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## Low-Income Housing Credit
### Table of Contents Chapter 1, Introduction Background Overview of the Credit Process: The Participants and Their Roles IRS Apportions Tax Credits to the Allocation Agencies Developers Apply to the Allocating Agencies for Credits State Housing Agencies Tax Benefits Provide a Return on Equity Investments Chapter 2, Qualified Low-Income Housing Project Introduction Residential Rental Requirements Functionally Related Facilities Scattered Site Project Mixed-Use Building General Public Use Minimum Low-Income Set-Aside Requirement Household Income Limitations Minimum Set-Aside Election Audit Techniques Chapter 3, Eligible Basis Definition Issues Specific to Acquisition Expenditures (Purchase of Existing Buildings) The 10-Year Rule Exceptions to the 10-Year Rule Waiver of 10-Year Rule for Certain Federally Assisted Buildings Related Party Ownership Like-Kind Exchange Property Issues Specific to New Construction Expenditures Expenditures Specifically Excluded from Eligible Basis Developer Fee Developer Fee Notes Contingent Liabilities Developer Fees Exceeding Economic Feasibility Under IRC section 42(m)(2) Allocation of Overhead and Soft Costs to Land New Construction Summary Issues Specific to Rehabilitation Expenditures Eligible Basis Computations for Mixed-Use Buildings Eligible Basis and the Compliance Period Eligible Basis in "Difficult Development Areas" Evaluating the Validity of Costs Included in Basis (The Corbin West Tax Court Case) Audit Techniques Closing Documents and Settlement Sheets AIA (American Institute of Architects) Statements or Construction Vouchers Development Agreements Certificate of Occupancy Prospectus/Offering Memorandum State Housing Credit Agency File Chapter 4, Qualified Basis Introduction Applicable Fraction Determination of Qualified Basis Increases to Qualified Basis Low-Income Unit Requirements Student Occupancy Rules On-Site Manager Projects with Four or Fewer Units Audit Techniques Chapter 5, Calculating the Low-Income Housing Tax Credit Audit Techniques Chapter 6, Federal Financing Impact of Federal Financing on a LIHC Project Types of Federal Grants Federally Subsidized Loan Mechanics of Election for Use of Lower Credit Amount Audit Techniques Chapter 7, Recapture of the Credit Audit Techniques Chapter 8, Related Tax Topics Related Tax Liability Restrictions At-Risk Limitations Audit Techniques for At-Risk Issues LIH Credits and the Passive Loss Limitations Introduction Overview of the Passive Loss Limitations LIH Losses LIH Credits Only One $25,000 Offset Ordering Rules Passive Income Issues Dispositions Forms Rehabilitation Credit Additional Help Summary of Passive Loss Limitations Low Income Housing and Passive Loss Limitations LIH Credit Issues LIH Loss Issues Alternative Minimum General Business Credit Limitation Audit Techniques Chapter 9, Extended Use Commitments Audit Techniques Chapter 10, Qualified Nonprofit Organizations Special Benefits Awarded to Nonprofits Nonprofit Set-Aside At-Risk Limitation Concessions Exception to the Rule for Owner Occupied Buildings Exception to the Rule for Transitional Housing for the Homeless Right to Purchase at the End of the Compliance Period Exception to the Rule for Fees for Supportive Services Exception to the 10-Year Rule Nonprofit Organizations Defined Safe Harbor Joint Venture Unrelated Business Taxable Income Tax-Exempt Use Property Property Leased to a Tax-Exempt Entity (Other Than Nonresidential Real Property) Failure to Make a Qualified Allocation (Any Depreciable Partnership Property) Disqualified Leases (Nonresidential Real Property) Debt-Financed Property Audit Techniques Chapter 11, Development Fees and Soft Costs Developer Fee Requirements Steps for Issue Identification Characterization of Expenses Position of the Service Summary Description of Syndication Scenarios and Current Industry Tools for Marketing the Low-Income Housing Tax Credit Chapter 12, State Administration of the Low-Income Housing Credit Appendix A, Low-Income Housing Tax Credit Interview Questions Appendix C, Code and Regulation Reference Table By Issue and Chapter Appendix D, Reference Guide Appendix E, Forms Used in Connection with the Low-Income Housing Credit Glossary ### Chapter 11, Development Fees And Soft Costs One of the significant issues encountered in low-income tax credit cases stems from the inclusion or general allowance of developer fees in the reported eligible basis of the respective real estate projects. #### Developer Fee Requirements Treas. Reg. section 1.42-6 provides guidance on whether certain developer fees qualify as part of carryover allocation basis for purposes of fulfilling the requirement that a project owner must incur at least 10 percent of the project's reasonably expected costs by the end of the year in which the allocation was made. Treas. Reg. section 1.42-6 also provides standards for determining whether fees, including developer fees, qualify for inclusion in eligible basis. Specifically, the fees must meet the following requirements: The fee is reasonable; The taxpayer is legally obligated to pay the fee; The fee is capitalizable as part of the taxpayer's basis in land or depreciable property that is reasonably expected to be part of the project; The fee is not paid (or to be paid) by the taxpayer to itself; and If the fee is paid (or to be paid) by the taxpayer to a related person, and the taxpayer used the cash method of accounting, the taxpayer could properly accrue the fee under the accrual method of accounting (considering, for example, the rules of IRC section 461(h)). A person is a related person if the person bears a relationship to the taxpayer specified in IRC sections 267(b) or 707(b)(1), or if the person and the taxpayer are engaged in trades or businesses under common control (within the meaning of subsections (a) and (b) of IRC section 52). In addition, there are other related "soft costs" which are routinely part of a syndicated and developed real estate project. Syndication fees relating to the selling of an equity interest in a project, and those legal and accounting expenses that are attributable to any such syndication, are not included in eligible basis. The "characterization" of these various fees as incurred for development, as well as the percentages charged in relation to the actual "hard costs" of the various projects raise questions as to their proper characterization for tax purposes. IRC section 42(m) affords the state housing credit agencies the authority to limit project costs to those that are feasible to bring the