The Many (Taxable) Faces of Tax Increment Financing– September 17, 2015 by Mike McGivney

In today's real estate market, large real estate developments and redevelopments are rarely executed without complex layers of debt and equity financing. While nontraditional capital can be obtained from private sources, often a financing gap is bridged by capital provided through federal, state and local governmental programs intended to provide incentives for meaningful economic development in a depressed area. One tool increasingly employed is tax increment financing (TIF).

TIFs have long been used for financing public improvements, such as public infrastructure (streets, utilities, sewers, etc.) but have become increasingly used by private developers to construct nonpublicly owned property. However, when a developer receives proceeds from a TIF bond for private improvements, the tax treatment of those subsidies becomes an immediate issue. Is the subsidy a grant, and, if so, are the proceeds taxable to the developer immediately? And are the increased real estate tax payments fully deductible? Or is the subsidy actually debt, and payments must be trifurcated among real estate taxes, interest and debt reduction? The answers to these questions can have a significant impact, as capital provided by TIFs often can range from $10 million to more than $100 million. Below are three most common tax treatments for TIF financing and what to watch out for.

As a Grant
When exploring grant treatment, you must first determine whether the grant is taxable or nontaxable, particularly with such large amounts of tax dollars at stake. If a taxpayer treats a grant as taxable, it will recognize income under Sec. 61. The taxpayer will use TIF proceeds to acquire, develop, construct or improve property, and the taxpayer's basis in the property will be equal to the amounts expended, thus allowing for cost recovery through depreciation deductions and a higher tax basis upon sale. In addition, over time, the taxpayer will deduct the PILOT payments, or service payments above the base value of a property made in lieu of taxes, as real estate taxes.

Ultimately, a taxpayer will realize a large amount of income in the year the TIF proceeds are received and realize deductions over a long period. If a taxpayer cannot offset this income with losses from other activities, the tax bill for such a transaction may be large and must be covered with funds other than the TIF proceeds. This could make TIFs taxed as grants cost-prohibitive, stopping the project from moving forward.

As a Contribution to Capital
Alternatively, treating the subsidy as a nonshareholder contribution to capital under Sec. 118 would allow the taxpayer to avoid recognizing the receipt of TIF proceeds as income. Although it would also result in a lower basis in the improved property, it is a significantly better result. However, any consideration of excluding TIF proceeds from income immediately raises the question of the applicability of Sec. 118 to the TIF transaction.

Sec. 118(a) states, "In the case of a corporation, gross income does not include any contribution to the capital of a taxpayer." Sec. 118(b) states that a contribution to capital generally "does not include any contribution in aid of construction or any other contribution as a customer or potential customer." Any property acquired with such proceeds characterized as a contribution to capital under Sec. 118(a) will have zero basis under Sec. 362(c)(2), so a taxpayer must forgo depreciation expense on acquired assets and eventually recognize increased gain (or decreased loss) upon final disposition of the property. As with the first alternative of recognizing the proceeds as income, a taxpayer will preserve its deductions for the PILOT payments.

In the case of taxability of subsidy payments received from noncustomers, there is a five-part test to determine whether subsidy payments can be considered contributions to capital:

  1. The contribution must become a permanent part of the transferee's working capital structure;

2. The contribution must not be compensation;

3. The contribution must be bargained for;

4. Any asset transferred foreseeably must result in a benefit to the transferee in an amount commensurate with its value; and

5. The asset transferred ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect.

TIF proceeds seemingly meet each of these five characteristics, so exclusion from income by corporate entities is a strong possibility. However, the major hurdle for real estate developers is that they typically employ noncorporate structures for real estate activities, and Sec. 118 specifically states that the section applies only to corporations.

The question then revolves around the applicability of Sec. 118 to noncorporate taxpayers. Unfortunately, over the past 35 years, taxpayers seeking relief from the IRS on this issue have been met with conflicting rulings, with the current position being very unfriendly to taxpayers. Based on the current IRS position, if a taxpayer-partnership treats TIF proceeds as a nontaxable shareholder contribution, it can reasonably expect the IRS to take a no-compromise position if the issue is raised under audit. Taxpayer prudence is advised, and if a taxpayer (especially an entity taxed as a partnership) claims exclusion from income of the TIF proceeds under Sec. 118, advisers should strongly consider disclosure on Form 8275-R, Regulation Disclosure Statement, to potentially limit penalties.

As a Debt Obligation
A third alternative is to treat the TIF proceeds as a debt obligation. Under Regs. Sec. 1.166-1(c), “A bona fide debt is a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” This treatment will preserve available depreciation deductions. The 13 factors used for determining bona fide debt seem to indicate that TIF obligations could reasonably be treated as debt. This treatment would avoid immediate taxation under Sec. 61 or the uncertainty from a position taken under Sec. 118, especially since the TIF bonds usually require a mortgage and declaration of covenants and conditions to be recorded on the property and an agreement with the county not to sell any real estate tax liens or foreclose on the property prior to the bonds' being repaid in full.

However, other tax and nontax considerations become relevant when recording a TIF as debt. First, any required financial ratio covenants (such as debt service coverage ratios) with other capital sources must be considered. Those calculations should specifically make allowances for the impact of TIF debt and debt service on the balance sheet and income statement. Second, lease terms with lessors must be considered. Very often, leases allow for the passthrough of real estate tax assessments. PILOT payments must be specifically addressed in lease agreements so that tax and book/GAAP treatment do not affect the economics of a lease agreement and the PILOT payments will be considered recoverable real estate taxes. Third, the application of original-issue discount should be addressed. Finally, while most TIF bonds are taxable bonds, any depreciable property acquired using proceeds from tax-exempt TIF bonds must be depreciated under the alternative depreciation system per Sec. 168(g)(1).

Great care must be taken when considering the tax effects of TIFs. Your advisory team can help you recognize and act on the issues created, while considering the full scope of the transaction and historical treatment of nonshareholder contributions to capital. Despite the tax uncertainties, a TIF is a great tool for developers to leverage public finance capabilities to complete private projects.

Originalarticle written by Michael McGivney and Adam Hill. Copyright 2015. American Institute of CPAs, Inc. All rights reserved. Reprinted with permission from The Tax Adviser. Click here to read the entire article as originally published.

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