New Markets Tax Credits
By Samuel R. Kwon
Up to $2.7 billion dollars worth of tax credits still remain available under a US government program designed to encourage the flow of capital into low-income areas in the United States. These “new markets tax credits” expire at the end of 2007.
In 2000, the US government was looking for ways to stimulate business investments in impoverished urban and rural areas of the United States. Congress created the Community Development Financial Institutions Fund, or “CDFI” fund, that year to administer a new markets credit program. It authorized the fund to select entities that would devote themselves to making investments in low-income areas in the United States — known as community development entities, or “CDEs” — and to authorize them to capitalize themselves with funds from investors. In exchange, the investors would receive tax credits allocated to the CDEs by the CDFI fund.
In 2002, during the first round of the selection process, the CDFI fund selected 66 CDEs out of 345 applicants and authorized them to accept up to $2.5 billion in capital contributions from investors in exchange for tax credits equal to 39% of the contributions over seven years. The largest amount of investment a single CDE was allowed to accept was $170 million, and 20 CDEs were allowed to accept investments of up to $50 million or more. The smallest was $500,000, and the median investment size was $17.5 million. In 2003, the fund authorized another 63 CDEs to accept a total investment of $3.5 billion in exchange for tax credits. The largest investment allowed was $150 million. Fourteen CDEs were allowed investments of more than $100 million and 31 CDEs were authorized to accept more than $50 million. The smallest amount of investment allowed was $2 million, and the median investment size was $47 million.
The application process for 2004 was completed in September 2004. The CDFI fund is expected to authorize a large number of additional CDEs to accept up to $2 billion worth of investments in exchange for tax credits for 2004. The fund will authorize an additional $7 billion of investment into CDEs in exchange for tax credits over the next three years. Investors who want to take advantage of these credits must make a qualified investment in a CDE before the end of 2007.
Any person who makes a “qualified equity investment” in a “qualified CDE” receives new markets tax credits each year for seven years as long as he holds the investment for those seven years. The investment must be made up front. The credit is 5% of the qualified equity investment for each of the first three years, and 6% in each of the next four years, for a total of 39%, or approximately 30% of the qualified equity investment on a present-value basis. The investment in a CDE may be sold and the new owner can claim the remaining tax credits so long as the investment qualified for the credits in the hands of the seller.
“Qualified equity investment” is any equity investment in a CDE whether in the form of stock in a corporation or capital interest in a partnership. Qualified equity investment includes, in addition to the investment into a CDE, any amount paid by the investor on behalf of the CDE such as underwriter’s fees. Generally, an equity investment made in a qualified CDE before the CDE enters into an allocation agreement with the CDFI fund is not eligible for tax credits. However, there is an exception. If the investment is made after the Internal Revenue Service publishes a “notice of allocation availability” in the Federal Register, the CDE later receives an allocation of tax credits, and the investment otherwise satisfies other requirements for new markets tax credits, then the investment is treated as having been made on the effective date of CDE’s allocation agreement. An allocation agreement is a contract a qualified CDE enters into with the CDFI fund under which the fund authorizes the CDE to issue an approved amount of ownership interests in it in exchange for new markets tax credits to investors.
An investor who makes a qualified equity investment in a qualified CDE receives tax credits as long as three conditions are satisfied.
The first condition is that the investment in a qualified CDE must be acquired by the investor claiming the credits at its original issue, directly or through an underwriter, solely in exchange for cash. The IRS clarified in 2003 that cash includes proceeds borrowed by the investor from a bank, regardless of whether the loan is recourse or nonrecourse. This provides an opportunity for investors to use borrowed funds to receive tax credits. The 2003 IRS announcement gives an example of two investors who form a partnership and capitalize it with $800. Then the partnership borrows $1,200 from a bank on a nonrecourse basis. The partnership, in turn, invests the $2,000 into a qualified CDE in exchange for an ownership interest in the CDE. The loan is secured only by the partnership’s equity interest in the CDE. It is not secured by any assets of the CDE, and it is not convertible into an equity interest in the partnership. Under these facts, the partnership is entitled to new markets tax credit each year for seven years equal to a percentage of the full $2,000 invested (rather than solely on the $800). All of the tax credits may be allocated to the two partners as long as the allocation of the credits is in accordance with the tax rules.
The second condition for qualifying for new markets tax credits is that at least 85% (or 75% in the seventh year of investment) of the investment must be used by the qualified CDE to make a “qualified low-income community investment.” The investment has to be made “directly” into the qualified CDE. For instance, if a CDE uses a line of credit from a bank to make a qualified low-income community investment, and then takes the equity investment later to pay off this line of credit, the investor may not be viewed as having fulfilled this “direct’ investment requirement.
There are four types of “qualified low-income community investments.”