project to completion. One of the main areas addressed by the states under the authority of IRC section 42(m) is developer fees. The text which follows attempts to identify the potential issues regarding developer fees as well as other soft costs. Additionally, an attempt will be made to highlight some potential forms the developer fees may take, the applicable Code sections, and positions successfully used to address the various issues. It should also be noted that other names may be used to characterize these types of fees and soft costs and which will be addressed later in this chapter. - Return to Table of Contents - #### Steps For Issue Identification To address potential developer fee issues, an examiner must first identify various aspects regarding the developer fee as presented by the project under examination. The primary task is to identify the following: The amount of the developer fee and how it was to be paid (cash or note). Determine if the cash payments and payments per any notes or financing were actually paid to date. How the developer fee amount was determined (for example, based on arms-length negotiations, etc.). Fully understanding who controls any entities involved as well as who the key players are is important. The developer. Note: If the developer is an entity, identify the ownership through any tiers, etc., which may have been layered to insulate the real owner of the developer entity. For #2 and #3 above, a chart may be helpful to outline the principals involved. Trace the entire series of transactions to identify all entities and who owns/controls them. This also could be part of the chart. The developer fee mechanism. It is also important to determine what type of development scenario is involved. Several potential types follow: Turnkey Project -- Consider a situation where the partnership enters into a development agreement with a developer to pay an amount which includes all hard construction costs and the balance is earned by the developer as the developer fee. An example of this arrangement would be a situation where the development agreement calls for a payment of $2 million with the estimated hard costs of the project budgeted at $1,200,000. If the actual costs are consistent with the budgeted amounts, then the developer will have earned a fee of $800,000. NOTE: The key factor to establish in this case is what type of service the "developer" has performed to justify this compensation or fee, and how these amounts should be "characterized" for tax purposes. The partnership/owner usually acquires the building before the development contract is entered into. There may be a variation of this turnkey situation where, in addition to contracting for the development of the project, the shell purchase is also included in the contract price. Fixed Amount Developer Fee -- A fixed amount developer fee occurs in a situation where the "hard costs" and the developer fee are separately-stated items. The developer fee is usually based on the estimate or budget for hard costs. For example, $1 million of hard costs with a developer fee added in a fixed amount of $150,000. In this situation, the partnership has usually already acquired the shell prior to entering into the development contract. Unlike a turnkey agreement, the developer fee does not decrease if the hard costs exceed their budgeted amounts. Completed Project Developer Fee -- A completed project developer fee is one which is passed on to the ultimate purchaser of the building as a component of the purchase price. The building in this case is sold as a completed package after the new construction or the rehabilitation work is finished. The sales price includes components of costs for the original land, shell, rehabilitation costs, and any development costs or other "soft costs." The primary task is to determine what the components of the purchase price are, who was involved in the transaction, what their role in the transaction was, and what their role was in the transaction. This analysis may lead to conclusions which include "substance versus form" arguments. To make this argument, the facts and transactions must be established, and the players and their roles properly identified. These costs, if determined to be for syndication aspects, are not includable in the tax credit basis (or the depreciable or amortizable basis, etc.) for the low-income housing credit or rehabilitation credit. Depending on the size of the project or the materiality of the fees involved, adjustments may be needed to "re-characterize" these soft costs. Failed Project Developer Fee -- A developer fee under either a turnkey agreement or a fixed amount developer agreement may be evident in another type of project which is commonly referred to as a "Failed Project." The key factor to remember in this situation is that the failure referred to is usually one in terms of depleted finances or total bankruptcy of a former owner. Usually the salvaging of this project by the new developer depends upon their ability to syndicate and sell this project to a new group of investors. Enough capital must be generated to buy the project, complete the remaining construction or rehabilitation items, and also cover the "soft costs" incurred for the services of the individuals involved in completing the project. As in all the above scenarios, the identification of all the transactions and players is imperative. There have been other situations where syndication fees or follow-up for due diligence purposes is referred to as construction monitoring fees, contingency fees, acquisition fees, etc. Whatever characterization is on the taxpayers books or tax returns, it is important to determine the true nature and propriety of the costs incurred. In addition to the identification of the particular developer fee or soft cost scenario, there are various examination techniques which can be used and some Information Document Request (IDR) items which can be beneficial in developing these issues. Note that Items 1, 6, 10, 11, 12, 13, 15, 16, and 17 on the IDR (see appendix A for an example of an IDR) may pertain to this issue. In most instances the Offering Memorandum for a syndicated partnership should discuss the transactions of the partnership, including any development contracts to be entered into or development fees to be paid, as well as any significant soft cost items. Offering Memorandums are also beneficial in that the parties to the various transactions will be disclosed; particularly if there are conflicts of interest which would signal transactions which are not at arms-length. On occasion, the settlement