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How Will Modifications to NMTC IRS Regulations Impact Your Non-real Estate Investments?


While investors and Community Development Entities (CDEs) have always been able to make both real estate and non-real estate investments through the New Market Tax Credit program, the program has generally favored real estate investments - as opposed to investments in shorter-term assets such as working capital or equipment loans. However, the NMTC community may be interested in learning about new modifications to NMTC IRS regulations intended to encourage non-real estate investment. Effective for Qualified Equity Investments (QEIs) made on or after September 28, 2012, investors and CDEs need to become familiar with these modifications and understand the challenges that may arise in their practical implementation.

Historically, it has been difficult for CDEs to make working capital or equipment loans to businesses because the term of such loans is typically shorter than seven years while program requirements dictate that NMTC funds remain invested for seven years. Prior to the new modifications to the regulations, principal returned before the end of the seven-year period was required to be reinvested within 12 months to maintain NMTC program compliance—putting investors at risk if the CDE failed to redeploy the funds within this time frame. As a result, many investors strongly favored investments – such as those in real estate - with extended maturity dates. And from the CDE's perspective, it is more cost-effective to recoup transaction costs on a large long-term transaction than on a series of much smaller business loans.

The New Modifications

The new modifications allow CDEs to reinvest a certain amount of funds generated from the repayment of principal from non-real estate investments in other CDEs that are also CDFIs. This provides CDEs with an additional option for redeployment and the added benefit of mitigating the risk of non-compliance due to delayed or non-deployment of returns. The new modifications, however, require the CDE to effectively segregate real estate and non-real estate cash flows if a single purpose entity was not set up for the transaction. To take advantage of the additional reinvestment option, the initial Qualified Equity Investment (QEI) must be designated as a non-real estate QEI by the CDE. Such QEIs must be subsequently invested in non-real estate Qualified Active Low-income Community Businesses (QALICBs) and must meet the “substantially all” test. In order to meet the “substantially all” test, amounts received by the CDE from a non-real estate QALICB for the repayment of principal on a loan or equity must be reinvested in a qualified CDFI no later than 30 days from the date of receipt in order for it to be treated as continuously invested.

The regulations define a non-real estate QALICB as one whose predominant business activity generates more than 50 percent of the business’ gross income from activities other than the development, construction, rehabilitation, management or leasing of real property. The investment may not be used by the non-real estate QALICB in the development, construction, rehabilitation, management or leasing of real estate, nor used to develop real estate for use in its own trade or business.

Once the CDE finds another suitable non-real estate QALICB in which to make a Qualified Low-income Community Investment (QLICI), it may withdraw its investment in the qualified CDFI and reinvest those proceeds no later than 30 days from the date of their receipt from the qualified CDFI. There are, however, limits as to the aggregate amount of a CDE’s non-real estate QEI that may be comprised of investments in a qualified CDFI at any point in the seven-year compliance period.  The aggregate limitations by year and percentage required to be reinvested are as follows:

Amounts received in the seventh year of the compliance period are not required to be reinvested.

A Step in the Right Direction – But is it Enough?

The policy goal of the new modifications is clear: to encourage non-real estate investment necessary for the economic revitalization of low-income communities. However, it is unclear if the recent regulatory changes alone will be sufficient. Three challenges in the practical implementation of the new modifications are immediately apparent:

  1. While compliance risk due to a failure to redeploy principal can now be mitigated, the fixed transaction costs of making loans remain. Such costs include underwriting costs and fees incurred for the agreed-upon procedures that investors rely on to ensure that the businesses receiving investments are indeed qualified. As a result, it may be cost-prohibitive for a CDE to engage in smaller business loan activity.
  2. The commercial financing market is very different from the real estate market and it requires a different set of skills and capabilities in terms of being able to assess and work with clients, correctly value assets and measure risk. And administering what is essentially a revolving loan fund requires a different type of management than overseeing one or two large real estate projects. Not surprisingly, it is challenging for CDEs who do not have experience working with shorter-term loans to manage a stream of more frequent, short-term assets.  
  3. Finally, as CDFIs provide a safety valve for CDEs looking to redeploy returned principal from non-real estate investments, CDFIs’ investment options remain somewhat unpredictable as they are required to return principal amounts on demand to CDEs.


Due to the challenges outlined above, it remains to be seen as to whether additional regulatory changes to promote non-real estate NMTC investment are necessary. CohnReznick looks forward to assisting clients in navigating the modified regulations and in fostering a dialogue on this issue within the NMTC community.

Contact:

For more information, please visit the CohnReznick NMTC webpage or contact one of the following CohnReznick Partners:

Scott Szeliga at 410-783-7472; or
Ira Weinstein at 410-783-8328.

To ensure compliance with the requirements imposed by the IRS, please be informed that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

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