Creative Financing with New Markets Tax Credits

Thane R. Hodson and Barry A. Burns[1][2] 

A new high school in a Los Angeles inner city neighborhood.  A manufacturing plant for custom electrical equipment in Phoenix, Arizona.  A new building for a Denver, Colorado city center hospital.  What do all these diverse projects have in common?  New Markets Tax Credits (“NMTC”) helped provide creative financing to bring each of these real estate projects to completion, creating jobs and providing vital services to their communities.

Congress created the NMTC program with bipartisan support in 2000 with the intent of encouraging investments in economically distressed communities across the United States.[3]  For purposes of the NMTC program, an economically distressed community is one that is located in a census tract with a poverty rate of twenty percent or greater or in a census tract in which the median family income is less than eighty percent of the metropolitan area or state median.[4]  These investments were intended for real estate projects, small businesses, and a variety of charitable activities, which would result in economic growth and an increase or retention in jobs. 

According to Thane Hodson, senior tax attorney at the national law firm Kutak Rock LLP, “The program works by providing an investor with a federal tax credit of thirty-nine percent taken over seven years for a community development project in an economically depressed area.  The credit schedule is five percent for each of the first three years and six percent for the subsequent four years or a total of thirty-nine percent.  Investors may not change or alter this schedule.” 

Currently, the Department of Treasury administers the program, through the Community Development Financial Institutions Fund (“CDFI Fund”).  The CDFI Fund reviews applications and awards tax credit allocations on a competitive basis to Community Development Entities (“CDEs”).[5]  One or more investors, using both equity and borrowed funds, make capital contributions (“QEIs”)[6] to the CDE.  The CDE makes loans or equity investments (“QLICIs”)[7] in qualifying low-income businesses (“QALICBs”).[8]  Finally, the CDEs manage the investments, providing reports back to the CDFI Fund about the progress of the project.  To date, NMTCs have been used to finance a wide variety of charitable projects including hospitals, health care clinics, research facilities, manufacturing plants and recreational facilities.

One such recently completed project was a $10,000,000 newly-renovated public high school managed by Green Dot Public Schools in Los Angeles.  Green Dot is a nonprofit focusing on transforming public education by building and operating high-achieving charter schools, encouraging and supporting higher parental participation in schools, and by working with the Los Angeles Unified School District to fully fund and improve schools.

“We were able to effectively combine public and private capital sources to acquire a new public LEED Certified high school facility in a highly distressed neighborhood within Los Angeles.  NMTC provided much needed equity for the acquisition and allowed Green Dot to save $300 per student in annual debt service, at a time when charter schools are at a critical junction facing statewide cutbacks in K-12 funding.  These significant operational savings allowed Green Dot to invest more dollars in the classrooms for educational purposes and for smaller class sizes,” said GVC Capital representative Brian Curd who is NMTC consultant for Green Dot.

For many nonprofits looking at new buildings or infrastructure renovations, utilizing NMTCs reduces the cost of capital for qualifying projects, making it substantially lower than in the case of conventional financing.  In addition, such credits permit an infusion of equity into a qualifying project that would not be possible for many tax-exempt organizations.  Moreover, the credits spur growth in areas surrounding the project and thereby provide indirect benefits to the intended recipients of charitable services.  Finally, in contrast to historic tax credits, there are no restrictions on the use of New Markets Tax Credits for projects used by tax-exempt organizations.  In appropriate circumstances, NMTCs may be used in connection with historic or Energy Tax Credits as well.

In the case of a manufacturing plant in Phoenix, Arizona, NMTCs were used by Keller Electrical Industries, Inc. which expects to create approximately 125 jobs in the city over the next five years.  The $16 million facility was completed in the summer of 2010 and will be utilized to build custom electrical equipment, components and supplies and repair large industrial motors, generators and transformers for companies across the Western United States.

