New Market Tax Credits (I.R.C. § 45D)

November 16, 2009

The Players:

  • CDE: Community Development Entity.
  • CDFI Fund: Authorized by Treasury to allocate to CDEs the authority to issue to their investors up to the aggregate amount of equity as to which NMTCs may be claimed.
  • NMTCs: Credits the CDE may allow to investors of qualified equity investments.
  • Treasury: Manages the CDFI Fund.

The Basics:

An investor who makes an investment to acquire stock or equity in a CDE may take certain tax credits (the “NMTCs”) so long as the investment constitutes a “qualified equity investment” (“QEI”). The credit provided to the investor total 39% of the cost of the investment and is claimed over a seven year period. In the first three years, the investor may claim 5% per year. In the remaining four years, the investor may claim 6% per year.  The NMTCs can be subject to RECAPTURE!

For the investment to remain a QEI, the (1) CDE must use (2) substantially all of the proceeds from the (3) QEI to make (4) QLICIs in (5) QALICBs located in (6) LICs:

  1. CDEs: (a) Must have a primary mission of community development, (b) Maintain accountability to LIC representatives through at least 20% representation on the CDE governing or advisory board, (c) Must be certified by the CDFI Fund, (d) Must be a domestic corporation or partnership including a multiple member LLC.
  2. Substantially All: (a) 85% of QEI must be invested in QLICIs (tested annually), (b) 12 months to invest QEI or to reinvest nonscheduled QLICI repayment, (c) Issuance costs and CDE overhead are not included in the “substantially all” requirement, (d) Up to 5% loan loss reserves do count toward QLICIs.
  3. QEI: (a) Must be investment in CDE, (b) Either stock or capital interest, (c) Acquired at original issue solely in exchange for cash, (d) Substantially all of such cash must be used to make QLICIs, (e) CDE must designate the investment as a QEI and provide notification of designation to investor and CDFI Fund.
  4. QLICIs (Qualified Low Income Community Investment): (a) Any capital or equity investment in, or loan to, any QALICB, (b) The purchase of qualifying loans from another CDE, (c) Financial counseling and other services to businesses located in, and residents of, LICs, (d) Any equity investment in, or loan to, another CDE to the extent the second CDE uses the proceeds as described in paragraphs (a) through (c).
  5. QALICBs: Any corporation or partnership (and LLCs including nonprofits) engaged in the active conduct of a qualified business that meets the following requirements:
    1. Gross Income Test: At least 50% of the total gross income is derived from the active conduct of a qualified business within an LIC. This test is met if the entity can meet the tangible property or services test using 50%;
    2. Tangible Property Test: At least 40% of the use of the tangible property (owned or leased and on a cost basis) of the business is within any LIC;
    3. Services Test: At least 40% of the services performed for the business by its employees is performed in any LIC. If business does not have any employees, it can meet the Gross Income and Services Tests if it meets the Tangible Property Test at 85%;
    4. Collectibles Test: Less than 5% of the average of the aggregate unadjusted bases of the assets of the entity is attributable to collectibles (antiques, stamps, alcoholic beverages, art, etc.)
    5. Nonqualified Financial Property Test: Less than 5% of the average of the aggregate unadjusted bases of the property of the entity is attributable to nonqualified financial property (includes debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities and other similar property). There are certain safe harbors to this test.
    6. Rental Real Estate Rules: (a) Cannot be Section 168(e)(2)(A) “residential rental property” (building which derives 80% or more of gross rental income from dwelling units), (b) Substantial improvements must be located on property, (c) Any lessee of the property must not be an excluded business, (d) No country club, golf course, massage parlor, hot tub facility, suntan facility, racetrack or other gambling facility or liquor store.
  6. LICs:
    (a) Any population census tract if: (1) the poverty rate for that tract is at least 20%; or (2) in the case of a tract not located within a metropolitan area, the median family income for the tract does not exceed 80% of the statewide median family income, or in the case of a tract located within a metropolitan area, the median family income for the tract does not exceed 80% of the greater of statewide median family income or the metropolitan area median family income; or
    (b) High out-migration rural county census tracts, which are population census tracts within a county which, during the 20-year period ending with the year in which the most recent census was conducted (2010), has a net out-migration of inhabitants from the county of at least 10% of the population of the county at the beginning of such period, if the median family income for the census tract does not exceed 85% of statewide median family income [The CDFI Fund has a list of census tracts that qualify under this provision. See the CDFI Fund Web site.]; or
    (c) Low-population/empowerment zone census tracts, which are population census tracts with a population less than 2,000 if the tract is within an empowerment zone, and is contiguous to 1 or more LICs (not including other LICs in this category) [The Department of Housing and Urban Development has a list of qualifying empowerment zone communities on its Web site and the CDFI Fund’s mapping program.]; or
    (d) Targeted populations, which include certain individuals or an identifiable group of individuals, including an Indian tribe, who (A) are low-income persons or (B) otherwise lack adequate access to loans or equity investments.

