WASHINGTON -- The tax-exempt status of a multifamily housing bond issue will not be jeopardized if only part of the issue is redeemed with money from the foreclosure sales of seven of the 33 projects that were financed with the bonds, the Internal Revenue Service has ruled.
Bond lawyers said the ruling, which the IRS published yesterday, is favorable to issuers and will be particularly helpful during recessions because it will not force them to sell all of the residential rental projects financed by a tax-exempt multifamily bond issue when only some of those projects are in serious financial difficulties.
They also said the ruling is important because it negates a controversial 1987 private letter ruling in which the IRS reached the opposite conclusion.
An IRS official agreed with the bond lawyers' assessment. "What we did was move away from that 1987 letter ruling. For some time we have thought that that was an overly restrictive interpretation" of tax rules, he said.
In the 1987 ruling, the IRS concluded that bonds would become taxable if they were partially redeemed in an amount equal to a defaulted loan for one of several residential rental housing projects that had been financed with the bonds.
State and local issuers have been troubled for years by the question of whether an entire tax-exempt bond issue must be redeemed if there is to be a foreclosure on some, but not all, of the residential rental projects financed with the bonds.
Bonds issued to finance residential rental property are tax-exempt only if issuers set aside a certain number of the units for low-and moderate-income people.
For years, at least 20% of the units had to be rented to people with incomes of 80% or less of the area's median income. But in the Tax Reform Act of 1986, Congress said issuers had to meet one of two stricter requirements: Either 20% of the units must be occupied by tenants with incomes of 50% or less of median area income, or 40% of the units must be occupied by tenants with ncomes of 60% or less of area median income.
Under Treasury rules, those income limits do not apply to projects when there is no longer compliance with the limits because of unexpected events -- such as foreclosure -- as long as the bonds are redeemed. But the rules do not clarify whether all of the bonds must be redeemed orjust an amount that is in proportion to the foreclosed projects.
In the ruling published yesterday, which did not identify the parties involved, the IRS concluded that a state agency would not threaten the tax-exempt status of its 1985 bond issue by reddeming an amount that was in proportion to the seven projects to be sold through foreclosure.
The IRS said that, while tax rules could be read to imply that an entire bond issue must be redeemed when any single project is sold through foreclosure, "neither the statute nor the legislative history . . . require this reading."
The projects addressed in the ruling consisted of three-and four-story town houses that had been rehabilitated and that qualified for tax-exempt financing because more than 20% of the units were rented to tenants with incomes of 80% of area median income.
The proposed foreclosure sales were prompted by a default of the partnership. The rental money collected was not sufficient to meet debt service payments on the bonds, and in 1989, the trustee bank was forced to draw on a direct-pay letter of credit to make an interest payment and a sinking fund payment that had come due.
The parthership failed to repay the letter-of-credit provider and, therefore, defaulted on its scheduled mortgage loan payments. The bonds did not go into default because money from the debt service reserve fund was used to reimburse the draws on the letter of credit.
A workout plan was devised to save most of the projects, but seven of them were to be sold at foreclosure because of the high-vacancy rates due to drug-related crimes in the vicinity.
The IRS was told that, even without these seven projects, the remaining projects still would meet the original 20% low- and moderate-income set-aside requirement for the entire issue. The IRS also was told that if the workout agreement did not go forward, all the projects would be transferred by deed in lieu of foreclosure. The projects would then be sold, and the set-aside requirements would be eliminated.
But the IRS official said that the favorable outcome of the ruling was not based on these facts.
"It's a very important ruling," said Anthony S. Freedman, a lawyer with the firm of Powell, goldstein, Frazer & Murphy in Washington, D.C.
Howard Zucker, a lawyer with Hawkins, Delafield & Wood in New York City, agreed, saying "This ruling is another indication of the common sense, even-handed approach of the [IRS] to questions that arise with respect to tax-exempt bonds, and I applaud it."