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As real estate investors, we're always on the lookout for opportunities and incentives to grow and scale our portfolios. Various programs, including 1031 exchanges, opportunity zones, and affordable housing incentives, all allow us to optimize our liquidity. The New Markets Tax Credit (NMTC) is no different, and it's not discussed enough within real estate investing circles.
Here's an overview of the New Markets Tax Credit, the pros and cons of using credits like this, and whether real estate investors should try to get in on the action.
Overview: The New Markets Tax Credit
The New Markets Tax Credit (NMTC) is sponsored by the Treasury Department through the Community Development Financial Institutions (CDFI) fund. This credit aims to incentivize economic growth and community development in "distressed communities." According to its website, the NMTC has generated $8 of private investment for every $1 of federal spending, financed over 5,400 businesses, and created 178 million square feet of retail, office, and manufacturing space.
In short, the NMTC program seeks to stop disinvestment in struggling local economies and, since its inception in 2000, has allocated $27 billion in tax credits. Investments that meet the NMTC criteria will provide tax credits applied to federal returns.
How does the New Markets Tax Credit work?
Investors are to provide capital to what is called a Community Development Entity (CDE). According to the Treasury Department, a CDE is "A domestic corporation or partnership that is an intermediary vehicle for the provision of loans, investments, or financial counseling in low-income communities. Certification as a CDE allows organizations to participate either directly or indirectly in the New Markets Tax Credit Program."
Once approved, the NMTC program awards tax credits to investors through CDEs, who can apply the credit on their federal tax return. Investors can claim 5% of the specified investment amount for each of the first three years and 6% for each of the remaining four years. This gives a tax credit incentive of 39% of the total amount invested.
Simply put, once a CDE is approved, they can allocate tax credits to investors who can then use those tax credits for their annual federal tax returns.
What types of real estate investments can NMTCs facilitate?
The NMTC program can facilitate most types of real estate investments and businesses -- referred to as Qualified Active Low-Income Community Businesses (QALICBs). QALICBs are then used to finance anything from business equipment to operations to even real estate. For real estate investors, this program can be used to finance a real estate transaction, such as a development or rehab. This can include assets such as housing, manufacturing, or retail developments, to name a few.
According to The Urban Institute, the following is an overview of the types of assets invested in through the NMTC program.
But wait; how is the New Market Tax Credit different from an opportunity zone?
Although similar, there are some key differences between the NMTC and opportunity zone programs. The primary difference is that the NMTC program requires Congressional appropriation on an annual basis and is approved via the Treasury Department and the CDFI staff.
Conversely, an opportunity zone does not require annual approval and is more of an Internal Revenue Service (IRS) rule than a program overseen by a government entity. Further, an opportunity zone affects capital gains on an investment, whereas the NMTC directly applies to a federal tax return of an investor on the amount invested.
What qualifies as a low-income community?
According to the IRS, a low-income community is as follows: "Any population census tract where the poverty rate for such tract is at least 20% or in the case of a tract not located within a metropolitan area, median family income for such tract does not exceed 80[%] of statewide median family income, or in the case of a tract located within a metropolitan area, the median family income for such tract does not exceed 80% of the greater of statewide median family income or the metropolitan area median family income."
Further, the American Jobs Creation Act of 2004 amended the definition to state that "targeted populations" are also treated as low-income communities. According to the IRS: "The term 'targeted population' ... means individuals, or an identifiable group of individuals, including an Indian tribe, who (A) are low-income persons; or (B) otherwise lack adequate access to loans or equity investments."
The New Markets Tax Credit: The process
It's important that investors consult with their appropriate accounting and legal professional team members as they look to explore the NMTC opportunity. What follows is the process of executing an NMTC program from a real estate investor's perspective. Keep in mind that this may vary depending on qualification and location.
- A Community Development Entity (CDE) is formed.
- An NMTC Allocation Application is submitted by the CDE.
- Once approved, the CDE receives tax credit allocations.
- The CDE can then source those allocations to private investors.
- Private investors place their money based on tax credit allocations received.
Keep in mind there are timeframes and deadlines, so please consult the CDFI website for more details.
New Markets Tax Credit FAQs
Why was the New Markets Tax Credit developed?
To help incentivize businesses and investments into low-income and disadvantaged economies in the U.S.
Who benefits from the New Markets Tax Credit?
Local businesses such as retailers, manufacturers, and housing investors and developers who can become CDEs and allocate tax credits to private investors. This helps struggling economies incentivize investment into a range of local businesses, including real estate.
How do investors use the New Markets Tax Credit program to transform low-income communities?
The NMTC tax credits can be used to attract private capital to an array of business and investment projects within a low-income community. Investors can apply these tax credits to their federal tax return, and businesses in these local communities (the CDEs) receive investment capital to help with gentrification, operations, and business expansion.
What are community development entities (CDEs)?
What can New Market Tax Credits be used for?
Once a CDE receives NMTC allocations, they can be distributed to private investors in a particular NMTC-qualified project. The investors then use these tax credits against their annual federal tax returns. Tax credits can only be used for this purpose.
How has the NMTC generated opportunities in communities?
According to the Urban Institute, the NMTC has supported over 5,300 projects in all 50 states, provided $27 billion in tax incentives for investors in low-income communities, and 75% of funding pledges recently have been for "severely distressed" communities.
Does the NMTC program expire?
Yes, it is set to expire at the end of 2020; however, Congress has extended it already a number of times and is expected to do so in the future.
What is the formula for the New Markets Tax Credit?
According to the CDFI: "The allowable credit is determined as a percentage of your investment. The available credit is computed as the sum of the current year allowable credit and the carryforward of credit from the previous year. The credit claimed is the amount used to reduce the taxpayer's tax liability."
Is there a limit on the New Markets Tax Credit?
Eligible investors in CDEs are allowed to claim 5% of the specified investment for each of the first three years and 6% for each of the remaining four years.
The bottom line
Clearly, the NMTC program can be a powerful tax incentive if your chosen investment location qualifies as a low-income community. The NMTC allows investors to gain a direct tax credit for seven years following an investment, culminating in a total credit on the amount invested of 39%.
It's critical when considering the NMTC tax incentive that investors consult with their professional real estate accountant as well as a lawyer to ensure that all qualifications are met and guidelines are followed.
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