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New Market Tax Credits: Tax Issues for Investors and Developers in Structuring Transactions Meeting IRS Program Compliance Requirements for NMTC Deals
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WEDNESDAY, FEBRUARY 15, 2012
Presenting a live 110-minute teleconference with interactive Q&A
Michael I. Sanders, Partner, Blank Rome, Washington, D.C.
Megan A. Christensen, Atty., Blank Rome, Washington, D.C.
Donald Nimey, CFA, FRM, Principal, The Reznick Group, Bethesda, Md.
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NEW MARKET TAX CREDITS: Tax Issues for Investors and For-Profit
and Non-Profit Developers
Michael I. Sanders 202.772.5808
NMTC Overview:
● Opportunity to subsidize or provide gap financing in a qualified census tract.
● Benefits to developers, businesses and charities.
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● Major investors such as Goldman, JP Morgan or PNC buy credits for cash infusion to the development which may not be paid back at the end of the 7-year compliance period.
● Under leverage structure, investor may receive in excess of 9 to 10 percent return after tax.
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New Markets Tax Credit – A Government Sponsored Joint Venture Vehicle -- $29.5 billion in NMTC allocated through 2011; subject to renewal by Congress.
Purpose:
The new markets tax credit (NMTC) serves as a way to provide subsidy or gap financing to real estate developments, business activities, or charitable operations planned in qualified census tracts (high unemployment or poverty rate, low median family income).
What does it provide?
39% tax credit on the capital invested in a community development entity (CDE), over 7 years (5% in yrs 1-3; 6% in yrs 4-7).
Who benefits from the credit?
The investor (typically national banks, insurance companies) making an investment in a CDE gets a tax credit of $0.39 for every $1 invested and CRA credit, which under a “leveraged” structure yields in excess of a 10% after-tax return. The CDE directs capital into qualified projects or businesses. The investor is not repaid its equity investment.
Eligible Investments:
• Community businesses, including e.g. hospitals, charter schools. • Commercial or mixed-use real estate projects (at least 20% of gross income from commercial component).
Examples:
•105-Unit, The Bradford -- $45M affordable housing and ground floor retail space in Bedford-Stuyvesant. Innovative structure allowed HDC and HPD financing to be used, with Goldman Sachs as the equity investor; BRP and Bedford-Stuyvesant Restoration Corp were the development partners. • $100M charter high school in Mott Haven, Bronx. Robin Hood Foundation was sponsor; JPMorgan Chase was investor.
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Use of Leverage Debt and Alternative Capital Sources
● In structuring an NMTC transaction one of the most important elements in structuring is the use of the leverage lender.
● Practitioners need to be creative in structuring; in this regard it is important to recognize that the lender may take a security interest in the investment fund borrower’s assets, but not QALICB/developer’s property.
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● And, typically the leverage lender will be required to forbear from exercising any remedies during the 7-year NMTC compliance period.
● If leverage loan funds are not fully available at
closing or are conditioned upon the completion of the project, a bridge financing source may need to be lined up; e.g., banks making short term bridge loans, provided that there is an anticipated take-out through government funds, such as HUD 108 program/tax-exempt financing, etc.
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● Leveraged lenders who are currently making loans and what the general nature of the business is of these lenders (for profit, nonprofit, government, etc.).
● The pros and cons of the leverage structure compared to a single investor structure.
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● The impediments keeping new investors from making leveraged loans and how can the NMTC industry address these impediments; e.g., 7-year forbearance and collateral issues.
● Leverage lenders demand more protection
today than in the past, although they are not the direct lender. Assets that may be pledged in view of the IRS’ ruling position. How to protect the leverage lender.
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● Examine the risks that the leverage loan will not be repaid. Use of the A note; how to handle the risks of foreclosure, casualty and condemnation. How to draft the consent provisions.
● The tax issues that nonprofits that act as leverage lenders in transactions that they sponsor: UBIT.
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● Key steps to ensure coordination between all parties to make sure that key issues are being raised and addressed early in the process.
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Unwind Exit Strategies: Put-Call Options, Planning Opportunities to Mitigate Burdens of Tax Consequences at Exit
● At the end of the 7-year compliance period, when the investor has received all the NMTCs for which it is eligible, it, along with the CDE, will likely want to unwind the transaction and exit the structure.
● This is typically accomplished through the use of a “put/call” technique that generates a subsidy or grant equivalent to the QALICB.
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● Under one version of this technique, the investor has the right to require the QALICB, over a specified period, to purchase the investor's interest in the Fund for a specified price (the “put”). In the event the put is not exercised, the QALICB (or an affiliate) has the right to purchase the investor’s interest in the Fund over a specified period for fair market value (the “call”).
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● The put and call will likely be priced substantially below the investor’s original investment in the Fund.
● If either the put or the call are exercised, the
investor would be removed from the structure. An affiliate of the QALICB typically would be substituted in place of the investor, thereby controlling the Fund, and would take steps to redeem the managing member of the CDE. The result here is a net benefit to the project measured by the amount of the investor’s original funds less fees, professional and administrative costs and the price of the put/call.
