A recent Internal Revenue Service (IRS) Chief Counsel Advice (CCA) Memorandum (CCA 201537022) clarified the tax treatment of tax increment financing (TIF) reimbursements received by a real estate developer in connection with the construction of infrastructure improvements. This guidance clarifies certain questions related to the tax treatment of TIF reimbursements but leaves several others unanswered.
What is TIF?
TIF is an incentive program authorized by a variety of state statutes that allows municipalities to promote economic development of designated areas and/or property types. TIF subsidies provided to developers are funded by the increase in tax revenue (property tax, sales/use tax, etc.) within a designated TIF district due to the economic activity generated by the developments. The developer will receive reimbursement for eligible expenditures over a period of time pursuant to a promissory note and/or reimbursement agreement. The TIF district or municipality may finance reimbursements through the issuance of bonds based on the anticipated increase in tax revenue.What project costs generally qualify for reimbursement under a TIF?
Since TIFs are authorized pursuant to state laws, they vary in substance and form. For example, these programs may be used to finance public infrastructure, land acquisition, sewer expansion, street construction, and environmental remediation.How can TIFs benefit real estate development projects?
TIFs continue to be useful tools to promote development and increase the economic viability of development projects. For example, a proposed development project in an underdeveloped area might require significant supporting infrastructure improvements, which the municipality may not be able to fund. By employing a TIF, the developer would be more inclined to provide the initial funding for the infrastructure with the expectation of reimbursement from the TIF district. Similarly, development of an area could be on hold due to costly environmental remediation required by federal and state agencies. In that case, the funding provided by the TIF could be sufficient to make a development project commercially viable.Tax reporting of TIFs
On May 29, 2015, the IRS Office of Chief Counsel issued a memorandum regarding the tax treatment of amounts advanced by a taxpayer to fund public infrastructure improvements that were subsequently reimbursed by the municipality. While the CCA doesn’t use the term “tax increment financing” or “TIF,” the reimbursement arrangement described in the CCA is equivalent to a TIF.The taxpayer (an S corporation) in the CCA was in the business of subdividing land and selling parcels to home builders and commercial developers. It acquired a parcel of land with the intention of creating a mixed use development but was required by the municipality to provide public infrastructure, including water, wastewater, and streets, in order to gain approval for its development plans. The taxpayer assisted the municipality in creating a special improvement district, which would provide for the reimbursement of the taxpayer’s infrastructure expenditures. The taxpayer conducted its development activities and provided funding to the district for the infrastructure improvements. At the conclusion of the taxpayer’s development activities, the special district issued promissory notes to the taxpayer with a stated interest rate and a maturity date four years later (the bond anticipation notes).
The taxpayer elected to treat all payments made for public infrastructure improvements as common improvements, and allocated the improvements to the developed lots. In this context, common improvements are real property improvements (e.g., streets, sidewalks, sewer lines) that benefit two or more properties. Accordingly, the taxpayer included the infrastructure costs in the bases of the improved lots within the development.
Following completion of its development activities, the taxpayer began selling lots to builders and commercial developers. In addition, it began to receive payments of principal and interest pursuant to the bond anticipation notes. The taxpayer treated the receipt of principal amounts under the notes as reductions to the bases of the lots that were sold in the year of repayment and subsequent years. Conversely, the taxpayer accrued interest from the notes and reported such income as tax-exempt interest income.
The IRS generally approved of the substance over form treatment of the infrastructure costs as expenditures made to improve properties held for sale versus as advances to the municipality. Accordingly, such costs were appropriately captured in the bases of the lots held for sale. The IRS concluded that the reimbursement of such costs should, therefore, reduce the bases of the properties held for sale at the time of the reimbursement. Reimbursements received after all of the properties were sold must be recognized as ordinary income. However, the IRS also concluded that no portion of any payment received from the special district constituted tax-exempt interest. Thus, all reimbursements, whether stated as principal or interest, must be treated as a reduction to basis (or as ordinary income after all properties have been sold).
How should TIF reimbursements be treated for tax purposes?
