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The Treasury Department's Community Development Financial Institutions Fund invites applications for New Markets Tax Credits on $2.5 billion in investments in low-income community economic development. As most Coalition members know, the New Markets Tax Credit has the potential to transform the financing of economic development in low-income communities much as Low Income Housing Tax Credits have done for affordable rental housing development. Enacted last December as new tax code section 45D, New Markets Tax Credits are authorized for and a total of $15 billion in private investments by 2007, starting with $1 billion this year. New Markets 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. The application materials are on the Treasury Department's CDFI web page at www.cdfifund.gov. There is no application deadline. The following is a primer from LISC on the CDFI-New Markets program:
How New Markets Will Work
New Markets Tax Credits are available to equity investors in "community development entities", which in turn will use the proceeds to make loans and investments in business located in low-income communities.
STEP 1:Community Development Entities (CDEs). 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. The Treasury Department must certify all CDEs. However, certified Community Development Financial Institutions and Specialized Small Business Investment Companies 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.
STEP 2:Allocation of tax credit authority. The Treasury Department will allocate New Markets Tax Credits, through its Community Development Financial Institutions Fund. The volume of New Markets 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. 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 Treasury Department may also add other allocation preferences, and will probably ask applicant CDEs for a plan for generating public benefits.
STEP 3:Tax credit amounts. 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% for each of the first three years, and 6% for each of the next four years. This stream of credits totals 39%, with a present value of about 30%. The investor's basis is reduced by the tax credits claimed.
STEP 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.
STEP 5:How CDEs will finance economic development. A CDE can use New Markets investment proceeds to assist eligible businesses by: providing loans and investments to businesses or other CDEs; purchasing loans made by other CDEs; providing financial counseling and other services; and financing its own eligible activities. A CDE could also invest in its own business, such as the development and operation of a shopping center. A CDE must use "substantially all" of the new Markets investment proceeds for these purposes. Treasury - probably the Internal Revenue Service - will define "substantially all," including any allowances for administrative expenses, loss reserves, an initial ramp-up period for placing investments, and a final wind-down period for recovering investments. A CDE must trace how tax credit investments are used for eligible uses if less than 85% of its gross assets are so invested.
STEP 6:Eligible businesses and communities. 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 are explicitly excluded, among them the operation of rental housing. Eligible communities are census tracts with either (a) a poverty rate over 20% or (b) a median income below 80% of the metropolitan area (if applicable) or state median, whichever is greater. The Treasury Department may also approve smaller areas.
STEP7:Recapture. Within the first seven years after the investment is made, an investor could lose the tax credits it has claimed (plus interest) if: (a) substantially all of the cash proceeds are not used for eligible purposes; (b) the investor cashes out its equity investment in the CDE; or (c) the CDE ceases to be a qualified CDE. Treasury is expected to write rules for curing violations within a reasonable period to prevent unwarranted recaptures.
What New Markets Can (and Cannot) Do
Understanding what New Markets 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, New Markets 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% of the investment made, in present value terms. By contrast, the Housing Credit generally has a present value of up to 70%, and up to 91% 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. 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. Further unlike Housing Credits, the New Markets credits claimed will reduce the investors' basis, potentially exposing investors to additional capital gains tax liability when they terminate their investments, and investment commitments may not be bridge financed.