Litigating rights of first refusal under IRS Code § 42(i)(7) in federal courts



August 16, 2019

Affordable Housing & Tax Credit Finance Alert 

Author(s): Louis E. Dolan, Jr.

A recent decision out of the Eastern District of New York provides a very effective roadmap for litigating these disputes in federal courts. The decision also suggests some arguments that property developers and investors may advocate in favor of an ordinary, state-law definition of rights of first refusal to protect their property rights.

On August 7, 2019, U.S. District Judge Raymond Dearie, Senior District Judge of the U.S. District Court for the Eastern District of New York in Brooklyn sustained federal question jurisdiction over issues involving IRS Code § 42(i)(7) rights of first refusal (Section 42 ROFRs) in Riseboro Community P’ship Inc. v. SunAmerica Housing Fund No. 682, et al., Action No. 18-CV-7261 (E.D.N.Y.). The action was commenced in state court and revolves around whether Riseboro had validly exercised a Section 42 ROFR without satisfying the requirements set by state law for common law rights of first refusal relating to real property. Defendants removed the case to federal court in part on the basis that the issues involved raised important federal questions regarding Section 42 ROFRs. Judge Dearie denied plaintiff’s motion to remand the action back to state court.

Even though the complaint purported to assert only state-law causes of action for breach of contract and declaratory judgment, Judge Dearie ruled that the plaintiff’s allegations squarely presented an “embedded” federal question relating to Section 42 ROFRs; the question rendered the suit an action (i) “arising under the . . . laws . . . of the United States,” within the meaning of the statute granting federal courts jurisdiction to decide federal questions, 28 U.S.C. § 1331, and (ii) “arising under any Act of Congress providing for internal revenue . . .” within the meaning of 28 U.S.C. § 1340. Judge Dearie’s decision appears to be the first to address and decide that federal question jurisdiction applies to disputed interpretations of a Section 42 ROFR.

Judge Dearie applied the test from Grable & Sons Metal Prods, Inc. v. Darue Eng’g Mfg., 545 U.S. 308, 312 (2005) and Gunn v. Minton, 568 U.S. 251, 258 (2013). Under this test, federal question jurisdiction exists over state-law claims if the federal issue is (1) necessarily raised, (2) actually disputed, (3) substantial, and (4) capable of resolution in federal court without disrupting the federal-state balance approved by Congress. Judge Dearie was persuaded that the following salient facts supported federal jurisdiction:

  • The complaint acknowledged that plaintiff could not prevail in its interpretation of its Section 42 ROFR if the ordinary, state-law definition of such rights applied. Therefore, the interpretation of Section 42(i)(7) was necessarily raised and actually disputed.[1]
  • The opinion by the Supreme Judicial Court of Massachusetts in Homeowner’s Rehab, Inc. v. Related Corp V SLP, L.P., 479 Mass. 741 (2018) relied exclusively on federal sources of law—specifically, IRS Code § 42—and departed from its own state law governing rights of first refusal. Riseboro’s complaint essentially relies on similar grounds to depart from New York common law.
  • While the wording of any given Section 42 ROFR may vary from case to case, the interpretation of IRS Code § 42(i)(7) would not vary. According to Judge Dearie: “The correct construction of 26 U.S.C. § 42(i)(7) and how it differs from a common law ROFR is a purely legal question that is substantial and will be applicable to many other [Low-Income Housing Tax Credit (“LIHTC”)] agreements nationwide that provide for a ROFR under 26 U.S.C. § 42(i)(7).”
  • The fact that there are already two inconsistent interpretations of IRS Code § 42(i)(7), one in Homeowner’s Rehab, 479 Mass. 741, and another in Senior Housing Assistance Grp. v. AMTAX Holdings 260, LLC, 2019 WL 687837, at *1 (W.D. Wash. Feb. 19, 2019) is evidence that the federal question is substantial and is national in scope.
  • The LIHTC program “is a creature of federal law that accords favorable tax treatment to investments in low-income housing by providing tax credits to offset significant tax liabilities.” While state courts may be a traditional forum for breach of contract claims, “‘(they are) not the traditional forum for interpretation of federal tax laws.’” Decision-Order at 12 (quoting New York ex rel. Jacobson v. Wells Fargo Nat’l Bank, N.A., 824 F.3d 308, 318 (2d Cir. 2016)).
  • The availability of federal question jurisdiction under 28 U.S.C. § 1340 “demonstrates that Congress intended disputes involving federal tax statutes to be heard in federal courts.” Therefore, a decision in favor of federal jurisdiction would not disturb the federal-state balance approved by Congress.

