A Role For Federal Tax Credits In The Redevelopment Of Economically Distressed Communities
Economic development, redevelopment, and rehabilitation of abandoned and/or distressed industrial and commercial sites as well as economically challenged and underserved communities is on the rise in Fort Wayne and elsewhere in the Northeast Indiana region. One of the major drivers of this welcome economic activity is the availability of federal and state tax credit programs that provide developers with needed financial assistance to support these often challenging and aggressive projects. This blog post discusses federal programs and a subsequent post will discuss the state programs. Click here to ready about Indiana state tax credit programs.
Federal Tax Credit Programs
New Markets Tax Credits
The New Markets Tax Credit (NMTC) program was created under the Community Renewal and Tax Relief Act of 2000 and is designed to stimulate the economies of distressed urban and rural communities and create jobs in low-income communities by expanding the availability of credit, investment capital, and financial services. The NMTC program has been subject to reauthorization and was most recently extended in 2015 for a term of 5 years (2015-2019) at its current level of $3.5 billion annually.
The program is administered by the Community Development Financial Institutions (CDFI) Fund within the U.S. Department of the Treasury. Tax credits are allocated through the CDFI Fund annually and are distributed to qualified Community Development Entities (CDEs).CDEs include a range of for-profit and non-profit organizations, such as community development corporations, CDFIs, organizations that administer community development venture capital funds or community loan funds, small business development corporations, specialized small business investment companies, and others. The City of Fort Wayne has created a CDE known as the Fort Wayne New Markets Revitalization Fund, LLC (FWNMRF). It was announced on February 13, 2018, that the CDFI Fund awarded $3.5 billion in allocation authority to 73 CDEs under the calendar year 2017 NMTC allocation round, which included a $55.0 million allocation to the FWNMRF CDE.
Once a CDE receives an allocation of tax credits, the CDE can offer the tax credits to private-sector investors, including banks, insurance companies, corporations, and individuals. Investors acquire (using cash only) stock or capital interest in a subsidiary of the CDE (Sub‑CDE). The investor can gain a potential return for a “qualified equity investment” in the Sub‑CDE. The investor also receives a thirty-nine percent (39%) tax credit on the amount of the investment (total purchase price of the stock or capital interest). The credit is claimed over a seven-year period with a five percent (5%) credit annually during the first three years after purchase and a six percent (6%) credit annually during the final four years.
Investors may not redeem their investments in CDEs prior to the conclusion of the seven-year period. Thus, for each $100,000 investment, an investor would realize $39,000 in tax credits over a seven-year period. In short, the CDE secures investors through the sale of stock or issuance of an equity interest in its Sub‑CDE in exchange for tax credits and then uses the resulting investor equity to make investments in low-income communities. In return for providing the tax credit to the investor, the CDE receives cash. The CDE through its Sub-CDE must invest “substantially all” of the cash proceeds into qualified low-income community investments (QLICIs). Eligible QLICIs include, but are not limited to, loans to or investments in businesses to be used for developing residential, commercial, industrial, and retail real estate projects.
Historical Tax Credits
Historic rehabilitation tax credits were adopted by Congress to discourage unnecessary demolition of sound older buildings and to slow the loss of businesses from older urban areas. The tax credits encourage private investment in the restoration and rehabilitation of historic properties. The National Park Service (NPS) administers the program in partnership with the Internal Revenue Service (IRS) and State Historic Preservation Offices (SHPOs). The credit was fixed at its current twenty percent (20%) rate in 1986 when Congress amended the federal tax code under President Ronald Reagan. At that time, rehabilitation work on older, non-certified structures built before 1936 qualified for a credit equal to ten percent (10%) of the cost of the work.
Public Law No: 115-97 (Tax Cuts and Jobs Act), which was enacted at the end of 2017 and became effective January 1, 2018, modified the 20% Historic Rehabilitation Tax Credit (HTC), repealed the 10% tax credit for the rehabilitation of non-historic buildings, and provided transition rules for both credits. While the general rule was that the tax credit could be claimed in the year in which the rehabilitated building is placed back into service, The Tax Cuts and Jobs Act amended the statute to provide that the 20% credit for qualified rehabilitation expenditures with respect to a certified historic structure must be claimed ratably over 5 years, beginning in the taxable year in which a qualified rehabilitated structure is placed in service.
