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Volume 1, Issue 2, 2001   Federal Reserve Bank of Dallas

New Markets Tax Credits
The Next Tool for Community Development Financing


New Markets Tax Credits may be used to help finance economic development projects, including shopping center developments in low- and moderate-income neighborhoods 

By Buzz Roberts, Vice President of Policy
Local Initiatives Support Corp.

The New Markets Tax Credit (NMTC) has the potential to transform the financing of economic development in low-income communities much as the Low Income Housing Tax Credit (LIHTC) has done for affordable rental housing development.

Enacted last December as new tax code sec. 45D, NMTCs are authorized for a total of $15 billion in private investments by 2007.

The NMTC 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. New Markets Tax Credits may be used to help finance economic development projects including shopping center developments in low- and moderate-income neighborhoods.

How New Markets Tax Credits Will Work

The Treasury's CDFI Fund will allocate NMTCs to community development entities (CDEs). Equity investors in CDEs will receive tax credits for their investment. The CDEs will use the equity investments to make loans or investments in Qualified Active Low-Income Community Businesses or CDEs or provide financial counseling or other services to eligible businesses.

Community Development Entities. A CDE must have a primary mission of community development, evidenced by serving or providing investment capital for low-income communities or people. It must maintain accountability to residents of low-income communities through representation on a governing or advisory board.

The CDFI Fund must certify all CDEs. Certified community development financial institutions and Specialized Small Business Investment Companies will qualify as CDEs.

CDEs can be nonprofit or for profit, but only for-profit CDEs are eligible to apply for tax credit allocations from the CDFI Fund. For example, a nonprofit organization could form a for-profit subsidiary, partnership or limited liability company to act as a CDE and apply for tax credit allocations. A CDE can meet the community accountability requirement through its controlling parent organization.

Allocation of Tax Credit Authority. The CDFI Fund will allocate NMTCs. The volume of tax credit-generated investment starts at $1 billion in 2001 and rises to $1.5 billion annually in 2002 and 2003, $2 billion annually in 2004 and 2005, and $3.5 billion annually in 2006 and 2007. Unallocated tax credit authority may be carried over through 2014.

Priority for allocations will go to CDEs that:

  • have a successful community development track record (directly or through a controlling parent), or
  • intend to invest in businesses in which unrelated parties hold the majority equity interest.

The CDFI Fund may also add other allocation preferences and will probably ask applicant CDEs for a plan for generating public benefits.

Tax Credit Amounts. Investors will receive tax credits based on the amount of their equity investment in a CDE. They can claim tax credits over seven years, starting on the investment date and then on each anniversary. The credits are 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.

Qualified Equity Investments in CDEs. 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. The CDE may designate certain investors to receive the tax credits.

Ways CDEs Can Finance Economic Development. A CDE can use NMTC proceeds to:

  • provide loans and equity investments to eligible businesses or other CDEs,
  • purchase from other CDEs loans made to eligible businesses,
  • provide financial counseling and other services to eligible businesses, or
  • finance its own eligible businesses. For example, a CDE could develop and operate commercial real estate, such as a shopping center.

A CDE must use "substantially all" of the NMTC investment proceeds for these purposes. The CDFI Fund will define "substantially all," including any allowances for administrative expenses, loss reserves, initial ramp-up period for placing investments and final wind-down period for recovering investments. A CDE must trace how it uses tax credit investments for eligible purposes if less than 85 percent of its gross assets are so invested.

Eligible Businesses and Communities. A wide range of businesses operating in eligible low-income communities may receive CDE investments or loans, including nonresidential real estate and nonprofit businesses. However, some businesses are explicitly excluded, such as those operating rental housing, liquor stores or gambling facilities.

Eligible communities are census tracts with either a poverty rate over 20 percent or a median income below 80 percent of the metropolitan area (if applicable) or of the state, whichever is greater. The CDFI Fund can also approve smaller, low-income areas.

Recapture. Investors risk losing the tax credits if:

  • substantially all the cash proceeds are not used for eligible purposes,
  • the investor cashes out the equity investment in the CDE within seven years, or
  • the CDE ceases to be a qualified CDE.

The CDFI Fund will write rules for curing violations within a reasonable period to prevent unwarranted recaptures.

What NMTCs Can (and Cannot) Do

Understanding what NMTCs can and cannot do is the first step toward making the most of this new tool.

NMTCs can provide a boost to rates of return for economic development investors. The tax credits should help bridge moderate gaps in financing businesses and commercial and industrial real estate development. Tax credits can make the critical difference for the many ventures that can generate significant cash flow and repayment of capital but not enough to get off the ground without some initial help.

NMTCs will not, however, substantially reduce investment risks. Moreover, NMTCs offer a much shallower subsidy than Low Income Housing Tax Credits. The NMTC is worth about 30 percent of the investment made, in present value terms. In contrast, the LIHTC generally has a present value of up to 70 percent, and up to 91 percent in distressed and high-cost areas.

In addition, the LIHTC is based on the cost of building the housing, not on the amount invested. That means the LIHTCs alone can drive an investment. NMTCs, on the other hand, are based on the amount invested in a CDE. The NMTCs' relatively modest size means that activities financed will generate sufficient economic benefits¾ cash flow and capital recovery/appreciation¾ to attract investors.

Furthermore, unlike LIHTCs, the NMTCs claimed will reduce the investment's basis, exposing investors to additional capital gains liability when they terminate their investments.

Next Steps

On April 20, the Treasury's CDFI Fund issued guidance on the NMTC application process, CDE certification process and other rules governing use of the tax credits. The IRS also issued an advance notice of proposed rulemaking.

The guidance is on the Treasury Department's Community Development Financial Institution Fund's web site at www.cdfifund.gov Off-site page.


You can find Local Initiatives Support Corp. online at www.liscnet.org Off-site page


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e-Perspectives, Volume 1, Issue 2, 2001

Federal Reserve Bank of Dallas Off-site page
Community Development Office Send an e-mail
P.O. Box 655906, Dallas, Texas 75265-5906
214-922-5377
Gloria Vasquez Brown Send an e-mail
Vice President
    Nancy C. Vickrey
Assistant Vice President and
Community Development Officer
Toby Cook
Community Development Specialist
    Jackie Hoyer Send an e-mail
Houston Branch
Senior Community Development Advisor
Diana Garza
Community Development Specialist
     
The views expressed are the authors' and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System. Articles may be reprinted on the condition that the source is credited and a copy is provided to the Community Development Office.

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