The Abcs Of The New Markets Tax Credits Program
The purpose of this article is to provide an overview of the New Markets Tax Credit Program (the “NMTC”), which is intended to encourage lending institutions and private and public investors to invest in economically-distressed communities. Unlike other tax credit programs, such as the Low Income Housing Tax Credits program whose credits are only available to develop affordable rental housing, the NMTC allows a wider range of investment such as affordable and market-rate for-sale housing, and commercial, retail, office, manufacturing, and industrial developments. From an investment standpoint, the NMTC provides investors with a significant rate of return on its investment. From a business standpoint, the NMTC is extremely useful in providing financing for projects that would otherwise be stalled due to a lack of capital.
The goal of the NMTC, which is part of the Community Renewal Tax Relief Act passed by Congress in 2000, is to encourage private investments in commercial real estate and business ventures in low-income communities in need of revitalization. The NMTC is administered by the Treasury Department’s Community Development Financial Institutions Fund and the Internal Revenue Service under Section 121 of the Community Renewal Tax Relief Act of 2000.
Between 2001 and 2007, the NMTC will have provided investors $15 billion of new markets tax credits, totaling 39 percent of their investment. In order to qualify for these tax credits, investors must make investments through investment vehicles called community development entities (“CDEs”). In turn, CDEs make loans and equity investments to qualified low-income businesses for developing projects in urban and/or rural communities located in qualifying low-income census tracts.
Organizations that have expressed an interest in becoming a CDE have typically included non-profits and/or their subsidiaries; banks, thrifts, and bank-holding companies; and government-controlled entities and/or their subsidiaries. An interested organization must make an application to the Community Development Financial Institutions Fund (the “Fund”), become approved through its certification process, and enter into an “Allocation Agreement” with the Fund setting forth the statutory and regulatory terms and obligations that the CDE must meet in order to maintain its status as a CDE.
To become certified, the CDE must meet the following four requirements. First, it must be a domestic corporation or partnership for tax purposes. Second, its primary purpose must be to invest in qualified active low-income businesses (“Qualified Businesses”) as described later in this article. Third, it must make qualified low-income community investments (“Qualified LIC Investments”) also described later in this article to Qualified Businesses in an eligible community (meaning the community is located within a specified census tract). Fourth, at least 20% of its board of directors must consist of residents of the low-income community it is serving.
Next, the CDE must compete with other CDEs for the tax credits on an annual allocation basis. The Fund awards tax credits based on a CDE’s performance, accountability, and record of success in providing assistance to disadvantaged businesses or communities.
Then, if an award is granted to the CDE, the CDE will be able to receive equity from individual and corporate investors and commit those funds to investments or loans to a Qualified Business. Equity invested in a CDE is considered a Qualified Equity Investment if the investment is acquired by the investor at its original issue solely in exchange for cash to substantially be used by the CDE to make Qualified LIC Investments in a low-income community.
Finally, the individual and corporate investors in the CDE become eligible to claim a 39 percent tax credit, based on the amount of their investment, over a seven-year credit allowance period.
Once a CDE has received the capital proceeds of a Qualified Equity Investment from its investors, it is required to use substantially all of the capital proceeds to make Qualified LIC Investments in Qualified Businesses during the seven-year credit period, which then allows the investors to claim the tax credits over a seven-year period. In general, a Qualified LIC Investment can be:
- Any capital or equity investment in, or loan to, any Qualified Business;
- The purchase from another CDE of any loan made by such entity which is a Qualified LIC Investment;
- Financial counseling and other services specified in statutory regulations to businesses located in, and residents of, low-income communities; and
- Any equity investment in, or loan to, any CDE.
The credit begins on the date in which the investor makes a Qualified Equity Investment in a CDE and continues for a seven-year period. The investors would be entitled to claim tax credits equaling 5% of its Qualified Equity Investment for each of the first three years, and credits equaling 6% for each of the next four years.
In the event the CDE is unable to utilize all of the Qualified Equity Investments issued by the investors for the development project, the investors may be subject to the recapture of all the tax credits issued to date unless the CDE can prove it has used “substantially all” the Qualified Equity Investments. Under the “substantially all” test, the CDE must show that it has used at least 85% of its Qualified Equity Investments in Qualified Businesses for the first six years of the seven-year credit period and 75% of its Qualified Equity Investments in Qualified Businesses in the last year.
THE STRUCTURE OF THE DEAL
The NMTC allows the terms of the deal to be negotiated at the discretion of the CDE and its investors. Although the deal terms may vary, the ebb of the credits and the flow of the equity are structured in two ways.
The Standard Structure
In this scenario, the Qualified Business (the “Borrower”) would typically layer its tax credits deal with a conventional loan(s) made by a lender. The lender would loan money directly to the Borrower and the investors would invest their capital as equity into the CDE. The CDE would then in turn loan the money received from the investors to the Borrower less administrative costs and transactional fees.
The Leveraged Structure
In this scenario, the lender does not loan the money directly to the Borrower. The lender here is an active player in the ebb and flow of the tax credits and equity. Typically, the lender would form an entity with the investor (the “upper-tier entity”), generally a limited liability company. The lender would make a loan to the upper-tier entity and the investor would invest capital in the upper-tier entity. The contributions by the lender and the investor are in turn invested by the upper-tier entity into the intermediary CDE. The CDE then in turn loans the money received from the upper-tier entity to the Borrower less administrative costs and transactional fees.
ON THE BUSINESS SIDE…
Over the past few years, certain business owners have shown an interest in qualifying as a Qualified Business. In order to qualify as a Qualified Business, each Qualified Business must satisfy all of the following requirements. First, at least 40% of the business’ services performed by its employees must be performed in a low-income community. Second, at least 40% of the leased or owned real property used by the business must be located within a low-income community. Third, at least 50% of the total gross income of the business must be derived from the active conduct of a Qualified Business within a low-income community (which may be reduced to 40% if the first two requirements meet a 50% increment level and not the stated 40%). Finally, no more than 5% of the average of the aggregate unadjusted bases of the property of the business can be attributable to nonqualified financial property (e.g., debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities and other similar property).
The NMTC has in its short life span proven to be a worthwhile financial opportunity for businesses, especially start-up businesses that may not necessarily meet the criteria to obtain adequate conventional financing.
However, many businesses are ineligible for tax credit financing. These include businesses involved in:
- The rental of residential real property- if more than 80% of the gross rental income from the development is from dwelling units;
- The rental of unimproved real property;
- Any trade or business consisting mainly of the development or holding of intangibles for sale or license;
- Certain farming operations; and
- Certain “sin businesses” such as massage parlors, gambling facilities and liquor stores.
The NMTC is being utilized in many areas of the country, in particular, California, Washington, and Maryland. In recent months, a developer in California utilized the NMTC to finance for-sale affordable housing. Ideally, more and more developers will take advantage of the tax credits to allow for more expansive mixed-use development projects.
For more information about the NMTC you may visit the Community Development Financial Institutions Fund web site at http://www.cdfifund.gov or contact Stephanie M. M. Smith, Esq. at firstname.lastname@example.org
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Stephanie M. M. Smith, Esq., is an attorney with Clark Hill, PLC, a full-service law firm in the State of Michigan with offices located in Detroit, Birmingham, Grand Rapids, and Lansing. Ms. Smith has extensive affordable housing experience, especially in Michigan and New Jersey, and was instrumental in forming the Community Economic Development Practice Group of Clark Hill, PLC, which is dedicated to representing developers and lenders in the tax credit financing and community economic development arenas.