The first is any capital or equity investment in, or loan to, a qualified active low-income community business. “Qualified active low-income community business” means a corporation or a partnership if for a year at least 50% of the total gross income of the entity is derived from the active conduct of a qualified business within any low-income community, a substantial portion of the use of the tangible property of such entity (whether owned or leased) is within any low-income community, a substantial portion of the services performed for such entity by its employees are performed in any low-income community, less than 5% of the average of the aggregate unadjusted bases of the property of the entity is attributable to collectibles other than collectibles that are held as inventory primarily for sale to customers, and less than 5% of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property.
The second type of qualified low-income community investment is a purchase from another CDE of any loan made by such an entity that is itself a qualified low-income community investment.
The third type of a qualified low-income community investment is financial counseling and similar services listed in IRS regulations for residents of low-income communities. Low income communities are census tracts where the poverty rate exceeds 20% or the median income is less than 80% of the greater of statewide median income or metropolitan area median income. In addition, the IRS may designate an area within a census tract as a low-income community if the boundary of the area is continuous, the area would be a low-income community if it were a census tract, and there is inadequate access to investment capital in the area.
Finally, the last type of a qualified low-income community investment is any equity investment in, or loan to, a qualified CDE.
The last condition before an investor can qualify for new markets tax credits is the qualified CDE must designate the equity investment as having been made for purposes of new markets tax credits on its books.
Because the new markets credit is in its infancy, there is not a lot of information on what types of investments the CDEs are making with the capital they are raising. Industry participants speculate that a large proportion of the investment will go into having the CDEs own real estate rather than into new business development, loan purchases or financing of other CDEs.
The investor will lose all of the new markets tax credits — whether already claimed or to be claimed — if a “recapture event” takes place within seven years of the original investment into a qualified CDE. There are three types of recapture events.
First, the investor will lose the new markets tax credits if the CDE ceases to be a “qualified CDE.”
A qualified CDE is a CDE that is any domestic corporation or partnership whose primary mission is serving or providing investment capital for low-income communities or persons, that maintains accountability to residents of low-income communities through representation on any governing or advisory boards of the entity, and is certified by the IRS as a CDE eligible for new markets tax credits. In addition, certain specialized small business investment companies and community development financial institutions under the Community Development Banking and Financial Institution Act of 1994 are treated as CDEs. CDE certification by the CDFI fund lasts for 15 years unless revoked or terminated by the fund. To maintain the certification, the CDE must certify annually during the 15-year period that it has continued to meet CDE certification requirements. One of these requirements is that at least 20% of its governing or advisory board must be representative of low-income communities within the selected service area. This means the members must reside in low-income communities within selected service area or otherwise represent interests of residents of low-income communities.
Second, both past and future credits will be lost if substantially all of the equity investment ceases to be used in qualified low-income investments. This suggests that the investor must make sure that the CDE has a pipeline of projects into which any repayments to a CDE of equity or principal from qualified low-income community investments can be reinvested. As long as such reinvestment takes place within 12 months of receipt by the CDE of a return of equity or principal, the CDE will be viewed as having kept the investment in qualifying investments for purposes of the “substantial investment” requirement.
Third, a recapture of the credits takes place if the CDE redeems the equity investment from an investor.
Upon a recapture, interest on the resulting underpayment is also incurred as if the investor should not have claimed any tax credits: this interest is not deductible, and other types of credits cannot offset the new taxable income. The CDE is required to provide a notice of recapture within 60 days to its investors.
Notably, a CDE’s bankruptcy is not in and of itself a recapture event, and it does not prevent future credits from being claimed.
The US tax code limits the ability of an individual or a closely-held C corporation (in which five or fewer individuals own more than 50% of the stock) to make use of the new markets tax credits; unless such an investor “materially participates” in the CDE’s business, it can only use the credits to offset income from “passive activities.”
Any unused new markets tax credits can be carried forward for 20 years and backward for one year. If any credits remain unused after the expiration of the carryforward period, then the investor is allowed to deduct the unused amount in the following year. New markets tax credits cannot be used to offset a taxpayer’s alternative minimum tax liability.
Generally, the “tax basis” of an equity investment in the hands of the investor is equal to the fair market value of the contribution the investor made in exchange for the investment. However, the basis of any qualified equity investment in a CDE for purposes of new markets tax credits is the fair market value of the investment minus the amount of the new markets tax credits he is allocated.
The amount of the new markets tax credits an investor can claim is not reduced even if the investor claims other tax benefits such as rehabilitation credits under section 47 of the US tax code. In addition to the credits, the investor may also be allowed a share of depreciation from the CDE where the investor is a partner of a CDE that is a partnership. Moreover, if the CDE’s business is successful, the investor can expect a cash return on the investment, and may have an interest in the residual value in cases where the CDE invested in hard assets like real properties. The IRS is currently studying whether a reduction is appropriate if the investor claims low-income housing tax credits with respect to the same investment under section 42 of the US tax code.