sheet will actually contain not only the purchase of the shell, but also all development costs or other separately stated items. Workpapers used to prepare the tax return and audit workpapers (if one was performed by the accountant) may also contain narratives and numbers related to a development contract or fees. Bank statements and canceled checks may evidence payments made as developer fees or related to a development contract. Financing agreements, particularly for construction financing, also assist in making determinations regarding the propriety of developer fees. Both the construction contract and the AIA (American Institute of Architects) formatted construction vouchers provide insight into the size of the project, the "hard costs," the time frames, and the degree of completion at various intervals throughout the construction period, etc. - Return to Table of Contents - #### Characterization of Expenses Based on both past and current tax law provisions dating from 1986 through 1996, developer fees are an allowable component of the "qualified basis". However, when analyzing transactions and establishing facts for IRC section 42 low-income housing credit projects and IRC section 47 rehabilitation credit projects, examiners may need to make adjustments to items that are characterized as development fees. Certain costs may be characterized as development fees to increase the qualifying costs for computing low-income housing or rehabilitation tax credit basis. Examples of expenses which may be incorrectly characterized to obtain tax benefits by their inclusion in basis are: Syndication Costs -- These are the costs of syndicating a partnership and its related investment units. Syndication costs are normally items incurred for the packaging of the investment unit (the partnership unit), and the promotion as an investment, including any marketing of the actual units, the production of any offering memorandums or promotional materials, the mobilization of any brokers/dealers who will sell the partnership units, and the actual sales commissions paid to the sellers of the partnership (whether they are unrelated third parties or the individuals who promoted the investment). Other costs normally incurred as a part of syndication could include legal costs associated with the offering, opinions, inquiries as to certain aspects, etc. Finally, any due diligence related aspects also constitute syndication. Note that the individual or entity who acts as the developer may have been involved in the syndication aspects of the project, including the structuring of the investment unit, the work necessary to coordinate and effectuate the promotion of the investment units through syndication, and the subscription for the partnership units, or the training and coordination with broker dealers. Also note that the developer, in many instances, is the one who originally created the investment units. The individual or entities involved in the project may characterize all of their activities as "development" in nature, take out their fees for all aspects as development costs, and include the associated costs in the tax credit basis. Under IRC section 709, these costs should not be currently expensed or amortized and are not includable in the qualified tax credit basis for purposes of either the low-income housing or rehabilitation tax credit, nor are they includable for depreciation purposes. Organization Costs -- The cost of organizing a partnership may be amortized over a period of time not less than 60 months (under IRC section 709(b)). The organizational costs should include the legal and accounting costs necessary to organize the partnership and facilitate the filings of the necessary legal documents and other regulatory paperwork required at the state and national level. In addition to the requirement that these costs be amortized, they are not includable in the tax credit basis for either the low-income housing or rehabilitation tax credit, nor are they allowable for depreciation purposes. There is a fine line which exists between syndication costs and organization costs. Generally syndication represents those costs associated with the sale of the actual investment units, while organization costs are those necessary to legally create the partnership, filings, etc. Acquisition Costs -- Under the provisions of IRC section 47, (formerly IRC section 48(g)), the rehabilitation credit, costs of acquiring the shell before rehabilitation, is not properly includable in the qualified rehabilitation basis. For purposes of IRC section 42, the costs may warrant inclusion in the qualified basis and generally will be subject to the lesser 30 percent present value credit. These costs may be passed on to the partnership in the purchase price of a completed project. If the partnership purchased the building before rehabilitation, then there are two components which must be identified. The actual cost of the land and shell can be identified through review of the settlement sheet while additional, indirect costs of acquisition are more difficult to determine. These indirect costs include amounts paid to the promoters' who have actually purchased the property on behalf of the partnership. The compensation for the promoter's services may be characterized as developer fees rather than acquisitional costs. These costs should be considered because promoters can complete feasibility studies to determine if they have selected the correct property. Also, buildings may be purchased months or years prior to rehabilitation and extensive "holding costs" may be incurred. Throughout this time period, the promoter's services may be necessary to effectuate the acquisition and reimbursements for these services. Rent Up/Lease Costs -- "Rent up" or "lease up" costs are the costs necessary to fully rent the newly-renovated building. This initial rental can, in some situations, take several years and costs may be extensive. For example, costs may include: advertising, sample unit costs, on-site rental managers and staff, initial rental costs, and any other costs to fully rent out the buildings. These costs normally would be amortized over the life of the leases if long term, (for example, a commercial situation), but, if short term, then the amortization should be over the period necessary to rent out all units, (for example, 24 months or 36 months). Rental Management -- "Rental management" is the continuing day-to-day management of the property including all dealings with the tenants, renewal of current leases, procurement of new tenants for any vacancies, etc. Rental management