Proposed regs would facilitate non-real estate investments under new markets tax credit

Preamble to Prop Reg 06/03/2011, Prop Reg §1.45D-1, Preamble to Prop Reg 06/03/2011, IR 2011-61

IRS has issued proposed regs (as well as an advance notice of proposed rulemaking soliciting public comments and an information release) that would allow more investments in non-real estate businesses located in low-income communities to qualify for the Code Sec. 45D new markets tax credit (NMTC). The proposed regs would be effective when published as final regs.

Background. Through 2009, the NMTC has helped to spur $16 billion of investments in approximately 3,000 businesses and real estate projects located in low-income communities throughout the country, including investments in manufacturing businesses, alternative energy companies, charter schools, health care facilities, and job training centers. Although investments may be made in non-real estate businesses, to date they have been made predominantly in real estate projects. Only 35% of NMTC dollars invested in qualified active low-income community businesses were invested in non-real estate businesses, and much of this supported real estate related projects (e.g, purchasing or renovations of owner-occupied facilities).

Under Code Sec. 45D, a taxpayer who holds a qualified equity investment in a qualified community development entity (CDE) may be entitled to a NMTC. The credit is 39% of the qualified equity investment during a 7-year credit period. The investor may claim 5% in each of the first 3 years and 6% in each of the final 4 years. The credit is recaptured if the substantially-all requirement is not met and is not corrected within the one-time 6 month cure period, the CDE ceases to be a CDE, or the CDE redeems or otherwise cashes out the investment.

A CDE is any domestic corporation or partnership (1) whose primary mission is serving or providing investment capital for low-income communities or low-income persons, (2) that maintains accountability to residents of low-income communities through representation on governing or advisory boards of the CDE, and (3) is certified by the Treasury Dept. as an eligible CDE. A qualified equity investment is an equity investment in a qualified CDE if: the investment is so designated by the CDE; the investment is acquired by the taxpayer at its original issue (directly or through an underwriter) solely in exchange for cash; and substantially all (at least 85%, reduced to 75% for the final year of the 7-year credit period) of the cash is used by the qualified CDE to make qualified low-income community investments—including capital or equity investments in, or loans to, any qualified active low-income community business or certain financial counseling and other services to businesses and residents in low-income communities.

The current requirement that a CDE that receives returns on investments (including principal repayments from amortizing loans) reinvest those proceeds in other qualified low-income community investments during the 7-year credit period makes it difficult for CDEs to provide working capital and equipment loans to non-real estate businesses because these loans are ordinarily amortizing loans with a term of five years or less.

New guidance. The proposed regs would allow a CDE that makes a qualified low-income community investment involving a non-real estate business to invest certain returns of capital from those investments in unrelated certified community development financial institutions that are CDEs under Code Sec. 45D(c)(2)(B) (certified CDFIs) at various points during the seven-year credit period. CDFIs are financial institutions that provide credit and financial services to underserved markets and populations. The CDE's reinvestment of returned capital in certified CDFIs would be considered to meet the reinvestment requirements of the new markets tax credit program. The proposed regs would allow an increasing aggregate amount to be invested in CDFIs and treated as continuously invested in a qualified low-income community investment in the latter years of the seven-year credit period—15% in the second year; 30% in the third year; 50% in the fourth year; and 85% in the fifth and sixth years. Amounts received by a CDE in payment of, or for, capital, equity, or principal for a non-real estate qualified active low-income community business during the seventh year wouldn't have to be reinvested. (Prop Reg §1.45D-1(d)(9)(ii))

The proposed regs would define a non-real estate qualified active low-income community business as any business whose predominant business activity (measured by more than 50% of the business' gross income) doesn't include the development (including construction of new facilities and rehabilitation/enhancement of existing facilities), management, or leasing of real estate. The purpose of the investment or loan could not be connected to the development (including construction of new facilities and rehabilitation/enhancement of existing facilities), management, or leasing of real estate. (Prop Reg §1.45D-1(d)(9)(i), Preamble to Prop Reg 06/03/2011)

Comments sought. IRS has also invited comments from the public on how the new markets tax credit program may be amended to encourage non-real estate investments. In particular, IRS requests feedback on streamlined substantiation requirements for second tier CDEs making small loans to non-real estate businesses. (Preamble to Prop Reg 06/03/2011)

References: For the new markets tax credit, see FTC 2d/FIN ¶L-17920; United States Tax Reporter ¶45D4; TaxDesk ¶384,701; TG ¶15550.