New Markets Tax Credits Can Benefit Investors and Stimulate Community Development
Small Business TimesApril 07, 2005
The New Markets Tax Credit (NMTC) program was developed by Congress at the end of 2001 to stimulate investment in low-income communities. The NMTC program provides investors with the opportunity to receive tax credits worth more than 30% of the amount invested in the communities they serve. The tax credits can be used to offset the investor’s federal income tax.
How can you qualify?
To qualify for NMTCs, a taxpayer must make an equity investment in a qualified community development entity (CDE) that has received an allocation of NMTCs from the Community Development Financial Institutions Fund. To date, three Wisconsin-based CDEs have received an allocation of NMTCs: Impact Seven, Inc. ($21 million), Johnson Community Development Company ($52 million), and Wisconsin Community Development Legacy Fund, Inc. ($100 million). The total credit available to the taxpayer equals 39% of the amount invested in the CDE, but is taken over a seven-year period—5% in each of the first three years and 6% in each of the next four years.
In order for a taxpayer to be eligible for the credit, the CDE must invest at least 85% of the taxpayer’s equity investment in qualified low-income community investments. These include equity investments in—or loans to—any qualified active low-income community business (QALICB). A corporation or partnership is treated as a QALICB if it meets certain requirements with respect to its income derived, services performed and tangible property used within a low-income community. A low-income community is any population census tract in which at least 20% of its population is at the poverty level or the area median income is not more than 80% of the greater of the statewide or metropolitan area median income.
Commercial Real Estate
The rental of improved commercial real estate located in a low-income community is considered a QALICB if there are substantial improvements located on the real property. Treasury Regulations issued in December 2004 defined "substantial improvements" as "improvements the cost basis of which equals or exceeds 50% of the cost basis of the land on which the improvements are located and the costs of which are incurred after the date the CDE makes the investment or loan." However, since being issued, this definition was deleted from the final regulations. Until formal guidance is issued, the IRS is expected to respect any reasonable interpretation of the term "substantial improvements" in connection with the development of real property located in a low-income community.
Although still evolving, there are several types of deal structures that developers, lenders and investors can utilize to take advantage of NMTCs in commercial real estate development projects. In a simple structure, the taxpayer makes a direct equity investment in a CDE for a stock interest or an interest in partnership capital, depending on whether the CDE is a corporation or partnership (including a limited liability company (LLC) taxed as a partnership). The CDE then uses at least 85% of the taxpayer’s cash investment to make loans to, or equity investments in, entities that are developing or improving commercial real estate located in low-income communities.
For example, if a taxpayer makes a direct investment of $1 million in a CDE for an equity interest, the taxpayer would receive $50,000 in federal tax credits for each of the first three years and $60,000 in federal tax credits for each of the last four years, provided the CDE makes at least $850,000 in loans to development entities located in qualifying census tracts and all statutory requirements are satisfied throughout the seven-year period.
Notwithstanding whether the CDE makes loans to qualifying businesses or whether the CDE makes equity investments in such businesses, the challenge for a CDE using a simple structure is providing investors with enough of a return on their investment to attract dollars to fund development projects in low-income communities.
If prospective investors are offered only a 5% or 6% annual tax credit during the seven-year credit period, investors will most likely expect to share in the cash flow of the CDE and receive back their initial equity contributions at the end of the seven-year period. CDEs that make low-interest loans often generate only enough interest income to cover operating expenses, leaving little, if any, cash to distribute to investors. Moreover, if the CDE loans or invests only 85% of the taxpayer’s equity investment (the remaining 15% is used to pay for various fees and expenses), the CDE may not have the ability to return to the taxpayer its initial investment, even assuming the CDE is repaid its loans or receives back its equity in full from the QALICBs at the end of the seven-year credit period.
Practitioners have attempted to remedy the pitfalls of the simple structure by using a more elaborate "leveraged structure" in which the tax credit investors invest in a partnership or LLC that in turn invests in the CDE. Under this arrangement, the partnership or LLC, in addition to the dollars contributed by its investors, borrows funds from an outside lender and then makes a qualifying equity investment in a CDE using both the investors’ contributions and the loan dollars. The primary advantage of the leveraged structure is that the investors receive NMTCs on their cash investment plus the portion of the CDE’s equity investment financed through the outside loan, increasing the return to the investors. A leveraged structure also allows lenders who would not otherwise be able to participate directly in a development project to make loans to the partnership or LLC that makes the equity investment in the CDE.
Referring back to the example used for the simple structure, if investors contribute $1 million to an LLC and the LLC then borrows an additional $4 million from an outside lender in order to make a $5 million equity investment in a CDE, the LLC will be entitled to an annual tax credit of $250,000 during the first three years and $300,000 during the last four years. This is assuming that the CDE makes at least $4.25 million in loans to entities that are developing or improving commercial real estate in low-income communities. How the tax credits get allocated to the investors by the LLC needs to be carefully addressed in the LLC’s operating agreement.
In order for the leveraged structure to be effective, the CDE must distribute to the LLC enough cash each year to allow the LLC to pay the debt service on its loan. Presumably, the loan to the LLC would be structured as an interest-only loan during the seven-year credit period. Problems arise when the terms of the loans made by the CDE do not match the terms of the loan made to the LLC, or when borrowers default on the CDE loans. The CDE will also need to purchase/redeem the interest held by the LLC in the CDE at the end of the seven-year period for an amount at least equal to the balance due the outside lender by the LLC. If the investors achieve enough of a return through the tax credits, the LLC will not have to share in the CDE’s excess cash flow and the CDE will not have to return the investors’ initial capital contributions at the end of the seven-year credit period.
Role of Banks and Financial Institutions
Banks and other financial institutions are participating as investors in NMTC projects not only for economic and tax reasons, but also to help satisfy their Community Reinvestment Act credit requirements. Banks are also forming their own CDEs and applying for NMTCs that can be used internally by the bank to subsidize below-market rate loans to developers. The ability of lenders to use tax credits to lower the interest rate on developer loans helps stimulate much needed development in areas that may not otherwise attract investment dollars or the attention of developers.
Success of the Program
Since the inception of the NMTC program, a number of significant development projects have been completed or are in progress around the United States. Developers, investors and lenders are becoming increasingly interested in NMTCs, and CDEs are submitting more and more credit applications to the Community Development Financial Institutions Fund.
The program serves a vital role in stimulating investment in low-income communities. Based on the number of Wisconsin-based CDEs that already have received an allocation of NMTCs, and the new Wisconsin CDEs that will receive an allocation in 2005, there will be plenty of opportunities for developers, investors and lenders to take advantage of NMTCs in commercial development projects in Wisconsin.
Attorney Michael Dwyer is the lead attorney of the firm’s Real Estate Practice Group. He counsels clients in a wide variety of real estate matters, ranging from buying, selling, leasing and financing real estate to private placement syndications.