The analysis of the memorandum leads to several conclusions. First, reimbursable expenditures made for infrastructure improvements should be treated as common improvements and included in the bases of the properties within the development. Second, reimbursements for infrastructure improvements made pursuant to a TIF note (whether considered as principal or interest) should be treated as reductions to the bases of the underlying properties held by the taxpayer at the time of the reimbursement. Third, to the extent that the taxpayer has already disposed of all of the improved property, the reimbursements for infrastructure improvements are to be treated as ordinary income. Fourth, repayments identified as interest under TIF notes associated with reimbursements for infrastructure improvements should not be considered tax-exempt interest income.Unresolved questions
The guidance provided by the CCA is likely instructive for a number of scenarios involving TIFs. However, a number of related questions appear to remain unanswered, including:- Costs other than infrastructure improvements. The CCA focused on facts involving TIF reimbursement of public infrastructure improvements. However, TIFs may be used to finance a variety of expenditures. The general treatment outlined in the CCA requires inclusion of reimbursable costs in basis of the property being developed, with a subsequent reduction in basis (or inclusion in income after all of the developer’s property has been sold). Is such treatment appropriate in all other situations?
- The sale of the TIF note. The facts presented in the CCA involved the taxpayer continuing to hold the note and receiving related payments from the municipality. What would happen if the taxpayer sold the TIF note? Would the general principles of the CCA be applied to enable the taxpayer to reduce basis of the property being developed by the amount of sales proceeds or would the taxpayer be required to recognize gain on the sale of the note?
- The timing of income recognition. While the CCA indicated that the amounts advanced by the taxpayer to fund public infrastructure improvements should be included in the taxpayer’s bases in the improved lots for sale, it did not discuss under what circumstances, if any, the taxpayer should/can treat the advances as a receivable. Additionally, it’s not clear how such advances should be treated if the property being developed is depreciable. If the taxpayer is required to reduce its basis in depreciable property when reimbursements are received, how does such a reduction impact depreciation and/or certain investment tax credits (e.g., historic rehabilitation tax credits)? Alternatively, if the taxpayer were allowed to treat the advances for improvements as a receivable, how would that change the timing or amounts of income recognized from TIF reimbursements and under what circumstances might a taxpayer prefer to treat the advances as a receivable?
- Application of Section 118. The CCA treated the reimbursement of infrastructure costs as a reduction of basis (or an inclusion in taxable income after all property has been sold). However, in the case of a corporate taxpayer (as was the case in the CCA), receipt of contributions to capital by a non-shareholder may be eligible to be excluded from taxable income in certain situations. Depending upon how the taxpayer structures the transaction, Section 118 of the internal revenue code may produce a similar result to that outlined in the CCA (deferral of income recognition related to the reimbursements and an increase in the subsequent gain on sale of the improvements). Why didn’t the CCA mention Section 118? Also, under what circumstances might the receipt of TIF reimbursements be treated as a contribution to capital by a non-shareholder under Section 118? This is how a grant received by a corporate taxpayer from a municipality would be treated under Section 118.
- Tax-exempt interest. The CCA provides that the purported interest received by the taxpayer was neither interest nor tax-exempt. Rather, the full amount of the payments received by the taxpayer were treated as reductions to basis (or inclusions in taxable income after all property has been sold). Such conclusion appears to be driven by the IRS’s desire to treat the interest components of the reimbursements consistent with the treatment of the “principal” portion of the reimbursements. Consequently, it would appear that the interest component of the reimbursements could be treated as tax exempt interest if the “principal” portion of the reimbursements are properly treated as a receivable from the municipality. However, as discussed above, it’s not clear under what circumstances, if any, a taxpayer should/could treat such advances as a receivable.
In conclusion
TIFs are a common and important form of public financing for use in real estate development projects, but they differ depending on the state and municipality. The recent CCA issued by the IRS Office of Chief Counsel provides guidance for the tax treatment of the incurrence of TIF reimbursable expenditures and the related reimbursement in the case of public infrastructure improvements. However, many additional questions remain unanswered depending on the facts of a particular development project.
Please contact your Plante Moran engagement team or a member of our Housing and Community Development Solutions Group if you’d like to discuss how the tax law applies to your particular situation.