Basic rules regarding RECAPTURE: NMTCs subject to recapture for 7 years after QEI is made in CDE.  The amount of the recapture is NMTCs allowed for all prior taxable years + Interest at the IRS underpayment rate.

Recapture is triggered if: (a) CDE ceases to be a qualified CDE; (b) QEI proceeds no longer satisfy the substantially all requirement; (c) QEI is redeemed by CDE; or (d) certain other abuses. CDE must give 60 days’ notice of becoming aware of a recapture event.  In addition, or to clarify what this means:

  • Investors may not redeem their investment in the CDE prior to the conclusion of the seven year period.
  • Repayments to a CDE of capital or principal from QLICIs must be reinvested in another QLICI within 12 months
  • Principal prepayments are generally not allowed

Recapture not triggered if: (a) CDE enters bankruptcy; (b) QALICB goes out of business; (c) Foreclosure of the mortgage on commercial rental real estate.

Cure: If the CDE fails to meet the 85% (substantially all) requirement and the CDE corrects the failure within 6 months after the CDE becomes aware (or should have become aware), such failure is not a recapture event.  One cure period per QEI!

Money Flows:

  • NMTCs: Treasury -> CDFI Fund -> CDE -> Investor

Use in Leveraged Financings and Public Finance Issues:

General Public Finance Issues in NMTC Transactions:

Consider the following issues relating to general public finance matters:

  • Relationship between the public entity (e.g., the entity providing additional loans for the project) and the QALICB:
    • Which parties will use the financed facilities?
    • Landlord/tenant relationship matters
    • Sale or ground lease of the site?
    • Control of the QALICB?
    • Statutory authority to create or be a member
  • Leasing powers:
    • Sale/ground lease? (public bidding and terms)
    • True lease requirement
    • Restrictions on length of lease terms
    • Annual appropriation
    • Use of rent to support the loan repayments on QLICI loans
    • Attornment, nondisturbance, subordination
  • Using public funds for leverage/source of financing:
    • Statutory authority
    • Leverage lender/source lender
    • Amortization/balloon requirement
    • Lender/creditor rights and remedies (impact of fund, sub-CDE operating agreements; relationship of remedies to put and call, give the 7-year investment requirement for NMTCs)

Tax Issues Relating to Use of Tax-Exempt Bonds as Leverage Loan:

Consider the following issues relating to the use of tax-exempt bonds as the leverage loan source:

  • Governmental and 501(c)(3) bonds:
    • Private business tests:  Apply ultimate use of proceeds to look through investor and CDE? (See discussion below)
    • Private loan test:
      • Can the loan to the investment fund be disregarded?  If the governmental body is the leverage lender (using bond proceeds) and is also the end user (e.g., lessee of the project), is it really a loan?  Can bond counsel rely on “ultimate use of proceeds” and ignore intermediate steps?
      • Loans to lenders and California Health Facilities Authority vs. IRS case.
  • Private activity bonds (other than 501(c)(3) bonds) and tax credit bonds:
    • Use of proceeds:  Are proceeds used to “provide” the facility?
    • Tracing proceeds when there are multiple loans, and when there are payments between related parties (investment fund and the CDE)
  • All bonds:
    • Allocation of proceeds to expenditures
    • Acquired purpose obligation yield:  Analyze loan between the issuer and the investment fund, or look at all levels from the issuer to QALICB?  Tax credits as investment yield?

The investor entity may be treated as a user of bond proceeds in connection with leveraged tax-exempt bond financings (leveraged in the sense that tax-exempt bond proceeds are loaned to the leveraged lender or investment fund and then further loaned to the QALICB).  Some firms are comfortable giving the tax-exemption opinion based on the conclusion that the ultimate use of the moneys (use by the QALICB) is the use that must be considered for tax-exempt bond purposes.  Other firms believe that the investor entity is treated as the user of the proceeds (because the investor entity receives the tax credits over the seven-year period), thereby disqualifying the bonds from governmental or qualified 501(c)(3) bond status.  In unleveraged structures, it is generally okay to use tax-exempt bonds together with NTMCs, however.

The following types of private activity bonds might be useful for the leverage loan:

  • Enterprise Zone Bonds
  • GO Zone Bonds
  • Liberty Bonds
  • Midwestern Disaster Bonds
  • Solid waste disposal bonds
  • QECBs, QSCBs, private activity QECBs
  • Recovery Zone Facility Bonds
  • Small Issue Exempt Facility Manufacturing Bonds
  • Cannot use multifamily housing bonds under I.R.C. § 142 because of mutually exclusive rules regarding residential rental housing!

