The key to making historic tax credit deals work is the ability of the property owner to “sell” the tax credits to large corporations and very wealthy investors, those most likely to have large state and federal income tax bills.

Federal tax credits, which are awarded by the National Park Service, are worth 20 percent of the overall cost of the project. State historic tax credits, which are awarded by the Virginia Department of Historic Resources, are worth 25 percent.

But there are key differences between federal and state credits.

In cases where the developer cannot use the tax credits, both federal and state law allow the developer to transfer the tax credits to the lessee of the building, or to a “pass-through entity,” usually limited liability companies with multiple partners or shareholders. But the ways the credits are distributed differ quite a bit. Federal credits are allocated based on the shareholder's investment in the company, or the amount of “profits” the shareholders receive. So, for instance, an investment partner with 50 percent ownership receives 50 percent of the federal tax credits.

State tax credits, however, are much easier to transfer. The pass-through entity can allocate the tax credits to partners in ways it deems appropriate. Often, ownership groups are created in which the shareholders own less than 1 percent of the project but receive 99 percent of the tax credits.

This ability to transfer tax credits to partners in such a way has for years invited scrutiny from the federal Internal Revenue Service. In an important case, Virginia Historic Tax Credit Fund 2001 v. the Commissioner of Internal Revenue, the IRS argued that the investment partners in two historic tax credit funds who received state credits weren't really true partners or investors. They, in fact, had become partners — with, collectively, less than 1 percent ownership in the development company — for the exclusive purpose of receiving tax credits.

Because the IRS considered this transaction a “sale,” the suit was an attempt to force the tax credit funds to pay $7 million in underpayments. The U.S. Tax Court, however, ruled in favor of the tax credit funds, ruling that the partnerships followed state law, and that the partners bore some risk — they had to become investment partners before the project is completed to be eligible for the tax credits.

Interestingly, the investment funds targeted by the IRS in that case were structured by real estate developer Dan Gecker, now chairman of the Chesterfield County Board of Supervisors, along with other partners, including fellow developer Robin Miller. Gecker didn't return calls seeking comment for this story. 

Gecker, in fact, helped draft the regulations that ultimately became the three-part application process used by the state Department of Historic Resources in allocating the state tax credits. Once the credits were paid out, Gecker's group bought out the partners for minimal cost, .01 percent of their original investment, or $6,995 for a total investment of $6,995,332. The IRS claimed this proved the sole purpose of the partnership funds were to receive the tax credits, therefore the investment deals were actually “disguised sales” as it relates to the tax code.

“There are in the law, especially in tax law, there are certain fictions, if you will, that are respected and the Congress and the General Assembly of Virginia both understood these fictions and validated the tax credit code,” explains real estate attorney Rick Gregory. In other words, it's clear the investment partners are in it only for the tax credits, but everyone knew that was the case when the laws were passed.

There's a simpler way, of course: Just hand over the money. “It's a tax credit to stimulate historic rehab. Why don't they just hand the money to the developer?” Gregory argues. It makes some sense. Since few are rich enough to actually use the credits outright, the only way to take advantage of them it to sell them to large corporations and the superrich.

“When Congress says let's create a tax credit, he forgets all about all the things in the tax code,” Gregory says. “It would put tax lawyers out of business, but the government's going to spend that dollar anyway.”

Correction: In earlier version of this story, we incorrectly reported that Dan Gecker drafted “state legislation” that created the tax credit program. Gecker, according to court documents, drafted the regulations for obtaining the tax credits. “Daniel Gecker … drafted, for DHR committee review and approval, the Historic Rehabilitation Program regulations. The regulations establish a three-part process for obtaining DHR certification of historic rehabilitation projects,” according to an court documents filed June 21 in U.S. Court of Appeals for the Fourth Circuit.