fees are usually a set amount plus 6 percent for any lease renewals and incentives for new tenants obtained to fill vacancies. These amounts should be expensed on a yearly basis and matched against current rental income. The above costs are the most common expenses related to low-income housing and rehabilitation tax credit basis. If additional categories are encountered, determine what the costs were for, how they were paid, and who received the payment. An analysis will then be necessary to determine the proper tax characterization. - Return to Table of Contents - #### Position of the Service Based on the above discussion and cases encountered over a number of years, a position has been developed to address cases involving developer fees. Notwithstanding arguments that to rehabilitate an existing building according to the historical standards or under tax credit provisions was more difficult than undertaking new construction, these fees can be high when compared to arms-length transactions. The development of the facts surrounding the fees and what services were provided to warrant the fees, are the important items that will support adjustments. Refer to Exhibit 11-1. It is a sample report which can be used to address the development fee issue. This position was tested in a Tax Court case where the Service prevailed. Details regarding the Tax Court case will follow this position in synopsis form. For purposes of this guide, fictitious names have been used. This report can be adapted to address various developer fee scenarios. It should be noted that although the court case was for a rehabilitation tax credit situation, applications can be adapted for some low-income housing tax credit scenarios. - Return to Table of Contents - #### Summary The case presented in the sample report (Exhibit 11-1) is Richard E. Carp and Minda Carp v. Commissioner, and Franklin D. Zuckerman and Lois Zuckerman v. Commissioner, T.C. Memo. 1991-436. The court determined that the partners/developers failed to establish that they performed any of the services relating to the renovation of the property as set forth in the development agreement. In addition, the court found, as developed by the examiner, that most of the services had actually been performed by a third party under a separate agreement and for which that third party was separately compensated. Cases with similar fact patterns have been sustained in the courts using the above report as a guide. The significance of the case lies in the Court's acceptance of the analysis of purported development fees and determination of proper tax treatment. Finally, examiners should be aware that there are regulations which address situations where a developer fee occurs upon the sale of a completed rehabilitation building first placed in service by the new owner. In these situations, examiners can use the following regulation sections which treat the developer fees added to the purchase price as costs of acquisition and thus not includible in the qualified rehabilitation tax credit basis. Note: The regulation below only relates to the rehabilitation tax credit. For purposes of the low-income housing credit under IRC section 42, acquisition costs may warrant a separate allocation of the 30 percent present value credit. Treas. Reg. 1.48-12(c)(3)(iii) provides examples of expenses incurred by the taxpayer for purposes of qualified rehabilitation expenditures. #### Extract #### Treas. Reg. section 1.48-12(c)(3)(iii), Examples (3) and (4) Example (3). D, a taxpayer using the cash receipts and disbursements method of accounting, begins the rehabilitation of a building on January 11, 1982. Prior to May 1, 1982, D makes rehabilitation expenditures of $16,000. On May 3, 1982, D sells the building, the land, and the property attributable to the rehabilitation expenditures to E for $35,000. The purchase price is properly allocable as follows:
    _____________________________________________________

    land                                          $ 5,000
    existing building                              11,000
    property attributable to                       19,000
    rehabilitation expenditures
    total purchase price.                         $35,000
    _____________________________________________________
The property attributable to the rehabilitation expenditures is placed in service by E on September 5, 1982. E may treat a portion of the $35,000 purchase price as rehabilitation expenditures paid or incurred by him. Since the rehabilitation expenditures paid by D ($16,000) are less than the portion of the purchase price properly allocable to property attributable to these expenditures ($19,000), E may treat only $16,000 as rehabilitation expenditures paid or incurred by him. The excess of the purchase price allocable to rehabilitation expenditures ($19,000) over the rehabilitation expenditures paid by D ($16,000), or $3,000, is treated as the cost of acquiring an interest in the building and is not a qualified rehabilitation expenditure treated as incurred by E. Example (4). The facts are the same as in example (3), except that the purchase price properly allocable to the property attributable to rehabilitation expenditures is $15,000. Under these circumstances, E may treat only $15,000 of D's $16,000 expenditures as rehabilitation expenditures paid by D. The excess of the rehabilitation expenditures paid by D ($16,000) over the purchase price allocatable to rehabilitation expenditures ($15,000), or $1,000, is treated as the cost of acquiring an interest in the building and is not a qualified rehabilitation expenditure treated as incurred by E. - Return to Table of Contents - #### Description of Syndication Scenarios And Current Industry Tools For Marketing the Low-Income Housing Tax Credit The most common entity used for the promotion of real estate investments is a partnership. During the 1980's, the partnerships had numerous limited individual partners. This type of partnership with many limited partners worked well for purposes of the rehabilitation tax credit. Simultaneously with the creation of the low-income housing tax credit and as a part of the Tax Reform Act of 1986, the passive activity restrictions were enacted. Generally designed to curb tax shelters, the passive activity restrictions had a significant impact on real estate type investments. For the above reasons, partnerships are the most popular entity used to solicit credit equity investments. Although there still may be some individuals who participate in those low income housing investment partnerships, most significant low-income housing