The HTC allows developers and investors to take a credit of twenty percent (20%), ratably over 5 years, of the certified rehabilitation costs they incur in renovating historic, income-producing buildings that are determined by the Secretary of the Interior, through the NPS, to be “certified historic structures.”Such structures are identified as any building on the National Register of Historic Places or any building in a registered historic district that the government recognizes as significant to the district. The SHPOs and the NPS review the rehabilitation work to ensure that it complies with the Secretary’s Standards for Rehabilitation. The Internal Revenue Service defines qualified rehabilitation expenses on which the credit may be taken. Projects that qualify encompass a wide range of properties and project types, including offices, hotels, retail stores, warehouses, factories, and rental housing. However, owner‑occupied residential properties do not qualify for the federal rehabilitation tax credit.
Working in conjunction with SHPOs, the NPS must approve all rehabilitation projects seeking to use the HTC as a part of their financing. The rehabilitation must be consistent with the historic character of the property. Owners seeking to claim the HTC must complete a detailed application process and maintain certification throughout the rehabilitation work. As stated above, under the new Tax Cuts and Jobs Act, the owner can claim the HTC ratably over a five-year period. The owner of the building must maintain ownership of the building for five years after completing rehabilitation or be subject to a staggered recapture of the tax credit. In addition, a rehabilitation project must meet several IRS criteria to qualify for the tax credit:
1. The structure must be depreciable;
2. The rehabilitation must be “substantial,” defined as expenditures greater than $5,000;
3. The property must be returned to an income-producing use; and
4. The building must be maintained as a certified historic structure when returned to service.
Low Income Housing Tax Credits
The Low Income Housing Tax Credits (LIHTC) program was created under the Tax Reform Act of 1986 and made permanent in 1993. The LIHTC program is intended to provide incentives for the use of private equity in the development of affordable housing for low-income Americans. The program is administered at the state level. Each state receives an allocation of federal tax credits determined by a formula based on population. The 2018 Omnibus Appropriations Bill recently enacted by Congress and signed by President Trump would provide a twelve and one-half percent (12.5%) increase in LIHTC allocations, starting in 2018 and lasting until 2021. The new 2018 per-capita amount is $2.70 and the new small state minimum is $3,105,000. For 2019-2021, annual inflation adjustments would be applied to the new 2018 allocation amounts. Barring an extension, the LIHTC annual allocation in 2022 would revert to current law, adjusted for inflation. These credits are intended to ensure an attractive minimum rate of return on investments in low-income housing.
The LIHTC program enables funding for the construction of new and rehabilitation of existing structures that will provide affordable housing by allowing a taxpayer to claim federal tax credits for the costs incurred during the development of affordable units in a rental housing project. The program authorizes state housing credit agencies to award nine-percent (9%) tax credits for projects receiving no other federal subsidy, and four percent (4%) credits for projects financed with tax-exempt bonds. Tax credits are available only to help cover the cost of units within qualified projects reserved for rental to low-income households and are used by developers to raise equity capital from investors through syndication for their projects. The equity capital generated from the tax credits prior to the start of a project lowers the debt burden on LIHTC projects, making it easier for owners to offer lower, more affordable rental rates.
The nine-percent and four-percent tax credits are paid annually over a 10-year period. To qualify, a project must have at least 20 percent of its units rented to households whose incomes are at or below fifty percent (50%) of the area median income, or at least forty percent (40%) of its units rented to households whose incomes are at or below sixty percent (60%) of the area median income.
In addition to the allocation cap increase mentioned above, the 2018 Omnibus Appropriations Bill includes a provision from the Affordable Housing Credit Improvement Act (AHCIA, S. 548, H.R. 1661) to create an income-averaging option in addition to the current low-income requirements. Currently, household incomes in LIHTC properties cannot exceed sixty percent (60%) of the area median income (AMI) at move-in. The maximum housing expense (rent, utilities, and required fees) is correspondingly restricted. This provision would allow certain apartments in a LIHTC property to be available to residents earning up to eighty percent (80%) of AMI, so long as the development-wide average is sixty percent (60%) or less.
Allowing income averaging permits a broader mix of incomes and makes developing LIHTC properties attractive in places where it now is difficult, such as:
- high housing cost areas,
- sparsely populated low-income areas, where finding enough renters earning less than 60 percent of the AMI to justify the construction of new property is difficult,
- low-income neighborhoods in need of revitalization, and
- existing developments in need of preservation, but where tenant incomes have risen over the years.
Development capital is raised by “syndicating” the LIHTC to an investor or a group of investors. As these credits are syndicated, developers obtain the equity capital necessary to build or rehabilitate structures for low-income housing. The LIHTC is allocated to investors annually over a 10-year period.
For questions regarding federal tax programs, contact the author Richard E. Fox at ref@barrettlaw.com or directly at (260) 423-8913.