Section 42(d)(7) and the Purchase of a LIHTC Project During Construction

A low-income housing tax credit (LIHTC) project can change hands while it is still under construction, before any building has been placed in service. When a distressed project is sold in that posture, the buyer’s federal tax analysis under Internal Revenue Code section 42 turns on whether a credit had already been allowed to the seller. If it had, section 42(d)(7) lets the buyer step into the seller’s shoes, and Revenue Ruling 91-38 supplies the rule for how eligible basis is then determined: the buyer takes the seller’s eligible basis at the time of transfer, plus the buyer’s own includible costs of completing the building. Rev. Rul. 91-38, 1991-2 C.B. 3.¹ This piece addresses that mid-construction purchase from the buyer’s perspective: when section 42(d)(7) applies, how eligible basis is built when it does, and what governs when no credit had yet been allowed.

Scope. This piece addresses the federal income tax treatment under section 42 of a LIHTC project purchased during construction, before the building is placed in service. It does not address the acquisition of a stabilized building that has already been placed in service, which raises the existing-building and inherited-recapture questions this piece sets aside. It also does not address state agency and qualified allocation plan consents, the securities and partnership mechanics of substituting the developer or investor, the seller’s own tax on disposition, or the lender consent, workout, and bankruptcy issues that accompany a distressed transfer.

The threshold question

The short answer is that section 42(d)(7) applies only if a credit was allowed by reason of section 42(a) to a prior owner of the building, and the buyer acquires the building, or an interest in it, before the end of the compliance period. 26 U.S.C. § 42(d)(7)(B). During construction, the compliance-period timing is not the constraint, because that period has not begun. The operative question is the first one: had a credit already been allowed to the seller?

For a project under construction, a credit is allowed to the seller in one of two ways. In a 9% deal, the seller received a carryover allocation from the housing credit agency. § 42(h)(1)(E). In a deal financed with tax-exempt bonds issued after 1989, no separate housing credit allocation is required. § 42(h)(4)(B). Revenue Ruling 91-38 treats the credit as allowed to the seller of such a building when four conditions are met: the tax-exempt obligations have been issued; the building has met the requirements for an allocation of a housing credit dollar amount under the qualified allocation plan applicable to the area in which the project is located, as required by section 42(m)(1)(D); the governmental unit issuing the bonds has determined the credit dollar amount necessary for the financial feasibility of the project and its viability as a qualified low-income housing project throughout the credit period, as required by section 42(m)(2)(D); and the state housing credit agency has assigned a building identification number. Rev. Rul. 91-38. In either case, the ruling confirms that allowed may mean allowable: the seller need not have claimed anything, because during construction it could not have. Id. What is not sufficient is a mere reservation, or a binding commitment to allocate in a later year, because the agency can still revoke it. Id.

If the seller held an allocation or a bond qualification, section 42(d)(7) applies and the buyer continues the seller’s credit.

If no credit was ever allowed to a prior owner, section 42(d)(7) does not apply. A market-rate project that failed before it ever entered the credit program, or a project that applied for but never received an allocation, carries no prior credit for a buyer to continue. In that case the buyer is not stepping into anyone’s shoes. Its credit, if any, is determined under the ordinary rules of section 42(d) for the building the buyer itself places in service. Getting this threshold right is the first and most consequential step, because the two paths produce different basis, different credit amounts, and different exposure.

How eligible basis is built when the buyer steps in

The defining feature of a mid-construction step-in is that eligible basis has not yet been fixed. Eligible basis is determined at the close of the first year of the credit period, and that period does not start while the building is under construction. Revenue Ruling 91-38 addresses this directly. Where a taxpayer that received an allocation transfers a building before it is placed in service, the buyer takes an eligible basis equal to the seller’s eligible basis at the time of transfer, whether the purchase price is greater or less than that basis, and the buyer’s eligible basis is then determined at the end of the first year of the credit period as the sum of the seller’s eligible basis at transfer and any additional costs the buyer incurs after the transfer, to the extent includible. Rev. Rul. 91-38.

Two consequences follow, and both matter to a buyer pricing a distressed deal. First, the purchase price does not set eligible basis. Paying a premium for a troubled project does not create additional credit, and buying at a discount does not reduce it. The seller’s eligible basis at transfer is the starting figure regardless of what changes hands. Second, and unlike the purchase of a completed building, the buyer does add its own costs. A mid-construction buyer that funds the remaining development picks up those completion costs in eligible basis, to the extent they are includible, because basis remains open until the building is placed in service. The step-in during construction is therefore additive in a way that a step-in after placement in service is not.