credit partnership investment is coming from corporate investors. Partnerships and equity pools can own as few as one building or as many as dozens of multiple building projects. The larger the pools, the more equity required and usually more partners are necessary to make the projects feasible. Generally, although "tax credits can not be sold," one may buy an interest in an investment partnership (whether as an individual or corporation) to receive a share of the credits, as well as any tax attributes accruing from the partnership. Investors then must assume the burdens and benefits of ownership. #### Exhibit 11-1 #### Sample Report #### FORM 886-A, EXPLANATION OF ITEMS #### General Background/Facts ABC Historic Partnership started on October 15, 1990, per the 1990 partnership return and the partnership agreement as submitted during audit. Per the 1990 partnership return, there are 33 partners in ABC Historic. The partnership is a limited partnership and the sole general partner is "X". "X" has also been designated as the Tax Matters Partner per the partnership agreement, and based on recent correspondence, that Tax Matters Partner designation remains currently in force and effect. The Offering Memorandum indicates that ABC Historic is a partnership formed under Pennsylvania law to acquire a four story building in the Old City Historic District of Philadelphia, Pennsylvania. The partnership rehabilitated the structure into 42 apartments and 8,000 square feet of commercial space. Per the Offering Memorandum and background obtained during the audit, the partnership intended to, and actually has, operated this project as an apartment rental project. The partnership, from the outset, intended to obtain historical certification of the project's qualifying rehabilitation costs and take the 20-percent certified historical rehabilitation credit. Based on verification with the National Park Service and the Part III Certification as submitted by the partnership during audit, the rehabilitation work as performed has been "certified" by the National Park Service. As long as the costs are for "qualified rehabilitation expenditures" they can be included in the basis for the 20-percent historical rehabilitation credit. ABC Historic was one of various partnerships promoted, syndicated, organized, and managed through various general partners on behalf of the "Y" Group. These partnerships were very similar in nature in that all were primarily formed to acquire, rehabilitate and subsequently rent the historic structures as residential/luxury apartments. A major selling feature of these limited partnership interests was the 20-percent certified historic rehabilitation tax credit available for "qualifying rehabilitation expenditures" as defined by Federal tax law and subject to the rehabilitation works approval by the National Park Service. Adding to the attractiveness of these partnerships was their leveraged nature whereby usually less than 10 percent of the purchase price of the investors limited partnership interest was required to be paid by cash, while the remaining amounts were paid by notes from the investors to the partnership and which were payable over a 5-year period. The partnerships were also similar in that various functions and services necessary to carry out the intended purposes of the partnerships were usually performed by the many affiliates which operate under the auspices of "Y" Group. These functions included but were not limited to the following: The sponsoring, syndication, and promotion of the various limited partnerships to raise the necessary capital to acquire, rehabilitate, and subsequently rent out the projects. "Y" and its affiliates were responsible for creating an investment package (the limited partnership interests) that had an appeal to investors. Without this attractive investment package, as created and promoted by "Y", the functions performed by "X" as indicated below would be impossible to accomplish. After creation and formation of the various partnership investment vehicles it was then necessary to seek out and engage various broker dealers capable of selling these investments to the ultimate limited partner/investors throughout the country. Once engaged, "Y" had to mobilize these broker dealers to sell the units and complete syndication of the respective limited partnerships. One of the company's strengths was the creation of partnerships that had appeal to investors. Their staff had to communicate the merits of their programs. The limited partnerships were marketed through stock brokers, insurance agents, and financial planners who then communicated with and sold the partnership units to the investing public. "Y", through its employees, had to educate the registered securities dealers of the benefits of investing in the limited partnerships in addition to the economic and tax incentives. Additionally, for the later year projects, the company had a "Due Diligence Office" which provided detailed financial and tax information to broker/dealers on all more recent offerings. As indicated above, a substantial amount of time and work was invested in the creation of the investment package and the subsequent promotion, syndication, and sale of these limited partnership investments by "Y". The placement of a general partner for the various partnerships to act in the capacity of, and to perform the normal functions and duties of the general partner. In this fiduciary role as general partner, the individuals or entities who acted as general partners had the exclusive right to manage the business affairs of the partnership. In most of the promotions, the general partners were either "key employees"/owners of "Y", entities owned by "key employees"/owners of "Y", or shared some "affiliation" with the "key employees"/owners of "Y" and usually acted under the guidance of "Y" in their role as general partner. The work necessary to "organize" the partnership was more in the nature of an expenditure in relation to the creation of the partnership than of an expenditure relating to the carrying on of the intended business operations or "day-to-day business" of the partnership. The "acquisitional" work necessary by "Y" and its "affiliates" was to find potential buildings and perform economic and feasibility studies of the buildings, and their general market areas including phone and on-site type reviews, and analysis, negotiations by "Y" and its affiliates on behalf of the partnerships for the purchase of the land and buildings, the settlements/closings on the ultimately selected land and buildings, and the work necessary to