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Petaluma is preparing to sue the state in an effort to retain millions of dollars in redevelopment funds the city targeted for three major road projects — including one under construction.

At stake is about $38 million the city had been counting on from property taxes collected through its former Redevelopment Agency. The Legislature abolished redevelopment agencies throughout the state last year and has staked a claim to the tax receipts to supplement the state budget.

Former redevelopment agencies locally and statewide have been arguing with the state Department of Finance for the past several months over which planned redevelopment projects constitute "enforceable obligations." Funding for those the state deems not under contract is taken by the state.

In Petaluma, the state has denied about $15 million in funds directed toward two Highway 101 interchange projects: East Washington Street, which has been under construction for weeks, and Old Redwood Highway, which is ready for bid.

It also denied $7.5 million that Petaluma earmarked for the Rainier Avenue cross-town connector project.

The state rejects Petaluma's arguments that its signed agreements with Caltrans and the Sonoma County Transportation Authority, which administers local transportation tax money, constitute enforceable contracts.

"We're very, very close to filing a lawsuit," City Manager John Brown said. "Our concerns as expressed to the Department of Finance have gone ignored."

First, the city is expecting a third denial and is proceeding through legally required administrative appeals.

"But given the reception from the department to our arguments thus far, I don't see that bearing a lot of fruit," Brown said.

City Councilman Mike Healy, chairman the city's oversight board — the group that is overseeing the winding down of redevelopment business — said the city is basically going through the appeals motions.

"We may need to exhaust those with a futile face-to-face meeting before we can take it to court," he said. "We'll drive to Sacramento. They'll give us half an hour."

About half of the $4 million in redevelopment funds that the city set aside for the East Washington project has been spent. The city approved the project in 2005. It's unclear where the city would come up with that $2 million if the state's position holds.

The state has also denied more than $11 million of $15 million in redevelopment money that Petaluma had earmarked for the $41.5 million Old Redwood Highway redesign.

That project was identified as a redevelopment priority in 2003. Its construction plan also includes $21.4 million in Measure M county sales tax proceeds and $4.6 million in state funds.

It is the position of the state officials that the law passed by the State Legislature and signed by the governor last year allows redevelopment agencies to retain only those funds covered by enforceable legal contracts, such as construction contracts and bond obligations, and that agreements between governmental agencies general do not qualify.

However, City Attorney Eric Danly said the city believes the Department of Finance "lacks the legal authority to challenge the city's obligations with respect to these three interchange projects."

"We have asked that they relay to us ... any information that suggests we might resolve this issue short of litigation," he said, and they have received no response.

The state has also denied approximately $14 million Petaluma planned to use for the Petaluma River bike trail, a loan for work at the city's marina, affordable housing programs, administration, planning and more.