What counts, and what does not

The costs that build eligible basis, whether incurred by the seller before transfer or by the buyer after it, are the depreciable development costs of the residential rental building. Land is excluded, because eligible basis is limited to property of a character subject to the allowance for depreciation. § 42(d)(4)(A). A prepaid ground lease, being the cost of a leasehold in land, is likewise outside eligible basis, although the building the tenant constructs on the leased land is not.

Financing costs incurred during construction can be included. In 23rd Chelsea Associates, L.L.C. v. Commissioner, the Tax Court held that bond issuance and related financing costs incurred in connection with construction are indirect costs required to be capitalized under section 263A, and are therefore includible in eligible basis, whether the underlying debt is taxable or tax-exempt. 162 T.C. No. 3 (2024); see 26 U.S.C. § 263A(f). That is significant for a distressed project, which will often have carried substantial construction-period interest both before and after the transfer. What does not enter eligible basis is unchanged by the transfer: land and a prepaid ground lease, funded reserves, and amounts that were never spent constructing the building do not become basis merely because they passed through the financing.

The clock the buyer inherits

Stepping into the seller’s shoes during construction means stepping into the seller’s allocation, and the allocation carries deadlines. For a 9% carryover allocation, the building must be placed in service no later than the close of the second calendar year following the year the allocation was made, and the project must have satisfied the 10 percent basis test, meaning the taxpayer’s basis in the project exceeded 10 percent of its reasonably expected basis within the time prescribed after the allocation. § 42(h)(1)(E); see Treas. Reg. § 1.42-6. A buyer acquiring a stalled project must confirm that the 10 percent test was met on the seller’s watch and that the placed-in-service deadline can still be met on the buyer’s, because a missed deadline can forfeit the allocation. For a bond-financed deal, the analogous concerns are the timing of bond issuance and placement in service and the aggregate-basis financing test that supports the credit without an allocation. § 42(h)(4)(B).

Recapture, by contrast, is not the primary concern in a mid-construction purchase, because no credit has been claimed and the compliance period has not begun. The buyer’s exposure is prospective. It must complete the building, place it in service, and comply going forward. That is a different risk profile from the purchase of a stabilized building, where the buyer also inherits recapture exposure for the period before it owned the project.

Why the existing-building rules do not apply here

Because the building has not been placed in service, it is not an existing building, and the restrictions that govern the acquisition of an existing building do not apply. The ten-year rule and the bar on prior placement in service by the taxpayer or a related party, either of which can eliminate acquisition eligible basis, are provisions of section 42(d)(2)(B) and (D) that turn on a prior placement in service. § 42(d)(2)(B), (D). A mid-construction transfer does not itself place the building in service. Under Revenue Ruling 91-38, a transfer results in a new placed-in-service date only if the property is ready and available for its intended purpose at the time of transfer, which a building still under construction is not. Rev. Rul. 91-38. This is one reason the during-construction purchase is analytically cleaner than the purchase of a completed project: the related-party and ten-year questions that often defeat an existing-building acquisition credit are generally not in play.

The two cases compared

Issue	Seller held an allocation or bond qualification	Seller held only a reservation, or none
Section 42(d)(7)	Applies; the buyer steps into the seller’s shoes. § 42(d)(7)(B); Rev. Rul. 91-38	Does not apply; the buyer seeks its own allocation
Eligible basis	Seller’s eligible basis at transfer, plus the buyer’s own post-transfer includible costs; determined at the close of the first year of the credit period. Rev. Rul. 91-38	The buyer’s own depreciable development cost of the building it places in service. § 42(d)(1)
Purchase price	Does not set eligible basis, whether greater or less than the seller’s eligible basis. Rev. Rul. 91-38	Relevant only as it reflects capitalized development cost
Allocation and deadlines	Buyer inherits the carryover allocation, the 10 percent test posture, and the placed-in-service deadline. § 42(h)(1)(E)	Buyer must secure its own allocation or bond qualification. § 42(h)(1), (h)(4)(B)
Land and financing costs	Land excluded; construction-period financing costs capitalized under § 263A included. § 42(d)(4)(A), § 263A(f); 23rd Chelsea	Same treatment of land and financing costs
Recapture	Prospective only; no credit yet claimed and the compliance period has not begun	Prospective only

Big Picture Issues

Three issues recur.

The first is the allocation-versus-reservation line. Whether the seller had been allowed a credit turns on whether the agency actually made a carryover allocation, or qualified a bond deal under section 42(h)(4)(B), rather than merely reserving credit. Rev. Rul. 91-38. The distinction is factual, it depends on the agency’s records, and it decides whether section 42(d)(7) is available at all.