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● After the investor is removed, the QALICB may then cause the Fund to liquidate the CDE, often using the QLICI “A note” previously held by the CDE to repay the leverage lender, and subsequently liquidate the Fund, leaving the QALICB on its own and the leverage lender holding the A note.
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● In the event that the leverage lender is controlled by a §501(c)(3) entity or is itself a charity, it may decide to forgive all or a portion of the leverage loan at the end of the compliance period, but it must not be legally obligated to do so at inception.
● Alternatively the QALICB may also “refinance”
the property and use the funds it receives to repay to the CDE the QLICI note that mirrors the leverage loan (but not the QLICI note that reflects the investor's equity). The CDE will then use the funds received from the QALICB to repay the leverage lender.
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● There is often tension manifested between the equity investor and the QALICB in negotiating the put/call structure. Equity investors are interested in protecting the value of their cushion while the QALICB is interested in assurance that the investor will indeed exercise the put and may use techniques that would devalue the call (through the use of a fair market value formula, annual interest accruals and a significant partial payment in year 7). The investor, however, wants to be assured that it will be treated as the owner of the equity piece.
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● There is additional concern at the QALICB level that there could be a change of administration and attitude by the investor at the end of the compliance period as compared to its present intent, especially by an institutional investor, who may decide not to exercise the put.
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Cancellation of Indebtedness – COD Income
● Discharge of indebtedness: under Section 61(a)(12) a discharge of indebtedness, for example, by the debtors acquisition of its own debt for less than the principal amount of the debt, constitutes gross income to the debtor. Under Code Section 108(e)(4)(A) for purposes of determining income of the debtor of the discharge of indebtedness the acquisition of debt by a party “related” to the debtor is considered to be the acquisition of indebtedness by the debtor.
If the QALICB has operating losses, it may offset COD ordinary income.
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● If not, the B note could be payable in 25-30 years which would defer the taxability. However, the QALICB would need to pay interest annually during the life of the note.
● Related party acquisition uses the attribution and constructive ownership rules under Section 267(b) or 707(b)1.
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● Exception for qualified real property business indebtedness which would allow income realized pursuant to the related party rule to be excludable from gross income to the extent provided in Section 108(a), whereby gross income does not include discharge from indebtedness income if a taxpayer is not a C-corporation and the discharge indebtedness is “qualified real property business indebtedness.”
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● Use of equity rather than debt. ● Use of nonprofit as QALICB or leverage lender: no UBIT realized if project is substantially related to the exempt function, such as relief of the poor, underprivileged, relieves the burden of government, etc.
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Opportunities for Nonprofits
Consistent with its charitable purpose, a Section 501(c)(3) organization may play various roles in NMTC transactions:
● As CDE ● As QALICB ● As Leverage Lender
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History • 2000 – §45D enacted; §45D(e)(2) provides for Treasury to
designate any area within a census tract as a low-income community under certain conditions.
• 2004 - §45(e)(2) amended to provide that Treasury may prescribe regulations to treat “targeted populations” as low-income communities.
• 2006 – Notice 2006-60 issued; taxpayers may rely on the notice until regulations are issued.
• 2008 – IRS issues proposed regulations; taxpayers may continue to rely on Notice 2006-60 until final regulations are issued.
• December 5, 2011 – Effective date of final regulations.
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Treas. Reg. §1.45D-1(d)(9)
– “For purposes of section 45D(e)(2), targeted
populations that will be treated as a low-income community are individuals, or an identifiable group of individuals, including an Indian tribe, who are low-income persons as defined in paragraph (d)(9)(i) of this section or who are individuals who otherwise lack adequate access to loans or equity investments ad defined in paragraph (d)(9)(ii) of this section.”
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Treas. Reg. §1.45D-1(d)(9)
• Targeted Populations are either: – Low-income Persons (“LIPs”)(1.45D-1(d)(9)(i)); or – Individuals who otherwise lack adequate access to loans
or equity investments (1.45D-1(d)(9)(i))
• Remaining Discussion Only with Respect to LIPs
– (d)(9)(ii) addresses only QLICIs made under the increase in NMTC limitation in response to Hurricane Katrina, nearly all of which has already been used, or will expire if not used in the next few months.
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Low-Income Persons • Determined based on the individual’s family income (“IFI”),
determined by one of three methods: – Household income as measured by U.S. Census Bureau; – AGI as reported on Form 1040, including AGI of any family
member residing with the individual; or – Household income determined under §8 of Housing Act of 1937.
• IFI must not be more than 80% of applicable area median family income (“MFI”).
– New under the final regulations: Area MFI is determined in a manner consistent with such determinations under §8 of the Housing Act of 1937.
– Taxpayers must use annual estimates released by HUD and may rely on those until later of 45 days after a new release or effective date of new list.
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QALICBs • Must meet general QALICB rules (§1.45D-1(d)(4)(i)): (a) Corporation or
partnership; (b) Engaged in active conduct of qualified business; (c) <5% property attributed to intangibles; (d) <5% property attributed to nonqualified financial property.
