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Summer 2001 - Federal Reserve Bank of Boston
THE NEW MARKETS TAX CREDIT PROGRAM: MOVING MAINSTREAM CAPITAL TO DEVELOPING COMMUNITIES
by James Carras
Providing capital to low-income urban and rural communities is a key issue for America
in the twenty-first century. Problems holding back investment in urban communities
include prejudice, crime, and poor public education. Rural areas suffer from additional
problems including obsolete industries, population loss, and low educational achievement.
Coupled with these social obstacles, vast changes in the financial servic-es industry
have resulted in the closing of inner-city and rural branch facilities. Despite
these obstacles, successful investment approaches have been identified. In addition,
a substantial federal com-mitment to leverage private capital, known as the New
Markets Tax Credit Program, is working its way through the governmental imple-mentation
The legislation, signed by President Clinton as part of the Community Renewal Tax
Relief Act of 2000, authorizes $15 billion in tax credits for private investments
over the next seven years. New Markets Tax Credits (NMTCs) will have the potential
to enhance capital flow for economic development in "new market" low-
and moderate-income communities ù both urban and rural. The credits are valid
only for investment in commercial enterprises and businesses such as office buildings
or grocery stores; they may not be used for housing, for which the Low-Income Housing
Tax Credit is available.
One reason the program is likely to leverage private investment is because the Community
Reinvestment Act's investment test prompts banks to be proactive in making debt
and investment capital available to low- and moderate-income communities. Often,
private investors make investments in community development projects through intermediaries,
such as community development financial institutions. In the future, these intermediaries
will include a new category of institutions called "community development entities."
NMTCs are available only to private investors in eligible community development
entities. Private investors include corporations, banks, insurance companies, and
individuals. Banks are the most likely users of these tax credits because they are
the predominant investors in community development financial institutions. They
provide these institutions with capital and in turn they receive a return on their
investment, Community Reinvestment Act investment test "credit" and potentially
a Bank Enterprise Act award from the U.S. Treasury Department's Community Development
Financial Institution Fund. A community development entity must have as its primary
mission serving or providing investment capital for low- and moderate-income communities.
These entities must be certified by the Treasury and must maintain accountability
to the community, with either community representatives serving on the entities'
board of directors or in an advisory capacity (the regulations are still under construction).
Community Development Financial Institutions (CDFIs) certified by the Treasury's
CDFI Fund, or by the Small Business Administration as Specialized Small Business
Investment Companies, are automat-ically community development entities. Community
development corporations that establish for-profit subsidiaries or limited-liability
companies or partnerships may also qualify. New corporations or partnerships that
meet the community development mission and community- accountability requirement
may also be eligible. How does the New Markets Tax Credit Program work? Tax credits
will be allocated to community development entities through the Treasury's community
development program - the Community Development Financial Institutions Fund (CDFI
Fund). The allocation process will be competi- tive and community development entities
with successful track records, either directly or through affiliate organizations,
will receive priority. Coastal Enterprises, Inc., a nonprofit community development
corporation and certified CFDI with over twenty years of experience serving Maine,
was designated a community development entity in early July. After a community development
entity has received its allocation, it may distribute the tax credits to its investors.
Investors will receive tax credits based on the amount of their equity investment.
Equity investments (either stock or capital interest) must be paid in cash and made
within five years of the Treasury's tax-credit allocation to the entity. Tax credits
are claimed by investors during seven years, starting on the date of the investment
and on each anniversary; 5 percent is claimed for each of the first three years
and 6 percent for each of the next four years. This stream of credits totals 39
percent, with a present value of approximately 30 percent. (Investors may carry
back unused credits to years ending after January 1, 2001.) Funding of the program
starts at $1 billion in 2001 and rises in increments to an authorized $15 billion
in 2006 and 2007. Community development entities (CDEs) can use tax credit investment
proceeds to fund loans or make equity investments in for-profit and nonprofit businesses
or other CDEs. For example, a CDE could invest in a community development corporation's
project to build a daycare center in a low-income area.
The equity provided by the CDE may then enable the community development corporation
to persuade other investors to support its project. CDEs may also purchase loans
from other CDEs, provide financial counseling and other services, or finance their
own eligible activities. For example, an entity could develop and manage commercial
real estate, such as an office building or shopping center. A community development
entity must use "substantially all" of the tax credit investment proceeds
for the above purposes. When final guidelines are published, the Treasury Department
will define the term "substantially all," which will include at a minimum
any allowances for administrative expenses, loss reserves, and expenses related
to both a start-up period for placing investments and a wind-down period for recovering
investments. In addition, a CDE must track how tax credit investments are used if
less than 85 percent of its gross assets are so invested. Two Treasury divisions
will administer the New Markets Tax Credit program: the CDFI Fund will certify community
development entities and make tax credit allocations and the Internal Revenue Service
will develop regulations. Both the Fund and the IRS will monitor program compliance.
Applications for community development entity certification and allocations of NMTCs
are not expected to take place until late fall 2001; allocations should occur in
2002. Businesses eligible for investment by community development entities must
meet the following four tests: 1. Fifty percent of the business must be derived
from conduct within the low-income community; 2. A substantial portion of the services
performed by the business' employees must occur within the low-income community;
3. The majority of the facilities must be located within the low-income community;
and 4. Less than 5 percent of the business' assets can be held in unrelated investments.
A community is determined to be an eligible low-income community if its census tract
has a poverty rate of at least 20 percent or if the median family income does not
exceed 80 percent of the statewide median; or, in metropolitan areas, if the median
family income does not exceed 80 percent of the greater of the statewide median
or the metropolitan area's median. The Treasury Department may also approve a particular
area within a census tract as a low-income community. Community development programs
such as the New Markets Tax Credit and the CDFI Fund reflect the current mind-set
of utilizing market-driven approaches to revitalize economically distressed communities.
Coupled with economic forces turning to low-income urban communities for retail
opportunities, these capital resources will enhance the ability of community developers
to meet their mission and goals.
What Is the CDFI Fund? The CDFI Fund provides capital and technical assistance to
community development venture capital and loan funds. Through its Core Program,
the CDFI Fund provides grants and loans to bolster investment and loan capital.
The Fund's technical assistance component (known as the Small and Emerging Community
Development Financial Institutions Assistance Program) enables CDFIs to build capacity
through training, enhancing technology, and consulting services. The CDFI Fund also
provides grants to banks for community development investments through the Bank
Enterprise Act Program. Organizations are limited to $5 million in assistance during
any three-year period.
What Is the New Markets Venture Capital Program? The Small Business Administration
offers further support to community development through the New Markets Venture
Capital Program. Passed in December 2000, the program is providing up to $50 million
this year in direct support of community development venture capital companies.
Community development entities can apply for both the New Markets Tax Credit and
Venture Capital Programs.
For More Information New Markets Tax Credit Program
Community Development Financial Institution Fund
New Markets Venture Capital Program
About the Author: James Carras is Principal of Carras Community Investment, Inc.
a consulting firm providing development finance advisory services to regulated and
nonregulated financial institutions. Mr. Carras is also conducting a series of community
development finance workshops for the Federal Reserve Bank of Boston in 2001; the
next are September 26 in Portland, ME and October 24, in Springfield, MA. He can
be reached at firstname.lastname@example.org.
James Carras Carras Community Investment, Inc.