maintain, manage, and hold such land and buildings until the rehabilitation is commenced by a developer on behalf of the partnership. The formation/engagement of a developer entity to directly perform (or to subjugate to an affiliate in order to have performed) the necessary development work performed for the rehabilitation of the "historically certified" building owned by the particular partnership. This development work/contract usually includes a commitment of the various "Y" entities to effect the rehabilitation and renovation of the particular project owned by the partnership under audit. The development agreements are usually "turn key" in nature and for a fixed price the "developer" will arrange for, manage, and pay for the construction and completion of the rehabilitation and renovations planned for the particular project. In all of the examined partnerships, the identified "developer entities" were determined to be owned by individuals or entities which were also determined to have been "key employees" or owners of "Y". Two additional services included as "developer fees" were "cash flow guarantees" and "investor surety." While outside unrelated sureties were engaged to guarantee the payment of the "limited partners investor notes" for a non-refundable premium price, the "cash flow guarantees" were provided by an entity which was an affiliate of "Y". These affiliates would, for a set price, guarantee to lend to the particular partnership the cash amounts necessary to pay the obligations of the partnership under particular notes or, in some promotions, the guarantee was limited to a particular dollar amount. A final category which appeared in the partnerships or promotions was the use of an affiliate of "Y" as manager of the subsequent rental operations of the particular projects as the buildings became available to be "placed in service." These management agreements usually addressed renting, leasing, operating, and managing the projects for various commissions based on gross annual rentals. Additional incentives were paid for re-rentals and renewals at the various apartment buildings. #### Additional Facts Note: The preceding pages included general facts and background regarding both ABC Historic and the promoter "Y". Additional facts will address the dates, amounts, and specifics regarding the transactions entered into by the partnership during the acquisition and rehabilitation phase of the project. All of the information presented below was obtained during the examination through review of the offering memorandum, the books and records, legal documents (including but not limited to the settlement sheet for the acquisition of the property/ shell), the "development agreement," "development note," partnership agreement, AIA (American Institute of Architects) application and certificate for payment, statement/certificate of occupancy, the first lease executed after completion for occupancy, National Park Service application and responses Parts I, II, and III, which verify the historical certification of the rehabilitation work on the particular project, and any oral testimony as presented by attorneys or accountants acting as powers of attorney for the examined partnership, and officers or employees of the "Y" organization. The partnership name is ABC Historic and is located in Philadelphia. The rehabilitated building is also located in Philadelphia. The building shell was purchased September 6, 1990. The purchase price of the shell was: $600,000, ($400,000 as cash and $200,000 as seller take back mortgage from a bank). The developer entity is known as XYZ Development Company. The ownership of XYZ Development Company is as follows:
     65%  -  Apartments Inc. (100 percent Owned By "Z")
     15%  -  "X" (Current General Partner of ABC Historic)
     15%  -  "A" (Key Employee of "Y")
      5%  -  "B" (Key Employee of "Y")
The development contract is a "turn key contract" and the amount is $3,600,000 with $750,000 to be paid in cash while the remainder of $2,850,000 will be paid by note (development note). The rehabilitation expenditures, reflected as basis for the rehabilitation tax credit, have been tied to the books and records and verified by documents submitted during the audit. Based on all items as submitted, and information obtained during the audit, the examining revenue agent isolated "non-qualifying" items. The "Fact Law and Argument" presentation follows: #### Issue Whether syndication expenses in the amount of $650,000 are includable in the "qualified rehabilitation basis" for purposes of the historic rehabilitation tax credit and for depreciation basis purposes. #### Law Tax treatment of syndication and organization expenses. Under IRC section 709, the following treatment is applied to organization and syndication fees. #### Extract [IRC] Section 709. Treatment of Organization and Syndication Fees. General Rule. Except as provided in subsection (b), no deduction shall be allowed under this chapter to the partnership or to any partner for any amounts paid or incurred to organize a partnership or to promote the sale of (or to sell) an interest in such partnership. Amortization of Organization Fees. Deduction. Amounts paid or incurred to organize a partnership may, at the election of the partnership (made in accordance with regulations prescribed by the Secretary), be treated as deferred expenses and shall be allowed as a deduction ratably over such period of not less than 60 months as may be selected by the partnership (beginning with the month in which the partnership begins business), or if the partnership is liquidated before the end of such 60-month period, such deferred expenses (to the extent not deducted under this section) may be deducted to the extent provided in section 165. Organizational Expenses Defined. The organizational expenses to which paragraph (1) applies, are expenditures which-- are incident to the creation of the partnership; are chargeable to capital account; and are of a character which, if expended incident to the creation of a partnership having an ascertainable life, would be amortized over such life. Under Treas. Reg. sections 1.709-1 and 1.709-2, the following treatment is applied to organization and syndication fees. #### Extract #### Treas. Reg. section 1.709-1 Treatment of organization and syndication costs. -- General Rule. Except as provided in paragraph (b) of this section, no deduction shall be allowed under chapter 1 of the Code to a partnership or to any partner for any amounts paid or incurred, directly or indirectly, in partnership taxable years beginning after December 31, 1975, to organize a partnership, or to promote the sale of, or to sell, an interest in the partnership. Amortization of organization expenses. Under section 709(b) of the Code, a partnership may elect to treat its organizational expenses (as defined in section 709(b)(2) and in ? 