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A sign reads "For lease" at the Market City Center apartment building downtown on Friday, Nov. 16, 2018, in Chattanooga, Tenn. / Staff photo by Doug Strickland

Chattanooga and Hamilton County are in a multi-million-dollar legal battle over a tax incentive agreement with the developers of one of the city's largest downtown developments.

The two governments filed a roughly $1.6 million lawsuit last month against TSO Chattanooga Development, owners of Market City Center, for allegedly violating a tax abatement agreement by operating short-term vacation rentals since last summer.

Last week, the developers denied the allegations, filing a counter-complaint for more than $16 million from the city and county for an alleged breech of contract.

The $30 million development on Market Street came to central Chattanooga in 2017 as a 10-story, mixed-use apartment and retail space. With the promise of new business downtown, the development was heavily courted by the city and offered a payment-in-lieu-of-tax (PILOT) agreement if it maintained 25 affordable housing units.

(READ MORE: Stay Alfred vacation rentals to take up nearly half of Market City Center in downtown Chattanooga)

After struggling to fill both the residential and commercial space, TSO announced its plan to turn 53 of the 125 total units into Stay Alfred vacation rental units, beginning in late summer.

According to city officials, that conversion violates the original PILOT agreement, as the development no longer qualifies as a "multi-family residential project" under state law.

"The current use of this property for three floors as a hotel is in direct violation of the PILOT agreement and state law," the lawsuit filed by the city and county last month asserts.

In the filing, the city and county call for a judge to declare the PILOT agreement void, prohibiting any further tax relief under the agreement, which is set to run from 2017-2030.

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Signage for the Market City Center is put into place Tuesday in the 700 block of Market Street. / Staff photo by Tim Barber

The plaintiffs also ask the judge to order defendants to pay around $53,000 in combined 2019 taxes to the city and county, and somewhere between $1-1.6 million to the two governments over the remaining decade of the agreement term.

In a response filed last week, the developers denied the allegations, arguing that by maintaining the 25 affordable housing units they have stayed within compliance of the PILOT, even with significant use changes to the property.

The response further states that if the short-term rentals or general use change do violate the original agreement, it's because of a lack of clarity, not a willful violation of the agreement.

"If the Plaintiffs' theory of the case is correct, TSO was mistaken in its belief that the PILOT agreement allowed TSO to take any and all necessary steps to fill the vacant units at the Project," it reads. "As vacancy in the first few years is a primary concern of new residential construction like the Project, TSO would not have agreed to enter into the PILOT Agreement if it had known about the mistake and would have simply constructed the facility based on the original plans featuring only seven floors."

In addition to calling for the complaints against them to be dismissed and their related expenses to be compensated by the city and county, the developers filed a counter complaint asking for more than $16 million from the city and county for breech of contract and promissory estoppel, making the case that the original lawsuit illegally goes against the original agreement.

No response to the counter-complaint had been filed as of Friday.

Attorneys for the city and county did not respond to requests for comment on Friday.

Attempts to reach representatives of the development group were unsuccessful.

Contact Sarah Grace Taylor at staylor@timesfreepress.com or 423-757-6416. Follow her on Twitter @sarahgtaylor.

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