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New Markets Tax Credits: The next tool for community-development financing

Buzz Roberts, vice president for policy at Local Initiatives Support Corporation, explains how the New Markets Tax Credit will work and what this new financing tool can and cannot accomplish.

August 1, 2001


Buzz Roberts Vice President for Policy, LISC

New Markets Tax Credits: The next tool for community-development financing

In December 2000, the Community Renewal Tax Relief Act of 2000 was signed into law. The act includes the New Markets Tax Credit, a new community development tool that will provide tax credits for corporations that invest in certain entities. In the following article, Benson F. "Buzz" Roberts, vice president for policy at Local Initiatives Support Corporation, explains how the New Markets Tax Credit will work and what this new financing tool can and cannot accomplish.

The New Markets Tax Credit (NMTC) program has the potential to transform the financing of economic development in low-income communities, much as Low-Income Housing Tax Credits (LIHTCs) have done for affordable rental-housing development. NMTCs are authorized for a total of $15 billion in private investments by 2007, starting with $1 billion this year. The NMTC program promises to bridge financing gaps; create new partnerships among investors, communities, businesses and government; and generate jobs, services and physical revitalization in distressed urban and rural areas.

How NMTCs will work

NMTCs are available to equity investors in "community development entities" (CDEs), which in turn will use the proceeds to make loans and investments in businesses located in low-income communities.

A CDE must have a primary mission of community development, pursued by serving or providing investment capital for low-income communities or persons. It must maintain accountability to residents of low-income communities through representation on a governing or advisory board. CDEs can be corporations or partnerships. Only for-profit CDEs can apply for allocations of NMTCs, but a nonprofit organization could form a for-profit subsidiary, partnership or limited liability company to act as a CDE. A CDE can meet the community accountability requirement through its controlling parent organization. The U.S. Department of the Treasury (Treasury Department) must certify all CDEs. However, certified Community Development Financial Institutions (CDFIs) and Specialized Small Business Investment Companies will automatically qualify.

The Treasury Department's CDFI Fund will allocate NMTCs. The volume of NMTC investment starts at $1 billion in 2001 and rises to $1.5 billion annually in 2002-3, $2 billion annually in 2004-5 and $3.5 billion annually in 2006-7. Priority for allocations will go to CDEs that either a) have a successful community development track record, directly or through a controlling parent; or b) intend to invest in businesses unrelated to the CDE. The Treasury Department may also add other allocation preferences, and is expected to ask applicant CDEs for a plan for generating public benefits.

Investors will receive tax credits based on the amount of their equity investment in a CDE. Tax credits are claimed over seven years, starting on the date of the investment and on each anniversary: 5 percent for each of the first three years and 6 percent for each of the next four years. This stream of credits totals 39 percent, with a present value of about 30 percent. The investor's basis is reduced by the tax credits claimed. Investors may carry back unused credits to years ending after December 31, 2000.

Equity investments can take the form of stock or any capital interest in a partnership and must be paid in cash. The investor cannot acquire a previous investment, except to replace a previous NMTC investor. Equity investments must be made within five years of the tax-credit allocation to the CDE, and the CDE may designate certain investors to receive the tax credits.

"Substantially all" of the investor's NMTC equity investments must be used for eligible purposes. A CDE can use NMTC investment proceeds to provide loans and equity investments to eligible businesses or other CDEs, to purchase from other CDEs loans made to eligible businesses, to provide financial counseling and other services to eligible businesses and to finance its own eligible businesses. For example, a CDE could develop and operate commercial real estate, such as a shopping center. The Treasury Department will define "substantially all."

A wide range of businesses is eligible for assistance, including nonresidential real estate and nonprofit businesses, and several tests are designed to ensure that they operate primarily in eligible communities. However, some businesses, such as rental-housing operations, are explicitly excluded. Eligible communities are census tracts with either a) a poverty rate over 20 percent or b) a median income below 80 percent of the metropolitan area (if applicable) or state median, whichever is greater. The Treasury Department can also approve smaller areas.

Investors risk losing their tax credits if a) substantially all of the cash proceeds are notused for eligible purposes, b) the investor cashes out the equity investment in the CDE within seven years or c) the CDE ceases to be a qualified CDE.

What NMTCs can (and cannot) do

Understanding what NMTCs can and cannot do is the first step in making the most of this new tool. NMTCs can provide a significant boost to rates of return for economic development investors. The tax credits should work to bridge moderate gaps in financing businesses and commercial and industrial real estate development. This can make the critical difference for many ventures that can generate significant cash flow and repayment of capital, but do not have enough funding to get off the ground without some initial help.

However, NMTCs will not directly reduce investment risks substantially. Moreover, NMTCs offer a much shallower subsidy than LIHTCs. NMTCs are worth about 30 percent of the investment made, in present-value terms. In contrast, LIHTCs generally have a present value of up to 70 percent, and up to 91 percent in distressed and high-cost areas.

In addition, LIHTCs are based on the cost of building the housing, not on the amount invested, which means that these credits alone can drive an investment. In contrast, NMTCs are based on the amount invested in a CDE, which means that NMTC investors will need substantial cash flow, capital recovery and capital appreciation, in addition to the tax credits, to generate a reasonable return. Further, unlike housing tax credits, NMTCs claimed will reduce the investors' basis, exposing investors to additional capital gains liability when they terminate their investments. Investors may not use bridge financing for investment commitments.