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The New Markets Tax Credit (NMTC) program is a powerful tool for incentivizing private investment in low-income communities across the United States. While much attention is often given to the application, allocation, and investment phases of the NMTC lifecycle, an equally important phase—often overlooked—is the “exit strategy” for NMTC investments.
Investors, Community Development Entities (CDEs), and project sponsors must carefully plan for the end of the NMTC compliance period, typically at the conclusion of the seven-year investment holding period. This blog explores the key considerations and best practices for NMTC exit strategies.
Understanding the NMTC Structure
Before delving into exit strategies, it’s crucial to have a basic understanding of how NMTC investments are structured. The typical NMTC deal involves three primary parties:
1. Community Development Entity (CDE): The intermediary that receives NMTC allocation authority from the U.S. Treasury’s Community Development Financial Institutions Fund (CDFI Fund).
2. Investor: A private entity, often a bank or corporation, that provides equity capital in exchange for NMTCs.
3. Qualified Active Low-Income Community Business (QALICB): The project or business that receives NMTC-subsidized financing or investment.
The NMTC investment typically takes the form of a leveraged structure, where an investor makes an equity investment in a CDE and the CDE makes a loan or equity investment (equity investments are extremely rare) in the QALICB. The investor receives tax credits over a seven-year compliance period, equivalent to 39% of the investment made in the CDE. After the seven-year compliance period ends, an affiliate of the QALICB acquires the investor’s interest in the loans via the put/call structure and the B loan (NMTC equity net of CDE fees) is often forgiven.
Exit at the End of Year Seven
Once the seven-year compliance period ends, the NMTC investor has claimed all the tax credits, and the key question becomes how to exit the structure without triggering a recapture of the credits. Recapture occurs if certain program rules are violated during the seven-year period, so it is essential to avoid any actions that could retroactively invalidate the credits.
Here are common exit strategies that allow for a smooth unwinding of the NMTC transaction:
1. Put-Call Option Agreement
The most widely used exit strategy in NMTC transactions is the “put-call” option, a mechanism typically established at the onset of the investment. This approach involves two key components:
– Put Option: At the end of the seven-year period, the investor has the option to “put” its interest in the CDE back to the original project sponsor or a related party for a nominal amount, often $1,000. This enables the investor to exit the investment structure cleanly.
– Call Option: If the investor does not exercise its put option, the project sponsor has the right to “call” or purchase the investor’s interest at fair market value.
The put-call option is advantageous because it provides flexibility to both parties and mitigates risk. For investors, the put option offers a straightforward exit, while the call option allows the project sponsor to assume ownership of the CDE interest without substantial financial burden.
Considerations:
– Legal and Regulatory Compliance: It is crucial to ensure that the put-call option complies with Internal Revenue Service (IRS) guidelines. Any arrangements perceived as pre-arranged sales or transfers that undermine the risk profile of the investment could trigger a recapture event.
– Documentation: All terms of the put-call option should be clearly documented in the transaction’s legal agreements from the start.
2. Refinancing or Debt Conversion
In a vast majority of NMTC deals, substantially all of the investment (net of CDE fees) is structured as typically two loans from the CDE to the QALICB. One loan being the leveraged source of proceeds (the A loan) and the other being the investor’s tax credit equity net of fees (the B loan). At the end of the compliance period, one exit strategy is for the QALICB to refinance the A loan, either by obtaining new financing from a conventional lender or converting the loan into equity. As noted above, the B loan is often forgiven following acquisition of the loans by an affiliate of the QALICB.
Refinancing Approach:
– The QALICB secures new debt or equity financing to repay the CDE’s loan (typically only the A loan). This strategy allows the business to continue operating with more traditional financing terms while removing the NMTC structure.
– Benefits: The refinancing strategy is attractive when the project or business has demonstrated strong financial performance and can secure financing without the NMTC subsidy.
– Challenges: For projects still in their early stages or in low-income areas where financing options remain limited, refinancing can be difficult.
Debt Conversion:
– If refinancing is not feasible, the QALICB may negotiate to convert the CDE’s loan into equity in the business. This provides the CDE with ownership interest while eliminating the debt obligation for the QALICB.