The second is the placed-in-service clock. A project is often distressed in part because it is behind schedule, and the carryover allocation’s placed-in-service deadline runs from the original allocation year, not from the buyer’s acquisition. § 42(h)(1)(E). A buyer should model whether the building can be completed and placed in service within the remaining time, and should examine whether any agency or statutory extension is available, before assuming the allocation survives the transfer.

The third is the treatment of construction-period financing costs. The holding in 23rd Chelsea is favorable to taxpayers, but it is a Tax Court opinion rather than a regulation, the Service has not issued an action on decision, and the holding is contrary to positions the Service had taken in earlier sub-regulatory guidance. 162 T.C. No. 3 (2024). A buyer that capitalizes a stalled project’s construction-period interest into eligible basis in reliance on the decision should understand that posture.

The bottom line

For a buyer acquiring a LIHTC project during construction, the analysis starts with one question: had a credit already been allowed, or become allowable, to the seller? If a carryover allocation or a bond qualification was in place, section 42(d)(7) applies and Revenue Ruling 91-38 governs the basis mechanics. The buyer takes the seller’s eligible basis at transfer and adds its own includible costs of completing the building, the purchase price does not reset basis, and the buyer inherits the allocation and its placed-in-service deadline. 26 U.S.C. § 42(d)(7); § 42(h)(1)(E); Rev. Rul. 91-38.

If the seller held only a reservation, or had not entered the program, section 42(d)(7) does not apply. The buyer is completing a building on which it will seek its own allocation, and its eligible basis is the depreciable development cost of the building it places in service. § 42(d)(1). In either case, land is excluded, construction-period financing costs may be capitalized into basis, and the existing-building restrictions that govern completed projects are generally not implicated, because the building has not been placed in service. § 42(d)(4)(A); § 263A(f); 23rd Chelsea Associates, 162 T.C. No. 3 (2024).

The characterization is driven by facts a buyer can verify before closing: the agency’s allocation records, the project’s basis and placed-in-service timeline, and the state of construction at transfer. Those facts, not the label on the purchase agreement, determine the credit.

Citations

Cases

• 23rd Chelsea Associates, L.L.C. v. Commissioner, 162 T.C. No. 3 (2024) (holding that bond issuance and other financing costs incurred in connection with construction are capitalized under I.R.C. § 263A and includible in eligible basis under § 42, whether the debt is taxable or tax-exempt; the Service has not issued an action on decision).

Statutes

• 26 U.S.C. § 42(d)(1) (eligible basis of a new building is its adjusted basis).
• 26 U.S.C. § 42(d)(2)(B), (D) (existing-building requirements, turning on a prior placement in service: purchase from an unrelated seller, the ten-year rule, and the bar on prior placement in service by the taxpayer or a related party).
• 26 U.S.C. § 42(d)(4)(A) (eligible basis limited to property of a character subject to the allowance for depreciation; land excluded).
• 26 U.S.C. § 42(d)(7) (acquisition of a building before the end of the prior owner’s compliance period; the step-in-the-shoes rule).
• 26 U.S.C. § 42(h)(1)(E) (carryover allocations; the 10 percent basis test; placement in service no later than the close of the second calendar year following the allocation year).
• 26 U.S.C. § 42(h)(4)(B) (buildings financed by tax-exempt bonds; credit available without a separate housing credit allocation).
• 26 U.S.C. § 42(m)(1)(D), (m)(2)(D) (for a bond-financed building, the qualified-allocation-plan requirement and the bond issuer’s determination of the credit dollar amount necessary for the project’s financial feasibility, both of which Rev. Rul. 91-38 folds into the test for when a credit is “allowed” to the seller).
• 26 U.S.C. § 263A(f) (capitalization of interest allocable to property produced during the production period).
• Treas. Reg. § 1.42-6 (buildings qualifying for carryover allocations; timing of the 10 percent basis test).

Secondary Authority

• Rev. Rul. 91-38, 1991-2 C.B. 3 (Q&A 4) (property purchased during construction; concluding that “allowed” in section 42(d)(7)(B)(i) may mean “allowable,” that a purchaser acquiring before placement in service takes the transferor’s eligible basis at transfer plus the purchaser’s own post-transfer includible costs, with eligible basis determined at the close of the first year of the credit period, and that a transfer results in a new placed-in-service date only if the property is ready and available for its intended purpose; not superseded by Rev. Rul. 94-57).

Footnotes

1. The interpretations relied on here appear in a revenue ruling, which reflects the Internal Revenue Service’s reading of section 42 rather than a Treasury regulation. In 2024 the Supreme Court discontinued the longstanding practice under which courts deferred to an agency’s reasonable interpretation of an ambiguous statute, the practice commonly called Chevron deference, and the effect of that change on how much weight courts will give agency interpretations of this kind remains unsettled. ↩