NMTCs were used in this financing to help reduce the aggregate lending exposure by approximately thirty percent.  Further, because of the rate subsidy inherent in such a transaction, the debt service requirements of the underlying borrower were substantially reduced.  And even though the leveraged lender was primarily secured by a pledge of the tax creditor investor’s interest, the leveraged loan was guaranteed by the principals of the underlying borrower and supported by other credit enhancement.  In addition, even though the underlying loans do not permit the repayment of principal during the seven-year compliance period, the leveraged lender may arrange for the periodic purchase of portions of its loan by an affiliate of the underlying borrower, thereby creating synthetic amortization of its loan.   

“There are a variety of critical issues to work out when structuring this kind of financing for every project,” said Hodson, “including the nature of the collateral, forbearance, the fact that there is no loan amortization during the compliance period, and the use of other financing mechanisms.  For example, with a unit being built for a Denver city center hospital, we mixed a special type of tax-exempt bond (recovery zone facility bonds) and NMTCs to finance the construction of a facility which will house adolescent psychiatry, a dialysis center, outpatient surgery and office space, and related equipment and garage space.” 

In that circumstance, the issuer of the recovery zone bonds loaned the proceeds to an investment fund owned by an institutional investor.  The investor then used the bond proceeds together with its own capital to fund an investment in the hospital facility.  As a result, the debt service on the hospital’s financing was reduced both as a result of the utilization of the tax-exempt proceeds and the subsidy inherent in New Markets Tax Credit financings.

New Markets Tax Credits are a mutually beneficial tool for corporations or charitable organizations as well as investors.  Corporations receive an infusion of capital in their designated projects, with loans of significantly subsidized rates, and investors reap tax credits purchased at a discount.  In the end, by increasing investments in low-income communities with NMTCs, everyone wins.  

 


 

[1] Originally published by Western Banking. Reprinted with permission.

[2] Kutak Rock LLP is a national law firm with over 400 attorneys in sixteen offices around the country serving local, regional and national clients in a multidisciplinary practice.  Members of the firm’s NMTC group in Denver have acted as counsel to parties in every role of an NMTC transaction and have a comprehensive understanding of the various competing interests that need to be navigated in bringing a NMTC financing to a successful close.  

[3] See Community Renewal Tax Relief Act of 2000, Pub. L. No. 106-554 (2000) (codified at 26 U.S.C. § 1400e). .

[4] Id.

[5] A Qualified Community Development Entity (a “QCDE”) is a corporation or partnership that has as its primary mission serving low-income communities (a “LIC”) and persons and maintains accountability to that community through a governing or advisory board.  An entity applies to the Community Development Financial Institutions Fund, a government entity, for certification.  Typically, a QCDE will also form a number of subsidiaries (“Sub-CDEs), usually limited liability companies, which are also certified as QCDEs by the CDFI Fund and are eligible to receive sub-allocations of tax credits from the QCDE. 

[6] A qualified equity investment must be an equity investment in a QCDE which is acquired at its original issue solely in exchange for cash.  Substantially all of such cash is used to make one or more QLICIs and the QCDE designates the investment as a QEI.  An equity investment is stock in a corporation or a capital interest in a partnership.  If any part of the QEI is redeemed in the seven-year credit period, the credits can be recaptured.

[7] A QLICI can be any capital or equity investment in, or loan to, any qualified business.  In addition, it can be the purchase of a loan from another QCDE which is a QLICI, financial counseling and other services to businesses in, and residents of, low-income communities, and any equity investment in, or loan to, any QCDE.  Equity investments and loans are the most common QLICIs.  Loans will usually have below market interest rates or other unconventional terms.

[8] The business that receives the QLICI must meet the requirements to be a “qualified active low-income community business” (a “QALICB”).  A QALICB is a corporation (including a nonprofit corporation) or a partnership which engages in the active conduct of a qualified business.  A QALICB cannot be a single-member LLC.  In addition, a QALICB is subject to certain requirements regarding where its income is earned, where its tangible assets are located, and where its employees perform services and restrictions on the holding of collectibles and certain types of financial assets.  There are a number of other restrictions as well.  The following types of businesses, as well as several others, do not qualify:  A private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages off premises.