– Benefits: This strategy is ideal when both parties are willing to extend their partnership beyond the NMTC compliance period.
– Challenges: Due to certain restricting provisions of the tax code, this is only a viable option with the right fact pattern.
3. Sale of the Project or Business
In some cases, the most practical exit strategy is for the QALICB to sell the underlying project or business at the end of the seven-year period. The proceeds from the sale can be used to repay the CDE’s loan, allowing the investor to exit the NMTC structure cleanly. This is typically only considered in real estate transactions not operating businesses or non-profits.
Key Considerations:
– Market Conditions: The timing of the sale will depend heavily on the market conditions in the area and the financial health of the project or business. In some cases, the low-income community may have experienced economic revitalization, making a sale more attractive.
– Tax Implications: The tax consequences of a sale should be carefully considered by both the project sponsor and the investor to avoid unintended tax liabilities.
4. Loan Forgiveness
In many instances, especially in deals where the CDE’s loan to the QALICB is structured as a “soft loan” (with below-market interest rates or long deferment periods), the loan may be forgiven at the end of the compliance period. The loan(s) may be either formally forgiven or as is more often the case, deemed forgiven, when the investor’s interest in the loan is acquired via the put by the QALICB or an affiliate of the QALICB. Internal Revenue Code Section 108(e)(4) and related Regulations generally provide that in cases where a party related to the debtor acquires an obligation of the debtor at a discount, the debtor must recognize cancellation of debt income for the amount of the discount.
Considerations:
– Impact on QALICB: Acquiring the investor’s interest in the loan(s) may create taxable income for the QALICB, so tax planning is essential to ensure that the business is not burdened by unexpected tax liabilities at the time of the exit.
– Negotiation: This strategy typically requires negotiations between the CDE, the investor, and the QALICB. The parties need to be aligned on the objectives and ensure that loan forgiveness does not trigger recapture or tax issues.
QALICB Tax Mitigation:
Assuming the QALICB is a for profit entity (non-profits would not pay tax on debt forgiveness except in the unusual case where the debt forgiveness income is not directly related to the nonprofit’s primary mission or exempt purpose), there are several potential strategies to mitigate the impacts of the cancellation of indebtedness income (COD).
– Qualified Real Property Business Indebtedness (QRPBI): In transactions where the CDE’s loan(s) to the QALICB financed the acquisition or improvement of real property used in the trade or business and the loan is secured by that real property (not an unsecured loan), it is often possible to exclude the gain. To the extent that the QALICB’s QRPBI exceeds the fair market value of the secured property, the QALICB’s owners can make an election to reduce the depreciable basis of their share of depreciable real property in lieu of recognizing their allocable share of the COD as taxable income. This is merely a timing issue but can spread the taxability of the COD over the remaining useful life of the asset rather than at the time of the unwind. This exception is not available to corporate borrowers.
– Cost Segregation Study: Another common tactic (assuming this was not done when the asset was placed in service) is performing a cost segregation study at the time of unwind. These studies done by engineers break down various components of real property and allow for acceleration of depreciation for shorter-life assets that were formerly included in longer-life assets. Cost segregations can provide a deduction in the year of unwind that can offset all or a portion of the COD. As with Qualified Real Property Business Indebtedness, this is a timing issue, but again spreads the COD income over a longer period of time.
– Put to an Unrelated Party: In limited circumstances, the QALICB can transfer the put to an unrelated party and continue to make the loan payments for the life of the loan. This strategy can eliminate the COD income in situations where the QALICB does not have the available funds to pay the tax associated with the unwind.
5. Continued Partnership
In some cases, the NMTC investor may decide to remain involved in the project or business beyond the seven-year compliance period. This could be through retaining equity ownership, entering into a joint venture, or continuing to provide financing to the QALICB.
Key Factors:
– Long-term Viability: This strategy is most appropriate when the project has long-term growth potential, and both the investor and QALICB see value in maintaining the partnership.
– Alignment of Goals: Both parties must have aligned goals and interests for the continued partnership to be successful.
