar will result from treating petitioner as
  having agreed to pay directly the costs of building the sewerage system.

44 T.C. at 700.

The fact that interest was paid on the bonds did not distinguish Herzog from other cases
holding that contingent repayment obligations do not prevent a developer from adding
common improvement costs to basis in property held for sale. In Herzog, repayment of
the bonds was largely dependent on the success of the developer’s subdivisions. Id. at

701. Consistent with its position that the cost of the bonds was in substance the cost of
     a common improvement, the developer in Herzog reported interest received on the
     bonds as a reduction of its bases in its lots, rather than as tax-exempt interest on
     municipal bonds under the predecessor of § 103. Id. at 698. Likewise, the developer in
     POSTS-126047-14 7

Herzog reported amounts received on disposition of the bonds as ordinary income
(“petitioner on brief seems to concede that the amounts received for the bonds
constituted ordinary income”). Id. at 702, citing Hallcraft Homes.

If expenditures for common improvements are to be included under § 1016 as an
upward adjustment to the bases of a developer’s lots held for sale, Rev. Proc. 92-29,
1992-1 C.B. 748, permits an election to allocate common improvement costs to each
lot, under the alternative cost method. Under this method, a real estate developer
allocates to lots sold a proportionate share of common improvement costs that includes
estimated future construction costs without regard to whether the costs would qualify as
incurred under the economic performance rule of § 461. However, the cumulative
amount of such costs taken into account in the current and prior tax years cannot
exceed the total cumulative amount of common improvement costs incurred by the
developer in the development.

Section 2.01 of Rev. Proc. 92-29 defines “common improvements” to mean any real
property or improvements to real property that benefit two or more properties that are
separately held for sale by a developer. The developer must be contractually obligated
or required by law to provide the common improvement and the cost of the common
improvement must not be properly recoverable through depreciation by the developer.
Examples of common improvements include streets, sidewalks, sewer lines,
playgrounds, clubhouses, tennis courts, and swimming pools.

Section 2.02(1) of Rev. Proc. 92-29 addresses the treatment of a change in estimated
common improvement costs. It provides, in part:

  A developer may not adjust the estimated cost of common improvements
  for a prior taxable year when events after filing the prior year federal
  income tax return show the original estimate has been either understated
  or overstated. If, after the return is filed, it is determined that a greater or
  lesser amount should have been claimed, the remedy is to make the
  correction in and for the year the determination is made.

Taxpayer’s Advances and Repayments

As described above, prior to the formation of the Special Districts, Taxpayer paid
expenses necessary for both the formation of the Special Districts and other costs
necessary to further the development of the Parcel. Subsequent to the formation of the
Special Districts, Taxpayer continued to pay expenses on behalf of the Special Districts
and also advanced funds directly to the Financing District. In exchange for the
advances and payments, the Financing District issued promissory notes to Taxpayer.
Those promissory notes were eventually exchanged for bond anticipation notes, the
latest of which was issued as the Year 10 BAN.
POSTS-126047-14 8

As noted, the Special Districts were created exclusively to finance, construct and
operate public improvements for the Parcel, as reflected in the Service Plan. Taxpayer
has consistently treated all advances to and on behalf of the Special Districts as
additional costs incurred in developing Taxpayer’s properties and has accounted for the
costs by using the alternative cost method described in Rev. Proc. 92-29. Thus, in its
treatment of the advances and payments, Taxpayer has disregarded the form of the
transaction – the purchase of a debt instrument (note or bond) – and treated the
transaction according to its substance – expenditures made to improve properties held
for sale. This treatment appears to have been proper in light of the authorities
discussed above. Although the Special Districts were nominally designated to finance,
construct and operate the common improvements, the common improvements were
needed to enhance the value of Taxpayer’s development, and repayment of Taxpayer’s
advances – whether designated as principal or interest -- was contingent on the
success of Taxpayer’s development.

While Taxpayer disregarded the form of the transaction and took a return position
consistent with its substance in treating advances to and on behalf of the Special
Districts as common improvement cost expenditures, it took a different approach when
it accrued “interest” on the notes and bonds and reported these amounts to its
shareholders as tax-exempt interest under § 103.

Repayments received from the Financing District are properly treated as a reduction in
Taxpayer’s estimated common improvement costs under Rev. Proc. 92-29.
Accordingly, Taxpayer’s estimated common improvement costs are reduced in the year
of repayment.4 Under section 2.02(1) of Rev. Proc. 92-29, this will result in reduced
allocations to the bases of lots sold in the year of repayment and succeeding tax years.
Any repayments made after Taxpayer has completed lot sales must be reported as
ordinary income. Hallcraft Homes, 40 T.C. at 205 (refunds from the water company are
taxable as ordinary income); Herzog, 44 T.C. at 702 (amounts received for the bonds
constituted ordinary income). No portion of any payment from the Special Districts is
tax-exempt interest under § 103.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 622-7006 if you have any further questions.

4
Any repayments received will also reduce the “alternative cost limitation” described in section 4.01 of
Rev. Proc. 92-29.