Could taxpayers use Virginia's Historic Rehabilitation Tax Credit subtraction to restore a partnership-interest loss disallowed by the IRS?

Subject

Historic-credit subtraction did not restore disallowed partnership loss

Plain-English summary

Virginia upheld the taxpayers' 2003-2005 assessments because the state Historic Rehabilitation Tax Credit subtraction did not cover their IRS-disallowed partnership-interest loss. The related interest also could not be waived while the tax remained due.

The taxpayers received an allocation of Virginia Historic Rehabilitation Tax Credits through a partnership, sold their interest back to the partnership, and claimed a capital loss that they carried into later federal returns. The IRS disallowed the loss, increasing federal adjusted gross income for the years at issue. Because Virginia begins its individual-income calculation with federal adjusted gross income, the federal adjustment flowed into the Virginia calculation unless a state modification applied.

Virginia's 2012 amendment to Va. Code § 58.1-339.2 F was declaratory of existing law and therefore applied retroactively. But it excluded gain or income recognized from allocating or applying the credits; it did not create a subtraction for a loss on selling a partnership interest that the IRS treated as having no tax basis.

Interest under Va. Code § 58.1-1812 was mandatory. The time taken by the IRS audit did not permit the Commissioner to waive it because the underlying tax assessments were not adjusted.

What this means for you

• A credit-specific Virginia subtraction does not necessarily reverse every federal adjustment connected with the same investment.
• Virginia individual income generally starts with federal adjusted gross income, then applies only authorized Virginia modifications.
• The ruling distinguishes gain from allocating or applying credits from a loss on selling the partnership interest.
• Assessment interest is compensatory and generally remains due when the associated tax is upheld.

Common questions

Q: Was the 2012 Historic Rehabilitation Tax Credit amendment applied retroactively?

A: Yes, but only within its scope: gain or income from allocating or applying the credits.

Q: Did that provision authorize the taxpayers' capital loss?

A: No. The ruling held that it did not apply to the IRS-disallowed loss on the sale of their partnership interest.

Q: Were the 2003-2005 assessments and interest upheld?

A: Yes. The taxpayers were given 30 days from the revised bills to pay without further interest accruing.

Citations and references

• Va. Code §§ 58.1-1821, 58.1-301, 58.1-322, 58.1-339.2 F, and 58.1-1812.
• IRS General Counsel Advice Memorandum AM 2007-002.
• Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 15-34

Original ruling text

March 4, 2015

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter in which you seek correction of the individual income tax assessments issued to your clients, * (the "Taxpayers"), for the taxable years ended December 31, 2003 through 2005.

FACTS

In 2001, the Taxpayers obtained an interest in Virginia Historic Tax Credit Fund 2001 SCP LLC (the "Partnership") and received an allocation of the Partnership's Virginia Historic Rehabilitation Tax Credit (the "Credit"). In 2002, the Taxpayers sold their interest back to the Partnership and reported a capital loss, which they carried forward to their 2003 through 2006 federal income tax returns.

Under audit, the Internal Revenue Service (IRS) disallowed the loss, which increased the Taxpayers' federal adjusted gross income (FAGI) for each of the taxable years at issue. The Department received information from the IRS indicating that the Taxpayers' FAGI had been adjusted. When contacted, the Taxpayers asserted the capital loss deductions were allowable for Virginia income tax purposes based on legislation passed by the General Assembly in 2012. The auditor, however, concluded the legislation did not apply retroactively and assessments were issued.

The Taxpayers filed an appeal, asserting Virginia law permits them to subtract the loss for Virginia income tax purposes. Alternatively, if the Department upholds the assessments of additional taxes, the Taxpayers request that the Department abate the interest because of the amount of time it took the IRS to conclude the audit.

DETERMINATION

Transfer of Credits

In 2007, the IRS released a General Counsel Advice Memorandum that addressed the transfer of state tax credits. See AM 2007-002 (1/26/2007). The IRS determined that the allocation of certain state tax credits to investors by partnerships were sales and therefore taxable at the federal level. The recharacterization of the transaction produced gain for the partnership and increased the partners' distributive share of the partnership's gain. In addition, the IRS opined that because investors in such partnerships should not be considered partners, they have no tax basis in their partnership interests and thus are unable to claim any losses when those interests are sold.

In 2011, the federal Fourth Circuit Court of Appeals confirmed the IRS' characterization of such transactions as deemed sales in a case involving the Credit. See Virginia Historic Tax Credit Fund 2001 LP vs. Comm'r , 639 F.3d 129 (4 th Cir. 2011). The Court, however, declined to decide whether bona fide partnerships existed in that case. Nevertheless, in accordance with AM 2007-002, it appears that the IRS treats the investors as having no tax basis in their partnership interests.

In response to this decision, the General Assembly enacted House Bill 531 (Chapter 92, Acts of Assembly ) and Senate Bill 444 (Chapter 639, Acts of Assembly ) in 2012 to amend Va. Code § 58.1-339.2 to provide that gain or income under federal law from the allocation of Historic Rehabilitation Tax Credits shall not be taxable gain or income for purposes of the Virginia income tax. See Va. Code § 58.1-339.2 F. Because the provision was stated to be declaratory of existing law, the Department will apply it retroactively to transactions occurring before its effective date of July 1, 2012.

Sale of Partnership Interest

Virginia Code § 58.1-301 provides that the terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. For individual income tax purposes, Virginia conforms to federal law in that it starts the computation of Virginia taxable income with FAGI. Income included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Va. Code § 58.1-322.

Virginia Code § 58.1-339.2 F applies only to gain or income recognized from the allocation or application of Historic Rehabilitation Tax Credits. For example, because the act of claiming the credits is treated as a disposition of purchased property, a taxpayer claiming the credits has to report as income the difference between the amount of credits claimed and the cash paid to the partnership. See Public Document (P.D.) 07-82 (5/25/2007). The subtraction applies only to a gain recognized as a result of claiming the Historic Rehabilitation Tax Credits that the IRS deems to have been purchased. The subtraction does not apply to a loss on the sale of a partnership interest that the IRS disallows because the taxpayer is deemed not to have been an investor in the partnership.

Interest

The application of interest to tax underpayment is mandatory under Va. Code § 58.1-1812, and it cannot be waived unless the associated tax is adjusted. Interest is not assessed as a penalty for noncompliance, but represents a fee for the use of money that was properly due the Commonwealth.

The Virginia statute is clear with regard to the assessment of interest. After reviewing all the facts and circumstances presented and the applicable law, the Taxpayers' request for abatement of the interest is denied.

CONCLUSION

Based on the facts presented and the applicable law, the capital loss resulting from the sale of the ownership interest back to the Partnership was disallowed by the IRS. The subtraction described in Va. Code § 58.1-339.2 F was not applicable because that provision applies to the allocation or application of the Credit, not sales of partnership interests. In addition, interest cannot be waived unless the associated tax is adjusted.

Accordingly, the assessments for the 2003 through 2005 taxable years are upheld. Updated bills, with interest accrued to date, will be mailed to the Taxpayers shortly. No further interest will accrue provided the outstanding balance is paid within 30 days from the date indicated on the revised bills.

The Code of Virginia sections and public document cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department's web site. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns
Tax Commissioner

AR/1-5641970318.M