Originally published on Passive Activities and Other Oxymorons on April 20th, 2011.
VIRGINIA HISTORIC TAX CREDIT FUND 2001 LP v. COMM., Cite as 107 AFTR 2d 2011-1523
When I consider all the really interesting tax things I write about besides same sex couple issues - breast pumps, soldiers of fortune, strip joints and even World of Warcraft - it is amazing that my second ranked post is a pretty geeky one. Historic Boardwalk Hall addressed the question of whether it was valid to allocate an historic rehabilitation credit to a partner who was investing for a very limited economic return. The Court found that the point of the historic credit was to encourage developments to be done in a way that would be less than economically optimal, but had other social utility. The fact that the development would not otherwise be feasible is the whole point of the credit. The post even got some comments, including a negative one, which I thought was really cool.
At least one commentator has speculated that the more recent decision in Virginia Historic Tax Credit Fund (VHTCF) has emboldened the IRS to appeal the Historic Boardwalk (HB) decision. Apparently they filed the appeal in Boardwalk just after this decision. I'm not a lawyer so the mysteries of litigation strategy are beyond me. With that said, it seems to me that the IRS should not so much be emboldened by winning this case, rather they would have been utterly bereft if they had lost it. The entities are partnerships and they have historic in their name. There is an issue as to whether people were in substance partners. That's about what they have in common. Otherwise they are very different.
VHTCF does not concern the allocation of the federal historic credit. It is about the federal tax effects of dealings in a state historic credit. Many states make their historic credits and film credits freely transferable. It is a fairly convoluted story but this was true of Virginia credits up to a certain point. Subsequent credits though could only be used by owner of the building. The regulations, however, allowed partners in a partnership to allocate the credit any way they saw fit. That is not the way federal credits work.
VHTCF invested in partnerships that generated historic credits and also purchased some of the earlier transferable credits. Investors in VHTCF would receive $1.00 of Virginia credit for every $0.74 - $0.80 that they put in (VHTCF had bought the credits for around $0.55). In a subsequent year they would be redeemed for a nominal amount.
The promoters of VHTCF threw in a clever wrinkle. When they paid for the credits they recorded the amount paid as an expense. The money they received from the investors was considered a capital contribution. So the partnership had a loss. Frankly I get a headache when I try to think through the 704(b) issues that this transaction raises. My guess is that the "losses" were sheltering the promoter's income. If they were being allocated to the investors, I don't think anything very exciting would be happening, except maybe helping the investors stay out of alternative minimum tax. There are several rulings, including PLR 200348002, that hold that when you use a purchased tax credit certificate to offset your state tax, you are entitled to deduct your cost of the certificate under Code Section 164. I don't know what would have been happening from a federal income tax perspective to the VHTCF investors. If you paid $0.80 on the dollar to buy a certificate to apply to your state income tax and from a federal point of view you had a capital loss, that could work out to be a crappy deal unless you were in amt (which it seems almost everybody is nowadays) and had capital gains (which people used to have back in the good old days).
At any rate, the court ruled that what was happening in substance was a sale of the credits and there weren't any losses to allocate to anybody. Although it doesn't rise to the same level, this case has a little in common with some of the Son of Boss shenanigans that I have written about. When you try to put it into debits and credits, it's a little challenging. Bottom line, I don't think it was reasonable to expense the payments that were made for the credits, particularly if the loss was not being allocated to the partners who funded the deduction.
I really don't think there is any connection to the HB scenario. If the IRS were to prevail on HB, it will send shivers not just through the historic rehabilitation business, but also low income housing. In that industry, it is practically a given that the credit is not usable by the players actually doing the development. VHTCF appears to have been an effort to double dip on federal deductions.