Security for the bonds is a significant issue because the NMTC seven-year standstill requirement.  The NMTC investor requires a priority security interest, too.

Case study for a private 501(c)(3) college:

  • Project consists of renovation of existing dormitories and construction of a mixed-use building for use as a student center and hub for several key community outreach programs administered by students and faculty of the College.
  • Total development budget is $17.3 million:  $15 million in equity from a NMTC investor and $11.5 million leverage loan in the form of a tax-exempt loan purchased directly by a bank, which was also the ultimate parent of the CDE lender.
  • Issues:
    • College itself could not satisfy the NMTC requirements to be a QALICB.  To solve the issue, a portion of the College’s business was underwritten as the “QALICB” using the “portion of the business” rule under I.R.C. § 45D.
    • NMTC funds may not be used to finance businesses that are engaged in the rental of residential rental property.  Dormitory space had to be carefully analyzed in order not to violate this rule.

Some bond counsel take the position that combining NMTC with tax-exempt bonds is not limited to certain private activity bonds and can also be used in connection with qualified 501(c)(3) bonds and governmental non-private activity bonds.  Such bond counsel base this conclusion on the fact that the proceeds of the bonds are ultimately used for a qualified bond project without creating impermissible private use from the bond loan to the CDE.  Those bond counsel look to the following reasoning to conclude that the use of the tax-exempt bonds should look through the QEI loan to the QLICI assets that, in the case of private activity bonds, are eligible uses under I.R.C. §§ 145 and 141:

  • The Treas. Reg. § 1.141-3 regulations state that the ultimate use of the proceeds or the direct and indirect use of proceeds are what govern the qualification of the bond issue under I.R.C. §§ 141 and 145.
  • Prior IRS approval that loans to private lenders may not have impermissible private business use derived from the loan of the proceeds to the lender where the lender is required to loan the proceeds to a qualified housing development (the so-called “loans-to-lenders” ruling).
  • Prior case law holdings that the substance, not the form, of the transaction governs the tax law analysis:  California Health Facilities Authority v. Commissioner, 90 T.C. 832 (May 2, 1988); and GCM 39455 (March 30, 1984).

Other Leverage Matters:

NMTCs may be combined with other types of tax credits, including the Historical Tax Credits under I.R.C. § 47, energy tax credits under I.R.C. §§ 46 and 48 and various state and federal grants.  NMTCs, however, cannot be used together with loan income housing tax credits under I.R.C. § 42.

Frequently Asked Questions:

Q: What is the “equity” investment?
A: The “equity” investment is the investment by the investor in the CDE (or in the corporation established by the CDE).

Q: When does a NMTC allocation to the CDE expire?
A: The CDFI allocates NMTC allocations annually to select CDEs through a competitive process.  The CDE must use that allocation within five years.

Q: When does a NMTC allocation to a project expire?
A: The taxpayer’s cash investment received by a CDE must be invested in a QEI within the 12-month period beginning on the date the cash is paid by the taxpayer to the CDE (Treas. Reg. 1.45D-1(c)(5)(iv) and (d)(2)(i))The CDE’s allocation from the CDFI Fund, however, does not expire until after five years (Section 45D(b)(1)(C)).

Q: Can a CDE in one geographical area make an allocation to a project located in a different geographical area?
A: Each CDE has an assigned “service area” that is established at the time the CDE applies to be recognized as a CDE.

Q: What is the relevance of the Historic Boardwalk Hall case?
A: In a decision in August 2012 by the U.S. Court of Appeals for the Third Circuit, the court held that a tax credit investor was not a bona fide partner because the investor lacked a meaningful stake in the success or failure of the project owner.  Consequently, the project owner was not a valid partnership for tax purposes, and the investor partner was not entitled to any rehabilitation tax credits.  This decision could have far-reaching implications for various federal tax credit investments and affect the structure and economics of many tax credit transactions.  Investors in such credits may have to assume additional risk in order to be regarded as having a meaningful state in the partnership’s entrepreneurial risk.  Whether such added risk will entitle investors to a larger share of partnership profits or a lower pricing model for the tax credits is yet to be determined.  If a tax credit investor has no realistic possibility of upside and is insulated from construction, operational and tax risk, the investor may lose the tax credits.  According to the Third Circuit, complete risk mitigation may be inconsistent with a tax credit investor’s status as a partner.  The investor was Pitney Bowles.  See Bond Attorneys’ Workshop materials for 2013 for additional information.