• Also, must meet one of three tests (§1.45D-1(d)(9)(i)(D)(2)): – Gross Income Test;
• 50%+ derived from transactions with LIPs • Exception (New): If sole business is rental of real property, gross income
test satisfied if entity treated as being located in low-income community under §1.45D-1(d)(9)(i)(D)(1) (see Rental of Real Property, below).
– Employee Test; • 40%+ are LIPs • (determined at time of hire)
– Ownership Test. • 50%+ of entity owned by LIPs • (determined at later of (i) time QLICI is made, or (ii) time ownership interest
is acquired)
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Gross Income Test
• “Derived From” includes gross income derived from: – Payments made directly by LIPs; and – Money & FMV of property or services provided to the
entity primarily for the benefit of LIPs, but only if provider does not receive a direct benefit from the entity.
• If gross income is derived from transactions with
both non-LIPs and LIPs, gross income derived from transactions with LIPs includes the full FMV even if LIPs do not pay FMV.
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120% Income Restriction • Not a QALICB if located in census tract where MFI > 120% of
the applicable MFI (statewide or metropolitan) (“NQPCT”). • Considered to be located in NQPCT if have:
– Non-qualifying gross income amount (50%) (“NQGIA”); – Non-qualifying tangible property usage (40%) (“NQTPU”); and – Non-qualifying services performance (40%) (“NQSP”).
• If NQTPU or NQSP is 50%+, considered to have NQGIA. • If no employees, considered to have NQGIA and NQSP if
85%+ of use of tangible property is within 1+ NQPCTs. • 120% income restriction does not apply if the population is <
2,000 and is either: – is not in a metropolitan area; or – is in a metropolitan area and >75% of the tract is zoned commercial or
industrial.
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Rental of Real Property
• Entity will be treated as located in a low-income community, and thus a qualified business if:
– Rents to others real property for low-income targeted populations;
– Otherwise satisfies requirements to be a qualified business;
– 50%+ of total gross income is derived from rentals to LIPs or to a QALICB that meets either the gross income test or employee test.
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Donald Nimey Reznick Group
301-28-1846 [email protected]
7501 Wisconsin Avenue
Suite 400E Bethesda, MD 20814
Advanced Notice of Proposed Rule Making
• Facilitate greater investment into non-real estate businesses (Treasury and IRS identified issues and invited comments) – Investment returns to CDEs in non-real estate businesses
allowed to be reinvested for the seven year compliance period if invested into certified CDFI (encourage short amortization loans – five years or shorter)
– Reduce QALICB testing requirements required by second tier CDEs when lending NMTC proceeds into a small non-real estate businesses (reduce transaction costs for small transactions [$250K] that utilize a two tier CDE structure)
– Modifications of reasonable expectations QALICB safe harbor (encourage equity investments)
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HTC Equity $7.2 mm
NMTC Equity $2.8mm
Investment Fund $10 million NMTC capital
HTC & NMTC credits/ Cash Flows from operations/ Profit & Loss from operations/ Exit Amounts (sale, put, or call) less fees to CDE CDE
$10 million allocation to
Sub Sub-CDE
Master Tenant
Single Member LLC
Load 6% of allocation $.6mm at closing
HTC credits/ Priority Payments/ Interest Payments/ Residual Cash Flow/ Profit & Loss from operations/ Debt Service on Loans/Exit Amounts (sale, put, or call) Landlord
Qualified Project
$.5mm + Lease Pmts
HTC Credits + Cash, P&L, Sale
Twinning HTC with NMTCs
$.5
mm
Sponsor & Lender Capital
fees over time to cover costs
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Important Twinning Concepts
• NMTCs and HTCs are being received by the same taxpayer (employing additional allocation and a leveraged lender increases the amount of NMTC benefit)
• The amount of equity invested and the amount of ownership will be limited to less than 50% of all other equity invested (NMTC related party concern)
• Twinning relies on a pass-through of HTC to Master Tenant from Landlord (requires an operating lease for 80% depreciable life of the building)
• Master Tenant must be a disregarded entity so that the NMTC proceeds are financed into a qualified business
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Innovative and Helpful Structure Ideas
• Combining Buildings - Multiple contiguous buildings with identical ownership and management etc treated for depreciation purposes as single building (satisfy commercial building requirement)
• Dividing a Building - Condo a building so that LITHC or “excess residential” component is outside the NMTC condo which qualifies for commercial building depreciation (satisfy commercial building requirement)
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Innovative and Helpful Structure Ideas
• Use “one day loan” to monetize previously incurred sponsor costs into a source of leverage debt at the investment fund (increase QEI)
• Use a grant anticipation note [either at the investment fund level as a leveraged lender or as back leverage to an affiliate of the sponsor as the leveraged lender] to monetize future grant donation amounts for NMTC closing (increase QEI)
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Innovative and Helpful Structure Ideas
• Renewable energy ITC can be twinned identically to HTC
• Construct notes that utilizes deferred amortization and/or cash flow sweep to help control cash flows, e.g., if an affiliate of the sponsor is a leveraged lender then the note to the investment fund can carry deferred interest and cash available amortization such that “over performance” in an equity deal (like HTC twinned) does not over compensate the NMTC investor
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