1.709-2 (a)) paid or incurred in partnership taxable years beginning after December 31, 1976, as deferred expenses. If a partnership elects to amortize organizational expenses, it must select a period of not less than 60 months, over which the partnership will amortize all such expenses on a straight line basis. This period must begin with the month in which the partnership begins business (as determined under ? 1.709-2(c)). However, in the case of a partnership on the cash receipts and disbursements method of accounting, no deduction shall be allowed for a taxable year with respect to any such expenses that have not been paid by the end of that taxable year. Portions of such expenses which would have been deductible under section 709(b) in a prior taxable year if the expenses had been paid are deductible in the year of payment. The election is irrevocable and the period selected by the partnership in making its election may not be subsequently changed. Exhibit 11-1 (7 of 11) If there is a winding up and complete liquidation of the partnership prior to the end of the amortization period, the unamortized amount of organizational expenses is a partnership deduction in its final taxable year to the extent provided under section 165 (relating to losses). However, there is no partnership deduction with respect to its capitalized syndication expenses. *** The election to amortize organizational expenses provided by section 709(b) shall be made by attaching a statement to the partnership's return of income for the taxable year in which the partnership begins business. *** In the case of a partnership which begins business in a taxable year that ends after March 31, 1983, the original return and statement must be filed (and the election made) not later than the date prescribed by law for filing the return (including any extensions of time) for that taxable year. Once an election has been made, an amended return (or returns) and statement (or statements) may be filed to include any organizational expenses not included in the partnership's original return and statement. #### Extract #### Treas. Reg. section 1.709-2 Definitions. -- Organizational expenses. Section 709(b)(2) of the Internal Revenue Code defines organizational expenses as expenses which: are incident to the creation of a partnership; are chargeable to capital account; and are of a character which, if expended incident to the creation of a partnership having an ascertainable life, would (but for section 709(a)) be amortized over such life. An expenditure which fails to meet one or more of these three tests does not qualify as an organizational expense for purposes of section 709(b) and this section. To satisfy the statutory requirement described in paragraph (a)(1) of this section, the expense must be incurred during the period beginning at a point which is a reasonable time before the partnership begins business and ending with the date prescribed by law for filing the partnership return (determined without regard to any extensions of time) for the taxable year the partnership begins business. In addition, the expenses must be for creation of the partnership and not for operation or starting operation of the partnership trade or business. To satisfy the statutory requirement described in paragraph (a)(3) of this section, the expense must be for an item of a nature normally expected to benefit the partnership throughout the entire life of the partnership. The following are examples of organizational expenses within the meaning of section 709 and this section: Legal fees for services incident to the organization of the partnership, such as negotiation and preparation of a partnership agreement; accounting fees for services incident to the organization of the partnership; and filing fees. The following are examples of expenses that are not organizational expenses within the meaning of section 709 and this section (regardless of how the partnership characterizes them): Expenses connected with acquiring assets for the partnership or transferring assets to the partnership; expenses connected with the admission or removal of partners other than at the time the partnership is first organized; expenses connected with a contract relating to the operation of the partnership trade or business (even where the contract is between the partnership and one of its members); and syndication expenses. Syndication expenses. Syndication expenses are expenses connected with the issuing and marketing of interests in the partnership. Examples of syndication expenses are brokerage fees; registration fees; legal fees of the underwriter or placement agent and the issuer (the general partner or the partnership) for securities advice and for advice pertaining to the adequacy of tax disclosures in the prospectus or placement memorandum for securities law purposes; accounting fees for preparation of representations to be included in the offering materials; and printing costs of the prospectus, placement memorandum, and other selling and promotional material. These expenses are not subject to the election under section 709(b) and must be capitalized. Beginning business. The determination of the date a partnership begins business for purposes of section 709 presents a question of fact that must be determined in each case in light of all the circumstances of the particular case. Ordinarily, a partnership begins business when it starts the business operation for which it was organized. The mere signing of a partnership agreement is not alone sufficient to show the beginning of business. If the activities of the partnership have advanced to the extent necessary to establish the nature of its business operations, it will be deemed to have begun business. Accordingly, the acquisition of operating assets which are necessary to the type of business contemplated may constitute beginning business for these purposes. The term "operating assets", as used herein, means assets that are in a state of readiness to be placed in service within a reasonable period following their acquisition. #### Revenue Rulings and Applicable Court Cases Rev. Rul. 81-153, 1981-1 C.B. 387, states the following: An investor in a limited partnership may not deduct that part of the purchase price that is paid, through a rebate or discount arrangement, by the investor