Implications

Judge Dearie’s decision represents an important development for disputes arising under IRS Code § 42(i)(7). Judge Dearie’s adoption of a “federal question” framework for such disputes clarifies the status and persuasive force of other decisions in this area. For example, in Massachusetts, the precedential authority of Homeowner’s Rehab, 479 Mass. 741 may be limited if other courts agree that the construction of a Section 42 ROFR is an issue of federal law.

Two general legal principles could come into play. First, when a state statute or legal rule is at issue, both state and federal courts must follow the rulings of that state’s highest court. See Johnson v. Fankell, 520 U.S. 911, 916 (1997). When there is no definitive ruling by the state’s highest court, it is the duty of a federal court to determine how the state’s highest court might rule, with proper regard for the decisions of intermediate and inferior state and federal courts. In re Thelen LLP, 736 F.3d 213, 219 (2d Cir. 2013), certified question accepted sub nom. Thelen LLP. v. Seyfarth Shaw LLP, 22 N.Y.3d 1017 (2013), and certified question answered, 24 N.Y.3d 16 (2014). Second, when a federal statute is at issue, federal and state courts must follow the construction adopted by the U.S. Supreme Court, if there is one. See James v. City of Boise, Idaho, 136 S. Ct. 685, 686 (2016). Otherwise, the construction adopted by a U.S. Court of Appeals is controlling and binding upon subsequent panels and U.S. District Courts within the same circuit, and such construction is persuasive upon other U.S. Courts of Appeal, U.S. District Courts within other circuits, and state courts. See U.S. v. Walker-Couvertier, 860 F.3d 1, 8 (1st Cir. 2017) (discussing the binding authority of U.S. Court of Appeals decisions within the same circuit). Decisions by a U.S. District Court, such as Senior Housing Assistance Gr. from the Western District of Washington, do not have any binding force, even within the same District. Fishman & Tobin, Inc. v. Tropical Ship. & Const. Co., Ltd., 240 F.3d 956, 965 (11th Cir. 2001).

Under these principles, a decision of the Massachusetts Supreme Court may bind a federal court applying Massachusetts law, if the decision construed a Massachusetts statute or legal rule. But not if the Court has construed a federal statute. See Portalatin v. Graham, 624 F.3d 69, 84 (2d Cir. 2010) (holding that a U.S. Court of Appeals would “not defer to [the New York highest court’s] interpretation of federal law”). In this light, the Homeowners Rehab decision may be reasonably questioned within Massachusetts and in other jurisdictions. The Massachusetts Supreme Court directly construed a federal statute (Section 42). Therefore, it may be argued, even within Massachusetts, that Homeowners Rehab is not binding precedent with respect to the interpretation of Section 42, although the decision otherwise applied state-law contract principles. The federal question framework also appears to invite arguments concerning the special considerations that apply to the interpretation of a federal statute through judicial rulemaking, especially if a disputed interpretation would displace existing state law.

In sum, Judge Dearie’s decision concerning federal question jurisdiction is an important development for understanding the impact of prior cases involving Section 42 ROFRs. The decision also implies that litigants should advance arguments about how a federal statute should be construed, and the special considerations that might apply when a party seeks to displace more general state law through its interpretation of a federal statute.


  1. More specifically, Judge Dearie relied on existing case law to find that “Plaintiff’s claims are ‘predicated on . . . violations of obligations rooted exclusively in federal law.’” Decision-Order at 8 (quoting Varga v. McGraw Hill Fin., Inc., 36 F. Supp. 3d 377, 382 (S.D.N.Y. 2014). Judge Dearie also found that the alleged claims “‘necessarily stand[] or fall[] based on a particular application of’ the ROFR provided by 26 U.S.C. § 42(i)(7).” Id. (quoting CWCapital Cobal VR Ltd. v. CWCapital Investments LLC, 2018 WL 2731270, at *3 (S.D.N.Y. May 23, 2018).)
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