New Markets Tax Credits: The Next Tool for Community Development Financing

What is potentially the most significant federal economic development incentive in a generation is ready to debut. The Treasury Department's Community Development Financial Institutions (CDFI) Fund plans to open the competition for New Markets Tax Credits on $2.5 billion in investments this spring. The CDFI Fund will allocate the tax credits on a total of $15 billion by 2007.

Enacted in December 2000 as new tax code section 45D, the New Markets Tax Credit 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 New Markets Tax Credits Will Work

New Markets Tax Credits are available to individual and corporate taxpayers who make qualified equity investments in community development entities (CDEs), which in turn will use the proceeds for at least seven years to make loans and investments in businesses located in low-income communities.

Essential components of the new tax code are:

1. Community Development Entities (CDEs).

The CDFI Fund has already started certifying CDEs to participate in the program. A CDE must have a primary mission of 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. The CDFI Fund must certify all CDEs. However, certified CDFIs and specialized Small Business Investment Cos. will automatically qualify. CDEs can be corporations or partnerships. For example, a nonprofit organization could form a subsidiary, partnership or limited liability company to act as a CDE. A CDE can meet the community accountability requirement through its controlling parent organization.

2. Allocation of tax credit authority.

The CDFI Fund will allocate New Markets Tax Credits. The volume of New Markets investment starts at $2.5 billion this year, $1.5 billion in 2003, $2 billion annually in 2004-05 and $3.5 billion annually in 2006-07. Unallocated authority may be carried over through 2014. Priority for allocations will go to CDEs either: (a) with a successful community development track record (directly or through a controlling parent); or (b) intending to invest in unrelated businesses. The fund also may add other allocation preferences and will probably ask CDE applicants for a comprehensive business plan.

3. Tax credit amounts.

Investors will receive tax credits on the basis of the amount of their equity investment in a CDE. Tax credits are claimed during a seven-year period, 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 Dec. 31, 2000.

4. 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 New Markets 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.

5. How CDEs will finance economic development.

A CDE can use New Markets 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, or finance an independent business. A CDE must use 85 percent of the New Markets investment proceeds for these purposes.

6. Eligible businesses and communities.

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

7. Recapture.

Investors risk losing the tax credit if: (a) substantially all of the cash proceeds are not used 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. The fund has written rules for curing violations within a reasonable period to prevent unwarranted recaptures.

What New Markets Can (and Cannot) Do

Understanding what the New Markets Tax Credit can and cannot do is the first step to making the most of this new tool.

New Markets 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 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.

However, the tax credits will not directly reduce investment risks substantially. Moreover, New Markets offers a much shallower subsidy than housing credits. The New Markets Tax Credit is worth about 30 percent of the investment made, in present value terms. By comparison, the housing credit generally has a present value of up to 70 percent and up to 91 percent in distressed and high-cost areas. In addition, the housing credit is based on the cost of building the housing, not on the amount invested. That means the housing credit alone can drive an investment. In contrast, New Markets Tax Credits are based on the amount invested in a CDE. Further, unlike housing credits, the New Markets credits claimed will reduce the investors' basis, exposing investors to additional capital gains liability when they terminate their investments.

That means that New Markets investors will need substantial cash flow and capital recovery/ appreciation, in addition to the tax credits, to generate a reasonable return. The New Markets Tax Credits will not turn a bad business into a good investment, but they can make the difference for many economic development activities that would otherwise be only marginally profitable.

Additional Information

More information, including guidance on how to qualify to participate in New Markets and temporary IRS tax regulations, is available from the CDFI Fund at www.cdfifund.gov/programs/nmtc/index.asp. A more detailed description and analysis of how the New Markets Tax Credit will work is available from LISC at www.newmarkets.org/section/lisc_newmarkets/faq.