The New Markets Tax Credit: The "Forgotten" Incentive
What does the future of economic development incentives look like with so many states facing major budgetary challenges?
In recent years, project managers - for expansions as well as new facilities - have been overlooking the benefits of partnering with a qualified community development entity (CDE) to offset the cost of capital via the federal New Markets Tax Credit (NMTC). While not every project is eligible, those that are may potentially see reduced cost of capital of up to 50 percent.
How the Tax Credit Works
Typically, tax credits and incentives come after a company has had significant up-front cash outlays. While tax credits and incentives are valuable offsets against total project costs, what if you could reduce total project costs overall? By reducing the cost of debt interest, thereby limiting cash outflows for the project itself, a project is more likely to survive the first few years.
Capital market rates are computed on a project-by-project basis utilizing multiple factors, including but not limited to credit score, type of financing, and location of the project. While it is good business sense for lenders to pursue self-sufficient projects with little or no risk, the NMTC is designed to provide eligible lenders an incentive to offset the cost of doing business in low-income communities (LICs).
Since its inception in December 2000, the U.S. Congress has promoted the NMTC as an economic development catalyst for LICs across the country. It is designed to provide a federal tax credit (IRC Sec. 45D) to investors of CDEs, which in turn utilize investor funds to make below-market financing available in LICs. Congress believed the reduced cost of capital would reduce the number of business failures within LICs and spur additional investment.
To offset the reduced return rate and risk factors associated with projects in LICs, eligible CDE investors receive a 39 percent tax credit over a seven-year allowance period. Thus, the credit subsidizes the investor's risk and provides a significant return for pursuing LIC projects. As an example, if the project is eligible, the cost of capital can be 200 to 500 basis points lower over the first seven years of the project. From a cash-flow projection, this benefit far outweighs the benefits of other incentives. Although approximately 30 percent of existing census tracts in the United States qualifying for this program (most rural areas qualify), business leaders continually overlook this program.
The following real-world examples highlight the benefits of the NMTC. Each project was unable to move forward due the prohibitive nature of the respective cost of capital. Each project's cost of capital was based on its corresponding financial projections, proposed location of the site, credit score, etc. After exhausting the normal capital markets, the projects were able to find "affordable" capital via a NMTC lender. These projects highlight that not every project will be able to utilize NMTC funds, but those that can will have access to a lower cost of capital (financing or refinancing).
Case Study: Georgia
The first project was an expansion of a rural Georgia manufacturing/warehouse facility. The company had a long history in the community, but due to its rural location, traditional financial institutions bypassed the project to pursue projects in other areas such as Atlanta. Based on the size of the project, the local financial institution, with which the company had a 20-year relationship, determined it was unable to lend such a large amount.
After careful review with multiple lenders, the company was able to establish the cost of capital for the $10 million project as 8 to 10 percent. The cost of capital for similar projects in non-rural areas was significantly lower. Over the first seven years, the company determined the cost of interest via an interest-only repayment schedule would exceed $5,600,000. Thus, those lenders willing to provide funding would have charged such exorbitant rates/fees that it precluded the project from moving forward; the cost of capital for the project was economically infeasible.
After reaching out for assistance, the company was notified the project site was within an eligible LIC, thereby making the project eligible to partner with a NMTC lender, the CDE. After several weeks of discussions with various NMTC lenders, the project was offered financing on similar terms (interest only with balloon payment or gradual interest/principal payment) with a reduced interest rate of 4 percent. The reduced cost of capital provided almost $3,000,000 in savings. The reduced cash-flow requirements of the loan created long-term sustainability for the project.
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