to a tax advisor on behalf of the partnership for services related to the sale of the partnership interest. The partnership may not amortize this amount under IRC section 709(b). The investor's basis in the partnership is the amount of cash contributed. Rev. Rul. 85-32, 1985-1 C.B. 186, states the following: Syndication costs incurred in connection with the sale of limited partnership interests are chargeable by the partnership to a capital account and cannot be amortized. In Vandenhoff v. Commissioner, 53 T.C.M. (CCH) 271, T.C. Memo. 1987-116 and Isenberg v. Commissioner, 53 T.C.M. (CCH) 946, T.C. Memo. 1987-269, it was found that guaranteed payments by a motion picture partnership to the general partners were in the nature of syndication expenses and were required to be capitalized. In Schwartz v. Commissioner, 54 T.C.M. (CCH) 11, T.C. Memo. 1987-381, aff'd without opinion, 930 F.2d 920 (9th Cir. 1991), it was found that payments made to a partner were syndication expenses that must be capitalized and were not deductible as guaranteed payments. In Driggs v. Commissioner, 87 T.C. 759 (1986), it was found that amounts paid to a general partner as "sponsor's fees" were not deductible because the partnership failed to prove whether the expenses were for syndication fees or for organization costs. In Finoli v. Commissioner, 86 T.C. 697 (1986), it was determined that amounts paid for preparation of a tax opinion, incurred to promote or facilitate the sale of partnership interests, and commissions and consulting fees constituted non-deductible syndication expenses. In Surloff v. Commissioner, 81 T.C. 210 (1983), it was found that fees paid to an attorney by partnerships mainly for the preparation of a tax opinion letter that was used in a prospectus given to potential investors were syndication expenses and had to be capitalized. In Flowers v. Commissioner, 80 T.C. 914 (1983), it was determined that expenditures for tax advice were incurred for purposes of obtaining the tax opinion letter that accompanied organization and sales promotion of limited partnership interests and were non-deductible capital expenditures. In Tolwinsky v. Commissioner, 86 T.C. 1009 (1986), and Law v. Commissioner, 86 T.C. 1065 (1986), it was found that organizational expenses for a motion picture tax shelter were amortizable only to the extent that such expenses were substantiated. In Wendland v. Commissioner, 79 T.C. 355 (1982), aff'd, 739 F.2d 580 (11th Cir. 1984) it was determined that legal expenses paid to a law firm by a coal mining tax shelter partnership constituted organizational expenses that had to be capitalized in the absence of evidence allocating such expenses between legal advice and tax advice. In Johnsen v. Commissioner, 83 T.C. 103 (1984), motion denied, 84 T.C. 344 (1985), rev'd on other grounds, 794 F.2d 1157 (6th Cir. 1986), it was found that a partner could not deduct his share of claimed expenses for legal and tax advice because the evidence showed that the services concerned the organization and promotion of the partnership. In Egolf v. Commissioner, 87 T.C. 34 (1986), it was held that a partnership could not currently deduct organization and syndication costs by indirectly paying them to a partner under the guise of management fees. Since no election was made by the partnership, no amortization of partnership organization expenses was allowed. In Durkin v. Commissioner, 87 T.C. 1329 (1986), the court ruled that payments made by a partnership to two general partners for services were for expenses in connection with organizing the partnership and the offering and such payments were not currently deductible as guaranteed payments. The partnership was entitled to amortize the expenses. In Collins v. Commissioner, 53 T.C.M. (CCH) 873, T.C. Memo. 1987-259, it was found that management and consulting fees paid shortly after the formation of a general partnership were held to be organizational expenses and were required to be amortized rather than currently deducted. Similarly, legal and accounting fees incurred shortly after formation were nondeductible organization and syndication expenses. Rev. Rul. 88-4, 1988-1 C.B. 264, states that the fee paid by a syndicated limited partnership for the tax opinion used in the partnership prospectus is a syndication expense chargeable by the partnership to a capital account and cannot be amortized. #### Argument and Conclusion Syndication expenses have been adjusted as follows: Development contract of $650,000 has been re-characterized as syndication expense, and as such is not includable in either the depreciable basis nor the "qualified rehabilitation expenditures" for purposes of the historic rehabilitation tax credit. The promoter of the examined partnership was "Y" and its related and affiliated entities. Their primary function as sponsor, syndicator, and promoter of the various partnerships they syndicated was necessary to raise the required capital to acquire, rehabilitate, and subsequently place the projects in service. "Y" and its affiliates created an investment package and "trained" various brokers/dealers to sell the units to the ultimate limited partner investors. "Y" had an in-house "Investment Marketing Division" and "Syndications Department" which were responsible for sponsoring, syndicating, and promoting their partnerships. A substantial amount of time was expended to create, syndicate, and market these investment packages or limited partnership units. Additionally, the primary source of compensation for these services are the development contracts as entered into with ABC Historic. It has been determined, for the partnership ABC Historic, that the amounts as specified were attributable to the "syndicating aspects" of the project and as such these costs have been re-characterized to reflect their proper tax treatment. [Note: When an examiner determines costs are syndication expenses and, as a result, reduces the depreciable basis by the amount of such costs, the examiner should be aware that this change in treatment of the costs from depreciable property to nondepreciable property may be a change in method of accounting subject to IRC sections 446(e) and 481. While a full discussion of a change in method of accounting in this situation is beyond the scope of this text, the examiner must become familiar with the rules and exceptions applicable to a change in method of accounting in order to make the proper adjustment.] #### Taxpayer's Position The Tax Matters Partners have indicated they are in agreement with the adjustments as presented on this report. - Return to Table of Contents -