When I first came across tax credit finance at my previous job, I was suspicious. This is a natural tendency when you encounter an idea which you have never been exposed too. But, after educating myself and walking through the underwriting process, I found that tax credit equity solves a lot of unique problems.
So how does this work? First of all, we need to understand what a tax credit is, which of course is a tax break. Say you made $1 million, and you had to pay a 35% income tax on that income. This will mean you have to pay $350,000 to the government! Now, say you went out and bought $350,000 in tax credits so you don’t have to pay taxes at all on the $350,000. This makes sense, so long as your tax credits cost you less than $350,000. So, if you paid $200,000 to buy the tax credits, you now have saved yourself from paying $150,000 in taxes!
Now we understand how tax credits work, but why do we use them in development? Tax credits can be awarded or allocated to projects, so their developers can sell them to raise equity investment. Therefore, the money from the sale of the tax credits is used as an equity injection into the project that had been awarded the tax credits.
Tax credits come in an assorted variety. Historic tax credits (HTCs) are probably the most commonly available. They are awarded in tandem by a state historic preservation office and the National Parks Service. The tax credits are awarded for improving a historic structure, with the caveat that certain historic features must be preserved.
Low income housing tax credits (LIHTCs) are another widely used development tool. Each state’s housing authority is granted the ability to allocate a specified number of LIHTCs each year to develop housing that will serve low income residents.
New market tax credits (NMTCs) are used to support and develop businesses in areas designated as low income. In this respect, they are effectively available to anyone, so long as their project is not primarily residential. Because of this, receiving an NMTC allocation is highly competitive, with demand exceeding supply by a ratio of 10:1.
Various states also have their own tax credit programs too. The tax credits apply to state income taxes and will mimic programs like HTC, LIHTC, and NMTC. There are also tax credits for the development of renewable energy, constructing schools, etc. And the great part about tax credits is, anyone can buy them. It can either be the project developer, or a large faceless corporation faced with a tax liability.
Many lenders shy away from projects that have tax credit equity, because they have trouble understanding how it works. In reality, it may affect some aspect of the loan and foreclosure process, but those issues have solutions that usually don’t affect credit quality substantially.
In the end, if it were easy to understand and execute, everyone would do it. And in a world of growing competition, having a niche that doesn’t come with much measurable risk is always a good advantage to have.