Business

Opportunity Zone Fund's and New Markets Tax Credit's Impact on Construction Contractors

Both programs provide incentives for investors to deploy capital in low-income communities by providing federal income tax benefits that can help lower the cost of capital for for-profit businesses, non-profit organizations and developers in need of funding for projects.
By Michael Schiffer
December 3, 2018
Topics
Business

In assessing the business risk of a development project, contractors likely consider project location, as it may be indicative of project success and result in additional concerns for projects located in low-income communities. As part of the calculus, contractors should consider whether the project will benefit from the financial incentives provided by two federal tax incentive programs: the Opportunity Zone Fund (OZF) program just getting underway during 2018 and the New Market Tax Credit (NMTC) program that dates back to 2000. Both programs reduce project completion risk, while having a relatively minimal impact on contractors.

Both programs provide incentives for investors to deploy capital in low-income communities by providing federal income tax benefits that can help lower the cost of capital for for-profit businesses, non-profit organizations and developers in need of funding for projects.

The OZF program is just getting underway. The essence of the OZF program is to incentivize investors to reinvest capital gains from prior investments into new investments in low income communities and hold those new investments for at least 10 years. Investors in the program potentially realize three distinct federal income tax benefits:

  1. deferral of gain from the sale of a prior investment until the end of 2026;
  2. avoidance of 10 percent of tax on such rollover gain if the investment in the OZF is held five years and 15 percent if held seven years; and
  3. income tax avoidance on future appreciation if held for at least 10 years.

The NMTC program has a well-developed structure, but expires in 2019 (unless extended by Congress as has been done several time in the past). It provides an investor with credits against federal income tax aggregating to 39 percent over a seven year investment period. As the program aligns well with Community Reinvestment Act status for the investments that are desired by financial institutions, the larger financial institutions are the primary investors under this program.

The risk profile of a development project benefiting from these programs is lessened by a few factors. First, the project benefits from a reduced cost of capital. In OZF deals, the significant tax benefits of the program and the relatively short time frame for investors to shelter existing gains under the program are anticipated to drive a significant increase in the short term in capital invested into low-income communities—more capital available equals lower cost. In NMTC deals, the developer benefits from a structure that provides long-term, low-interest debt and the opportunity to have a portion of the debt effectively canceled.

Second, each program requires the applicable investor to be patient capital due to its applicable 10-year (OZF) or seven-year (NMTC) investment horizons. Although both programs allow for reinvestment of capital that would be returned due to a project foreclosure, the investors are wary of having to do so. This patience lowers the risk that the investor would act abruptly in foreclosing on a project before completion.

Third, in NMTC transactions, the investors are cautious in doing diligence on the viability of the project and modeling out that the project has sufficient resources to be completed, which may provide a contractor additional comfort on the project’s viability. While the investor profile and diligence protocols of OZF deals is not yet known, a similar level of caution is expected to be implemented. Finally, in NMTC projects, there is often significant community support removing common delays and barriers to completion.

While these programs reduce the risk profile of a development project, the direct impact on contractors is minimal in NMTC transactions and likely to be minimal in OZF deals. In NMTC transactions, construction contracts are standard construction contracts for financed projects, with only two key differences. A contractor will be required to provide the developer detailed information regarding the number of construction jobs and details of such jobs, such as pay and diversity due to program incentives for demonstrating that projects provide measurable community benefits via job growth.

In addition, NMTC limits on the amount of liquid assets held by a developer participating in the program incentivize participants to desire that construction be completed in a timely manner so that the NMTC funds are expended promptly. While this creates less patience with construction delays, it encourages timely disbursement approval. While OZF transactions typically are not expected to have the information sharing requirements of NMTC deals, OZF program requirements dictate the prompt deployment of invested gains similarly to NMTC deals.

Contractors should take comfort that projects benefiting from either the OZF or NMTC program may have a greater chance of success while not materially impacting the contractors themselves.

by Michael Schiffer
Michael Schiffer, a partner in Venable’s Corporate Practice in the Baltimore office, advises publicly and privately held REITs and other corporations in connection with mergers and acquisitions, corporate governance issues, securities transactions and financings.

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