NMTCs provide a low-cost source of capital for most real estate product types located within economically disadvantaged census tracts. New Market Tax Credits are primarily structured as mezzanine debt.
While most product types qualify for NMTC financing, multi-family rental property and “sin” businesses (massage parlors, alcohol vendors, etc.) do not.
NMTC loans can provide up to 100% of value for a 7 year term. Interest is fixed for the term, typically at a rate substantially below market. This unique combination of high leverage and low rate is allowed by a substantial tax credit awarded by the Federal government. The goal is to encourage development in low income areas.
Essentially, the loan is subsidized, and the NMTC lender (or “CDE”) makes a significant portion of their return through the sale of the tax credit income stream. NMTCs are complex to structure, and cannot be pre-paid.
Definition of Terms:
- CDE: Community Development Entity.
- The CDE is the entity that has received an allocation of New Markets Tax Credits. The CDE is the ultimate “lender” in the transaction
- NMTC: New Market Tax Credit.
- An allocation of NMTCs permits a CDE (or the investor in a CDE) to claim a 39% credit against federal tax liability for every dollar that it invests into qualifying investments. The 39% tax credit is recognized over a seven-year time period, at 5% during the first three years and 6% during the last four years.
- QEI: Qualified Equity Investment.
- The equity investment (amount of allocation used) from the Investment Fund into the CDE. It is the investment of the QEI that initiates the flow of tax credits.
- QLICI: Qualified Low Income Community Investment.
- The loan/investment from the CDE to a real estate project is called a QLICI.
- QALICB: Qualified Active Low Income Community Business.
- A borrower must be a QALICB in order to be eligible to receive NMTC financing. Prior to closing, counsel collects due diligence to ensure the borrower is a QALICB. The loan documents require the borrower to remain a QALICB throughout the loan term.
The Tax Credit Investor contributes equity to the Leverage Fund and is the 100% owner of the Leverage Fund. The Leverage Fund has the following entity attributes:
- Disregarded for tax purposes.
- “Special purpose entity”
- No other assets other than its 99.99% ownership of the CDE.
- The Tax Credit Investor is a passive investor and designates a separate entity, and the Fund Lender acts as the active Fund Manager of the Leverage Fund. The Fund Manager does not hold an ownership stake in the Leverage Fund.
The Fund Lender makes a Fund Loan to the Leverage Fund, which is passed through the NMTC structure and is ultimately invested in qualifying NMTC projects. The Fund Loan is secured by a pledge of the Leverage Fund’s 99.99% ownership interest in the CDE.
The CDE acts as the pass-through lender in the transaction and holds customary security instruments in the underlying real estate projects. The CDE has the following entity attributes:
- The entity is regarded partnership for tax purposes.
- The entity is a special purpose entity.
- Due to NMTC program requirements, the entity is mandated to be managed by an affiliate of the CDE; however, the Leverage Fund’s consent is needed for all significant decisions.
Via the controls afforded to the Fund Lender in the Fund Loan Agreement, Leverage Fund Operating Agreement, and Servicing Agreement, the Fund Lender achieves effective control over the QLICI (including authority to enforce the rights of the QLICI).
The Fund Lender typically enters into a Servicing Agreement with the CDE, whereby the Fund Lender will act as Servicer of the QLICI and which sets forth the roles and responsibilities of each party throughout the term of the financing. The Servicing Agreement provides the Servicer with typical rights relating to the collection of debt service payments, monitoring of real estate performance, and taking actions to maintain a perfected lien against the real estate. Like most customary servicing arrangements, and because the NMTC program requires the CDE to report certain aspects of its transaction to the CDFI Fund (an arm of the United States Treasury Department that oversees the NMTC program), the Servicer is typically asked to provide the CDE with monthly reports on its activities, e.g., amounts billed, monies received, etc.
The Fund Lender receives debt service payments on whatever schedule it sets forth in the QLICI loan documents (monthly, semi-annually, annually, etc.). The QLICI loan documents are based off of the Fund Lender’s customary legal documents, and the Fund Lender is able to establish all aspects of loan payments, including payment due date, grace period, late fees, etc.
Due to NMTC program regulations, which prohibit the “return of” principal from the CDE to the Leverage Fund during the seven-year NMTC compliance period, NMTC transactions require the Fund Lender to execute a seven-year forbearance agreement which prohibits the Fund Lender, in the event of default, from foreclosing on its security to collapse the NMTC structure and pursing the underlying collateral. The seven-year forbearance agreement requires the Fund Loan to remain outstanding through the seven-year NMTC compliance period, regardless of what transpires at the CDE level.
NMTCs cannot be used to finance real estate that generates more than 80% of its income from multifamily rental operations or so-called “sin” businesses (massage parlors, casinos, alcohol vendors, golf courses, etc.)