U.S. Court of Appeals for the Fourth Circuit Decision Threatens to Decrease the Value of State Historic Tax Credits

The Fourth Circuit Court ruling characterized the practice of allocating Virginia state tax credits to investors in a partnership as a “disguised sale” of property that is therefore subject to federal income taxation, as opposed to a distribution of tax benefits among partners. This characterization has significant economic ramifications. If 35% (the normal taxation rate) of an investor’s capital contribution to a project is now being collected by the U.S. Treasury, that reduces the net proceeds (the after-tax amount) to the project by that amount. In the case of a $2 million project, for example, that represents the disappearance of $700,000 in financing ($2 MM x .65). This is a very significant financing gap, especially during the current banking environment where construction financing is very scarce.

In Virginia, developers have the option to utilize the state historic tax credit to defray their own tax liability by an amount equal to 25% of their project’s qualified rehabilitation costs. Or, the developer may form a partnership with investors who can reduce their state tax liability by taking an ownership position in the project in exchange for a capital contribution. . Virginia law allows partnerships to allocate the state historic tax credits among the partners in any manner the partners agree.

The 4th Circuit Court ruled that the allocation of state tax credits by a particular partnership in Virginia represented in fact, the purchase of property by the investor partners, rather than simply an a distribution of tax benefits.  As such, the court found that the credit allocation was actually a “disguised sale” that is subject to federal income taxation at normal rates.

The ability of a developer to “syndicate” state historic tax credits is crucial to the project’s feasibility. Syndicating the credits enables a developer to benefit from the tax credit investor’s equity payments during the course of construction and lease up, rather than when the project is stabilized and tax returns are filed.  

The National Trust joins its preservation partners in the Fourth Circuit and nationwide in calling for the Court of Appeals to reconsider this ruling.  Developers and investors who use state historic tax credits to finance historic rehabilitation projects should not be penalized by the IRS and the courts for relying on a partnership syndication model to access those credits—particularly when that syndication structure is the only one available to them under state law.  The very future of state historic tax credits—in Virginia and elsewhere—may be at stake.