In CCA 201537022, the IRS Chief Counsel’s office addressed (1) whether a real estate developer could include amounts advanced to a special district to fund common improvements in the tax basis of the developer’s lots, and (2) whether interest on obligations issued by that district and held by the developer would be tax-exempt.  For purposes of this CCA, the IRS Chief Counsel’s office assumed that the special district was a political subdivision.

Most of the CCA involves the first issue. This is not surprising because its author is from the Income Tax & Accounting branch of the Chief Counsel’s office rather than the Financial Institutions & Products branch, which is the group that focuses on issues such as the second issue. However, readers of this blog may find the CCA of interest because of the second issue and the conclusion that, where the district repays the developer’s advances, “[n]o portion of the payments is tax-exempt interest under § 103.”

Before we dive in, the good news is that this CCA probably won’t affect most tax-exempt bond issues because the ruling has some unusual and unique characteristics.


The facts of the CCA may be briefly summarized and somewhat simplified as follows. A developer, which was an S corporation, advanced funds to a special improvement district, which used those funds to build public infrastructure to serve a neighborhood that the developer sought to develop. The special district issued notes to evidence these advances, which were ultimately held by the developer.  The developer elected under Revenue Procedure 92-29 to treat the advances to the special district as common improvement costs, an allocable portion of which was included in the tax basis of each lot that the developer sold.  On the Schedules K-1 that the developer issued to its shareholders, the developer treated accrued interest on the advances as tax-exempt interest under Section 103 of the Internal Revenue Code.  The developer designated the balance of a repayment of an advance as principal, and it reduced its basis in its lots by the amount of any such repayment by the special district.

The developer’s goal, of course, was to ultimately sell the lots. When the developer sells a lot, it must pay tax on its gain. As noted above, when calculating its gain on the sale of the lots in this case, the developer treated those advances to the district as its own costs, even though the advances were used to build public infrastructure, and the developer included a portion of the costs in the tax basis of lots sold by the developer, thus reducing its gain. When the district later made principal payments on the bonds that it issued to the developer, the developer treated the principal payments as a reduction in costs. This decreased the developer’s basis for the lots that the developer sold in the year of repayment and in later years. This had the opposite effect – it increased the amount of gain recognized by the developer on these later lots. The developer treated all  amounts it designated as accrued interest on the obligations evidencing the advances as exempt from federal income tax, and did not reduce the basis of any lots for interest received.


On the first issue, the CCA advises that a developer may include in its basis the cost of so-called “common improvements.” Common improvements are defined by Rev. Proc. 92-29 as “any real property or improvements to real property that benefit two or more properties that are separately held for sale by a developer.” That Rev. Proc. then provides examples of common improvements: “streets, sidewalks, sewer lines, playgrounds, clubhouses, tennis courts, and swimming pools.”

In Herzog Building Corp. v. Comm’r, 44 T.C. 694 (1965), one of the cases that the CCA cites, the developer wanted to build a subdivision, and the village would not permit it unless there was a sewer system. The village told the developer that the only way to get the system built would be to buy tax-exempt revenue bonds from the village, and the developer agreed to this. A construction company that was a related party to the developer then built the sewer system. The Herzog court, citing earlier cases, held that the developer could include the cost of the bonds (in other words, the developer’s advances to the district) in its tax basis in the lots. The court stated in dicta that any amount realized from the bonds would be ordinary income.  The court based its opinion in part on the fact that the bonds were not worth their face value and the fact that the value of the bonds would depend on whether the project was a success. Because the risk was with the developer, the court held it was proper to include the amounts paid to purchase bonds as a part of the basis in the land.

Both Herzog and Hallcraft Homes, Inc. v. Comm’r, 40 T.C. 199 (1963), also cited by the CCA, follow an earlier line of cases where developers would build a common improvement (such as a golf course or a sewer treatment plant) for the purpose of selling lots they owned and would give away full ownership and control of the common improvement, while perhaps keeping some contingent or reversionary rights to control or own the improvement. In the context of these earlier cases, it was fair and logical to allow a developer a means of recovering its cost to build the property once it transferred that property.

But how does this tie into tax-exempt bonds?

Implications and Analysis

There are those words – “[n]o portion of the payments” of “interest” on the advances from the district to the developer would be tax-exempt.  While it appears that this CCA was only intended to apply to the developer (and not to other holders of those obligations issued by the district), it would be helpful if the IRS would clarify this point.

The concept that whether interest is exempt depends on who holds the bond is unusual. In the context of the CCA, the reasoning appears to be based on general tax principles of fairness and accounting. If an amount was counted towards basis of the future lots, and that amount is actually repaid at a future date, then reducing the basis of future lots is a way to even out the income tax consequence (ignoring the time value of money). It is not clear how to reconcile this treatment with how the tax-exempt bond rules operate. Ordinarily, if a bond is tax-exempt, then all interest will be tax-exempt irrespective of who the holder is. This raises questions as to how counsel may opine about a bond, as they will ordinarily not know who holds it.

In some ways, the CCA appears to be addressing questions of debt vs. equity. Although its analysis is couched in the words “substance” vs “form”, the CCA may essentially be arguing that the instrument was equity and not debt. If the “bond” instrument was not likely to be repaid in full, and the developer would therefore not receive the full amounts it had spent, the developer’s advances more closely resemble equity-type costs. Where repayment of such expenditures is uncertain, the inclusion of these expenditures (in the form of advances) as part of the basis of the lots would be consistent with characterizing those expenditures as “equity” invested into the lots.

Bottom line, what this CCA truly means is not clear, but doesn’t seem to affect most tax-exempt bond issues.